Chapter 4: Adjusting Revenues and Expenses Flashcards
Accounting Cycle
Definition: Accounting cycle is the process used by entities to analyze and record transactions, adjust records, prepare financial statements, and prepare for the next cycle.
Steps: Analyze and record transactions, adjust records for reliable balances, prepare financial statements, and prepare for the next cycle.
Importance: Provides accurate and reliable financial information for decision-making.
Recording Transactions
Process: Transactions are recorded in the general journal in chronological order (journal entries).
Update: Related accounts are updated in the general ledger using T-accounts.
Illustration: Similar to the Gildan illustrations in Chapters 2 and 3.
Purpose: Tracks exchanges of benefits and obligations with external parties.
End-of-Period Steps
Focus: Primarily on adjustments to record revenues and expenses in the proper period.
Updates: Statement of financial position accounts are updated for reporting purposes.
Goal: Ensure accurate representation of the company’s financial position.
Preparation: Essential for preparing reliable financial statements.
4.1: The Accounting Cycle
Purpose of Adjusting Entries
Purpose: Adjusting entries are made at the end of every accounting period to update revenues and expenses, ensuring accurate financial reporting.
Necessity: Addresses differences in timing between cash transactions and when revenue is earned or expenses are incurred.
Principles: Follows the revenue recognition principle (recording revenues when earned) and expense recognition principle (recording expenses when incurred).
Asset Reporting: Assets reported at amounts representing probable future benefits at the end of the period.
Liability Reporting: Liabilities reported at amounts representing probable future sacrifices of assets or services owed at the end of the period.
Adjustment Process
Timing: Adjustments made at the end of the accounting period.
Reason for Timing: Daily adjustments would be costly and time-consuming; necessary for preparing financial statements.
Accounts Affected: Almost every account except cash might require adjustment.
Focus: Understand general types of adjustments and the process used to determine how to adjust accounts.
Avoid Memorization: Focus on learning the general principles and processes rather than memorizing specific examples.
Step 1: Recognizing Unrecorded Revenue
Question: Was revenue earned that is not yet recorded?
Action (If YES): Increase the revenue account. Credit the revenue account in the adjusting entry.
Purpose: Ensures revenue is properly accounted for in the correct period.
Step 2: Dealing with Cash Received and Future Receipts
Question: Was the related cash received in the past or will it be received in the future?
If Cash Received in the Past: Reduce (debit) the liability account (usually deferred revenue). Company fulfills obligations to the customer, decreasing its liability.
If Cash Will Be Received in the Future: Increase (debit) the receivable account (e.g., interest receivable) to record amounts owed by others (creates accrued revenue).
Purpose: Aligns cash transactions with revenue recognition, ensuring accurate financial reporting.
Step 3: Recording Adjusted Revenue
Action: Compute the amount of revenue earned and record the adjusting entry.
Variability: Amount may be given, computed, estimated, or known.
Accuracy: Ensures accurate representation of earned revenue in financial statements.
Relevance: Reflects the economic reality of the transactions, aiding decision-making processes.
Step 1: Recognizing Unrecorded Expenses
Question: Was an expense incurred that is not yet recorded?
Action (If YES): Increase the expense account. Debit the expense account in the adjusting entry.
Purpose: Ensures expenses are accurately reflected in the appropriate accounting period, aligning with the matching principle.
Step 2: Dealing with Cash Payments and Future Payments
Question: Was the related cash paid in the past or will it be paid in the future?
If Cash Paid in the Past: Reduce (credit) the asset account (e.g., supplies or prepaid expenses) recorded in the past. The asset has been used, decreasing its value.
If Cash Will Be Paid in the Future: Increase (credit) the payable account (e.g., interest payable or wages payable) to record the company’s obligations to others (creates accrued expenses).
Purpose: Aligns cash transactions with expense recognition, ensuring accurate financial reporting and adherence to the matching principle.
Step 3: Recording Adjusted Expenses
Action: Compute the amount of expense incurred and record the adjusting entry.
Variability: Amount may be given, computed, estimated, or known.
Accuracy: Ensures accurate representation of incurred expenses in financial statements.
Relevance: Reflects the economic reality of the transactions, providing a true financial picture of the company’s operations.
Note: Cash is never included in any adjusting entry, as it was recorded already in the past or will be recorded in the future, ensuring proper cash flow management and accurate financial reporting.
Figure: Adjusting Entry Pattern
4.2: Four types of Adjustments
Key Adjustments: Revenue and Expense Accounts
Adjustment Principle: Revenues and expenses are increased in adjusting entries to align with the accrual accounting method.
Focus: Ensures accurate matching of revenues and expenses to the correct accounting period.
Impact: Reflects the economic reality of business operations, providing a true financial picture of Gildan’s performance.
Exclusion of Cash in Adjusting Entries
Rule: Cash is never included in an adjusting entry.
Rationale: Cash transactions are already recorded or will be recorded in future entries.
Accuracy: Ensures proper cash flow management and accurate financial reporting, separating cash transactions from adjustments
Deferred Revenues: Definition
Definition: Deferred revenue is a liability representing prepayments made by customers for goods or services that a company has yet to provide.
