Ch. 3 The Financial Reporting Process

Question 1

Accrual-basis accounting

Answer 1

Record revenues when earned (the revenue recognition principle) and expenses with related revenues (the matching principle)

Question 2

Revenue recognition principle

Answer 2

• Record revenue in the period in which it’s earned.

- Not necessarily in the period in which we receive cash.

Question 3

Matching Principle

Answer 3

• Recognize expenses in the same period as the revenues they help to generate.
• Cause-and-effect relationship between revenue and expense recognition.
• In a given period, we report revenue as it is earned, according to the revenue recognition principle.
• It’s logical, then, that in the same period we should also record all expenses incurred to generate that revenue.
• Expenses include those directly and indirectly related to producing revenues.

Question 4

Cash-basis accounting

Answer 4

• Record revenues at the time cash is received and expenses at the time cash is paid.
• Because cash-basis accounting violates both the revenue recognition principle and the matching principle, it is generally not accepted in preparing financial statements.
• Over the life of the company, accrual-basis net income equals cash-basis net income. The difference is in the timing of when we record revenues and expenses.

Question 5

Adjusting entries

Answer 5

• Entries used to record events that occur during the period but that have not yet been recorded by the end of the period.
• 2 broad categories:
  * Prepayments (prepaid expenses, unearned revenue)
  * Accruals (accrued expenses, accrued revenues)
• We need to bring several of the accounts up-to-date.
• You adjust downward the balance of the asset (prepaid insurance) and record expense for the amount that has lapsed.
• Prevents assets and net income form being overstated and expenses being understated.
• Necessary part of accrual-basis accounting

Question 6

Prepaid expenses

Answer 6

The costs of assets acquired in one period that will be expensed in a future period.

Question 7

Contra account

Answer 7

An account with a balance that is opposite, or “contra,” to that of its related accounts.

• Contra Asset
  
  • accumulated depreciation
  • allowance for uncollectible (or doubtful) accounts
• Contra Revenue
  
  • sales discounts
  • sales returns
  • sales allowances

Question 8

Unearned revenues

Answer 8

When a company receives cash in advance from a customer for products or services to be provided in the future.

Question 9

Accrued expense

Answer 9

When a company has incurred an expense but hasn’t yet paid cash or recorded an obligation to pay.

Question 10

Accrued revenue

Answer 10

When a company has earned revenue but hasn’t yet received cash or recorded an amount receivable.

Question 11

Adjusted trial balance

Answer 11

A list of all accounts and their balances after we have updated account balances for adjusting entries.

Question 12

Classified balance sheet

Answer 12

Balance sheet that groups a company’s assets into current assets and long-term assets and that separates liabilities into current liabilities and long-term liabilities.

Question 13

Operating cycle

Answer 13

• The average time between purchasing or acquiring inventory and receiving cash proceeds from its sale.
• For nearly all firms, the operating cycle is shorter than one year.

Question 14

Temporary accounts

Answer 14

All revenue, expense, and dividend accounts; account balances are maintained for a single period and then closed (or zeroed out) and transferred to the balance of the Retained Earnings account at the end of the period.

Question 15

Permanent accounts

Answer 15

All accounts that appear in the balance sheet; account balances are carried forward from period to period.

Question 16

Closing entries

Answer 16

• Entries that transfer the balances of all temporary accounts (revenues, expenses, and dividends) to the balance of the Retained Earnings account (permanent account)
• Hears how:
• All revenue accounts have a credit balance. To transfer these balances to the retained earnings account, we debit each of these revenue accounts for its balance and credit retained earnings for the total.
• All expenses/dividend accounts have a debit balance. So we credit each of these accounts for its balance and debit retained earnings for the total.

Question 17

Post-closing trial balance

Answer 17

• A list of all accounts and their balances at a particular date after we have updated account balances for closing entries.
• Helps to verify that we prepared and posted closing entries correctly and that the accounts are now ready for the next period’s transactions.
• Does not include any revenues, expenses, or dividends, because these accounts all have zero balances after closing entries.

Question 18

Exception to Matching Principle

Answer 18

• Advertising cost: this is recorded as an expense in the period the as are provided.
• This is done because it is difficult to determine in which period(s), if any, revenue will occur.

Question 19

Accounting Cycle

Answer 19

1. Measurement Process
   
   • External Transactions (6 steps) (record and post)
   • Adjusting Entries (record and post)
2. Reporting Process
   
   • Adjusted Trial Balance
   • Prepare Financial Statements
3. Closing Process
   
   • Record and post closing entries

Question 20

Prepayments

Answer 20

• One of 2 broad categories of adjusting entries
• Create future benefits
• Expire in future periods
• Rent, Insurance, Supplies, Equipment (depreciable asset)
  
  • Prepaid Expenses
  • Unearned Revenues

Question 21

Depreciation

Answer 21

• Process of allocating the cost of an asset, such as equipment to expense.
• Depreciation is an estimate based on expected useful life, and is an attempt to allocate the cost of the asset over the useful life.
• (ie. at the time of purchase of $24,000 equipment on January 1, Eagle estimates the equipment will be useful for the next 5 years (60 months)

January 31
Depreciation Expense ………………… 400
Accumulated Depreciation ………………… 400
($24,000 / 60 months = 400)

Question 22

Accumulated Depreciation

Answer 22

• Contra Asset Account.
• Accumulated Depreciation is an asset. But unlike normal asset accounts, it has a credit balance.
• Accumulated Depreciation is subtracted when calculating total assets.
• In depreciation, we don’t reduce equipment directly by crediting the asset account itself.
• Instead we reduce the asset indirectly by crediting accumulated depreciation

Question 23

Book Value

Answer 23

• Original cost less accumulated depreciation.

