Chapter 3: Adjusting The Accounts Flashcards
Qualities of Useful Financial information
- Comparable
- Verifiable
- Understandable
- Consistent
- Timely
Relevance (for Financial information)
Financial Information must:
- Make a difference in a business decision
- Have predictive and/or confirmatory value
- Be material to the business (of a size that it is likely to matter to an investor or creditor)
Cost Constraint
When determining accounting standards those setting standards weigh the cost companies will incur to provide the information against the benefit of the information to financial statement users
Full Disclosure Principle
Requires that companies disclose all circumstances and events that would make a difference to financial statement users
Residual Value
Expected value of a depreciable asset at the end of its natural life
Adjusting Entries
- Ensure that the revenue recognition and matching principles are followed (expense recognition)
- Required every time financial statements are prepared
- Will always include one income statement and one balance sheet account
Contra Account
Account paired with a listed immediately after it’s related account in the chart of accounts and on the financial statements
normal balance is opposite of the normal balance of its related account
Worksheet
An internal document that helps summarize data for the preparation of financial statements.
Generally in excel
Sections:
1) Account Names
2) Unadjusted Trial Balance
3) Adjustments
4) Adjusted Trial Balance
5) Income Statement
6) Balance Sheet
7) Net Income or Loss
Depreciation
The process of allocating the cost of an asset to expense over its useful life
Accumulated depreciation is a contra-asset account
NOT an attempt to report the accurate change in (fair market) value. Allocation, not valuation
Book Value
The difference between the cost of an asset and its accumulated depreciation (remaining value)
Accrual Accounting
As opposed to cash-basis accounting
- Revenue increased when company performs work, not when it receives payment
- Expenses increase when company INCURS expenses, not when expenses are paid
Transaction recorded when events occur - not when they are paid for
Required per GAAP and IFRS
Cash-Basis Accounting
As opposed to Accrual Accounting
- Revenue increases when cash is received / Expenses increase when cash is paid out
NOT in accordance with GAAP
Revenue Recognition Principle
Emphasizes when obligations are satisfied
Companies recognize revenue in the accounting period in which it is earned
5 steps:
1) identify the contract
2) identify the performance obligations
3) determine the transaction price
4) allocate the transaction price to the obligations
5) recognize revenue when obligations are satisfied
Matching Principle
Also: Expense Recognition Principle
Per GAAP must match expenses with revenues in the period where the company makes the effort to generate those revenues (recorded when incurred)
Temporal Distortion:
If expense period is shorter than revenue period: earnings understated in early years, overstated later
if expense period is longer than revenue period:
earnings overstated in early years, understated later
Adjusting Entry for Accrued Expenses
Debit Expense account (increase)
Credit Liability Account (increase)
If not adjusted expenses are understated, liabilities understated
shows expenses incurred but not yet paid for
Adjusting Entry for Accrued Revenue
Debit Asset Account (increase)
Credit Revenue Account (increase)
Revenues earned but not yet received payment for
If not adjusted: Assets and revenues understated
Statement results if Accrued Revenues Not Adjusted
Assets understated
Revenue understated
income statement: revenues understated, net income understated
balance sheet: assets understated, equity understated
Accrued Revenues account
Revenue earned by not yet received - an Asset Account
Permanent account
If Accrued Expenses are Not Adjusted
Expenses understated
Liabilities understated
Income Statement: Expenses understated, net income overstated
Balance Sheet: Liabilities understated, equity overstated
Accrued Expenses Accounts
Expenses accrued but not yet paid - liability account
Permanent account - shown on balacne sheet
Unearned Revenue account
AKA Deferred Revenue
Considered a liability - payment collected in advance of services
Permanent account
When cash received:
Debit Cash (increase)
Credit Unearned Revenue (increase)
Adjusting Entry for Unearned Revenues
Debit Liability Account (decrease)
Credit Revenue account (increase)
done once revenue has been earned (time passed/ services provided)
If unearned revenue is not adjusted
Liabilities overstated
Revenues understated
Income statement: Revenues understated, net income overstated
Balance sheet: liabilities overstated, equity understated
If prepaid expenses not adjusted
Assets overstated
Expenses understated
Income statement: Expenses understated, net income overstated
Balance Sheet: assets overstated, equity overstated
Adjusting Entry for Prepaid Expenses
prepaid expense = asset, adjusted due to use of asset or passage of time
Debit Expense Account (increase)
Credit Asset Account (prepaid expense)(decrease)
accounts like supplies are adjusted by inventory
Adjusting Entry for Accumulated Depreciation
Accumulated depreciation is a contra-asset account , always appears immediately after the account it affects on the balance sheet
Debit Depreciation Expense (increase)
Credit Accumulated Depreciation (increase)
Essentially a prepaid expense
Property, Plant and Equipment
Also: Fixed assets or plant assets
Assets with long useful lives that are currently used for business operations (not investments)
Depreciation allocates costs over useful years
Accumulated depreciation = depreciation thus far expensed, listed as a single quantity after listed PPE assets
(Land is not depreciated)
Prepaid Expenses
AKA Deferred Expenses (because recognition is deferred)
considered an asset
- Payment of expenses that will benefit more than one accounting period.
- Permanent account
Debits asset account, credits asset or liability account
Adjusted Trial Balance
Second trial balance prepared after adjusting entries are journalized / posted
Proves debits = credits Income statement (1st), Owner's Equity statement (2nd) and Balance sheet (3rd) are prepared from the adjusted trial balance
Depreciation on balance sheet
Included under asset section
Asset
Less: Accumulated depreciation
= net asset
Straight Line Method
Depreciation formula
= (asset cost - residual value)/ useful life
usually measured in years
Interest
Amount of interest = principal x rate x times
Time is expressed as a fraction of a year in months or in days.