Recording: When a customer pays in advance, the company records the cash received in a deferred revenue account.
Recognition: Revenue recognition is deferred until the company fulfills its obligation by delivering goods or services.
Adjusting Deferred Revenues: Gildan’s Example
Scenario: Gildan received $12 in advance from a wholesale distributor for renting warehouse space for a year.
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Steps:**
Earned Revenue: Gildan earned $1 during the current period by providing the warehouse space.
Cash Received: Cash was received in the past and recorded in the deferred rent revenue account.
Adjustment Entry: Reduce the deferred rent revenue account by $1 to reflect the earned revenue.
Other Examples of Deferred Revenues
Examples: Magazine subscriptions, season tickets, plays, concerts, and advance airline ticket sales.
Adjusting Entries: Required at the end of the accounting period to recognize revenue earned by fulfilling contract terms.
New Accounts: When creating new accounts for deferred revenues, name them appropriately (e.g., deferred ticket revenue, deferred subscription revenue).
Adjusting Entry Format
Entry Type: Adjusting Entry.
Accounts Affected: Liability account (e.g., deferred rent revenue) and Revenue account (e.g., rent revenue).
Purpose: To recognize revenue earned during the period and reduce the liability representing unfulfilled obligations.
Accuracy: Ensures accurate financial reporting by matching earned revenue with the appropriate accounting period.
Accrued Revenues: Definition
Definition: Accrued revenues are revenues that have been earned but not yet recorded because the cash payment has not been received.
Scenario: Companies provide services or goods before customers pay, necessitating the recognition of revenue before cash is received.
Adjusting Accrued Revenues: Gildan’s Example
Scenario: Gildan sold merchandise on account for $10 on January 31, but sales invoices were not recorded.
Steps:
Earned Revenue: Revenue of $10 was earned in January but not yet recorded due to pending payment. Accrue revenue.
Future Payment: Cash will be received in the future, indicating the need to increase accounts receivable.
Adjustment Entry: Increase the revenue account and accounts receivable to reflect the earned revenue and pending payment.
Other Examples of Accrued Revenues
Examples: Interest on notes receivable, rent of facilities not yet received in cash by the end of the accounting period.
Adjusting Entries: Required to recognize revenue earned during the period, even if cash payment is pending.
Accuracy: Ensures accurate financial reporting by recognizing revenue in the appropriate accounting period.
Adjusting Entry Format
Entry Type: Adjusting Entry.
Accounts Affected: Asset account (e.g., accounts receivable) and Revenue account (e.g., sales revenue).
Purpose: To recognize revenue earned during the period and increase the corresponding asset account to reflect pending payments.
Importance: Aligns financial statements with the economic reality of revenue generation, providing an accurate representation of a company’s performance.
Deferred Expenses: Definition
Definition: Deferred expenses are assets representing resources with future benefits to the company. These include supplies, prepaid rent, insurance, buildings, equipment, and intangible assets.
Explanation: Expenses related to using these assets are deferred to the future, requiring adjustments at the end of each period to recognize the portion used.
Examples of Deferred Expenses
Examples: Supplies, prepaid expenses (e.g., rent, insurance), buildings, equipment, intangible assets (e.g., patents, copyrights).
Usage: These assets are gradually consumed or used over time in revenue-generating activities.
Adjustment: Periodic adjustments are necessary to record the portion of the asset used during the period.
Adjusting Entry Format (Differed expences)
Adjusting Entry Format
Entry Type: Adjusting Entry.
Accounts Affected: Expense account (e.g., supplies expense) and Asset account (e.g., prepaid rent, equipment).
Purpose: To recognize the portion of the deferred asset used as an expense during the period.
Importance: Ensures accurate financial reporting by matching expenses with the corresponding period of asset usage, aligning with the matching principle.
Prepaid Expenses: Definition
Definition: Prepaid expenses are payments made in advance for future expenses such as rent, insurance, or advertising.
Scenario: Gildan paid $26 at the beginning of January for future expenses, covering rent ($15), insurance ($8), and advertising ($3).
Adjusting Prepaid Expenses: Gildan’s Example
Scenario: Gildan used insurance coverage for one month, rented space for one month, and utilized advertising during January.
Steps:
Expense Incurred: Record an increase in insurance expense, rent expense, and advertising expense as they were used in January.
Past Payments: Gildan paid in advance at the beginning of January, covering future months. Reduce prepaid expenses for used amounts.
Adjustment Entry: Decrease the prepaid expenses account to reflect the amount used in January for insurance, rent, and advertising.
Adjustment Amount Computation
Calculation: Determine the amount of prepaid expenses incurred by considering the expired portion of the prepaid amounts for insurance, rent, and advertising.
Expired Period: One month has expired for insurance and rent since the beginning of January.
Purpose: To accurately reflect the expenses incurred during January by reducing the prepaid expenses account by the utilized amounts.
Importance of Adjustment
Relevance: Ensures that financial statements reflect the actual expenses incurred in generating revenue during the specific period.