- In the balance sheet, we report equipment at its current book value.

Question 24

Unearned Revenue Apple

Answer 24

• Most of Apple’s Unearned Revenue comes from sales of the iPhone.
• When you purchase an iPhone, Apple does not immediately record revenue from the sale.
• Instead, the company spreads this revenue over the next 24 months (the life of a typical iPhone contract).
• If you purchase an iPhone today, Apple initially records the entire sale as unearned revenue and then begins to recognize revenue (and decrease unearned revenue) as the company earns this revenue each month for the next 24 months.

Question 25

Accrued Salaries Adjusting Entry

Eagle pays total salaries to employees of $100 per day. For the 1st 4 weeks Eagle pays $2,800 cash to employees. For the remaining 3 days in January, employees earn additional salaries of $300, but Eagle doesn’t plan to pay the employees until the end of the week, Feb. 4. However Eagle must record the $300 salaries expense in the month employees worked (January). Stated differently, the salaries expense accrues during January even though the company won’t pay the expense until Feb.

Answer 25

January 31
Salaries Expense ……………………………. 300
Salaries Payable ……………………………………… 300

Question 26

Salaries Adjusting Entry and Transaction

Fighting Irish Incorporated pays its employees $4,200 every 2 weeks ($300 per day). The current 2-week pay period ends on December 28, 2012, and employees are paid $4,200. The next 2-week pay period ends on January 11, 2013, and employees are paid $4,200.

Record the adjusting entry
Record the payment of salaries

Answer 26

December 31
Salaries Expense …………………………………. 900
Salaries Payable ………………………………………….. 900
($300 x 3 days = 900)

January 11
Salaries Expense ………………………………… 3,300
Salaries Payable ……………………………………. 900
Cash ……………………………………………………………… 4,200
($300 x 11 days = 3,300)

Question 27

Accrued Utility Costs

At the end of January Eagle receives a Utility bill for $960 associated with operations in January. Eagle plans to pay the bill on February 6. Even though it won’t pay the cash until Feb. Eagle must record the utility costs for Jan. as an expense in Jan. The firm records the corresponding obligation to the utility company at the same time.

Answer 27

January 31
Utilities Expense ……………………………. 960
Utilities Payable …………………………………….. 960

February 6
Utilities Payable …………………………….. 960
Cash ……………………………………………………… 960

Question 28

Accrued Interest

Eagle borrows $10,000 from the bank to begin operations. Assume the bank charges Eagle annual interest of 12% (or 1% per month) on the borrowed amount. Interest is due by the end of the year, but repayment of the $10,000 borrowed is not due for 3 years. By the end of the 1st month, the loan has accrued interest of $………… calculated as follows…

Answer 28

• Amount of note Payable ($10,000) x Annual interest rate (12%) x Fraction of the year (1/12) = Interest ($100)*
  or
  -Amount of note Payable ($10,000) x Monthly interest rate (1%) x Number of Months (1) = Interest ($100)
• Notice that we multiplied by 1/12 to calculate the interest for one month (out of 12). If we had calculated interest for a 2 month period, we would have multiplied by 2/12, for 3 months we would have multiplied by 3/12….

January 31
Interest Expense ………………………………. 100
Interest Payable ………………………………………100
($10,000 x 12% x 1/12 = 100)

December 31
Interest Expense ………………………………. 1,100
Interest Payable …………………………………. 100
Cash ……………………………………………………….. 1,200
($10,000 x 12% x 11/12 = 1,100)

Question 29

Interest Receivable (Flip side)
Bank records this entry

Answer 29

Calculated the same way as interest payable:
($10,000 x 12% x 1/12 = 100)

January 31
Interest Receivable ……………………………. 100
Interest Revenue ………………………………………100

Question 30

No Adjustment Necessary

Answer 30

• No adjustments are made for the sale of common stock and the payment of dividends.
• Neither of these transactions involves the recognition of revenues or expenses.
• Similarly transactions in which we (1) receive cash at the same time we earn revenue or (2) pay cash at the same time we incur an expense will not require adjusting entries.
• Adjusting entries will never include the cash account.

Question 31

Retained Earnings in the Adjusted Trial Balance

Answer 31

• In the adjusted trial balance, the balance of the retained earnings account is its balance at the beginning of the accounting period-the balance before all revenue, expense, and dividend transactions.
• Ending retained earnings = its beginning balance plus the effects of all revenue and expense transactions (net income) less dividends.

Question 32

Closing entries serve 2 purposes

Answer 32

1. Update the balance in the Retained Earnings account to reflect transactions related to revenues, expenses, and dividends in the current period.
2. We reduce the balances of all revenue, expense, and dividend accounts to zero so we can start from scratch in measuring these amounts in the next accounting period.

Question 33

Closing Entries Illustration

Answer 33

a) Service Revenue ………………………………. 6,360
Retained Earnings …………………………………….. 6,360
b) Retained Earnings …………………………….. 5,860
Supplies Expense ………………………………………… 800
Rent Expense ……………………………………………….. 500
Depreciation Expense …………………………………. 400
Salaries Expense ……………………………………….. 3,100
Utilities Expense …………………………………………… 960
Interest Expense …………………………………………… 100
c) Retained Earnings ……………………………….. 200
Dividends ……………………………………………………… 200

Question 34

Posting to Retained Earnings Account

Answer 34

Retained Earnings
---------------------------
              I       0
              I       6,360
5,860    I
   200    I
------------I--------------
              I        300
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