Matching Principle: Aligns with the matching principle, matching expenses with the revenue they helped generate.
Accuracy: Essential for precise financial reporting, providing a true picture of the company’s financial performance during the period.
Property, Plant, and Equipment: Depreciation Principle
Principle: Property, plant, and equipment (excluding land) depreciate over time due to usage, aligning with the expense recognition principle.
Depreciation: Allocation of an asset’s cost over its estimated useful life.
Land Exception: Land does not depreciate as it does not wear away and retains its value over time.
Contra Account: Accumulated Depreciation
Definition: Accumulated depreciation is a contra account that offsets the primary account (property, plant, and equipment) by accumulating the used portion’s cost.
Purpose: Tracks the historical cost of assets while reflecting the portion used. It’s subtracted from the asset account to determine net book value.
Balance: Accumulated depreciation has a credit balance, reducing the net carrying amount of property, plant, and equipment.
Visualizing with T-Accounts
T-Account Representation: Contra accounts like accumulated depreciation are shown on the opposite side of the T-account from the primary account.
Decreasing Net Amount: As accumulated depreciation increases, the net amount (asset account balance minus the accumulated depreciation balance) decreases.
Accounting Accuracy: Helps maintain accurate historical records of assets and reflects their diminishing value over time.
Carrying Amount: Definition
Carrying Amount: Also known as the net book value, it’s the value reported for property, plant, and equipment on the statement of financial position.
Calculation: Carrying amount equals the ending balance in the property, plant, and equipment account minus the ending balance in the accumulated depreciation account.
Financial Reporting: Provides a realistic representation of the company’s assets, accounting for the accumulated wear and tear over time.
Recording Depreciation Expense: Principle
Principle: Depreciation expense is recorded to account for the usage of buildings and equipment over time, aligning with the expense recognition principle.
Reasoning: Reflects the wear and tear of assets used in revenue-generating activities.
Account Affected: Increase in the depreciation expense account is recorded.
Reducing Carrying Value: Accumulated Depreciation
Principle: The carrying value of property, plant, and equipment is reduced by increasing the accumulated depreciation contra account.
Process: Represents the portion of assets used over time, aligning financial statements with the asset’s actual value.
Balance Impact: Accumulated depreciation, a contra asset, has a credit balance and increases as depreciation is recorded.
Depreciation Calculation
Formula: Monthly depreciation = ($132 initial cost + 12 months × $11 depreciation per month)
Calculation: Computes the monthly depreciation for property, plant, and equipment used in revenue-generating activities.
Purpose: Accurately determines the monthly expense incurred, aiding in precise financial reporting and asset valuation.
Impact of Depreciation
Financial Position: Accurate depreciation accounting provides a realistic view of the company’s asset value over time.
Decision-Making: Helps in strategic decisions by providing insights into the true cost of using buildings and equipment for business operations.
Compliance: Ensures compliance with accounting principles by recognizing the asset’s reduced value over its useful life.
Accrued Expenses: Definition
Definition: Accrued expenses are costs incurred in the current period but not yet paid for, accumulating over time until settled in the future.
Examples: Interest payable, wages payable, property taxes payable, utility bills.
Adjusting Entry Type: Increases an expense account (e.g., utilities expense, salaries expense) and a liability account (e.g., accrued liabilities) to recognize the incurred but unpaid expenses.
Recording Accrued Expenses: Gildan’s Example
Scenario: Gildan incurred expenses for gas and electricity usage ($2), salaries of sales personnel ($7), and interest on long-term debt ($3) in January.
Steps:
Expense Incurred: Increase distribution expenses (utilities), selling and administrative expenses (salaries), and interest expense accounts.
Future Payment: Liabilities will be paid in the next period. Increase the accrued liabilities account to reflect the obligations not yet settled.
Calculation: Amounts are computed or estimated by Gildan for utilities, sales personnel salaries, and interest on debt.
Estimation and Accuracy
Method: Accrued expenses are estimated based on prior bills (utilities), known salary amounts, and debt obligations.
Accuracy: Estimations ensure that financial statements provide a reasonable representation of the company’s obligations.
Relevance: Allows for accurate financial reporting and adherence to the matching principle, aligning expenses with the corresponding revenue-generating period.
Accrued Liabilities Account
Purpose: All accrued expenses are recorded in one account, accrued liabilities, for simplicity and clarity in financial statements.
Consolidation: Simplifies reporting by consolidating various accrued expenses into a single liability account.
Reporting: Provides a comprehensive overview of the company’s obligations, facilitating financial analysis and decision-making.
Interest Calculation: Important Points
Interest Calculation: Important Points
Annual Rate: Stated interest rate is always given as an annual percentage.
Formula: Interest for the period = (Principal) x (Annual Interest Rate) x (Time/12).
Variables:
P: Principal amount.
R: Annual interest rate.
T/12: Time, representing the number of months out of 12 since the last accrual.
Interest Calculation: Simplified Formula
Formula:
Interest=
(P×R×T)/12
Explanation:
P: Represents the principal amount.
R: Denotes the annual interest rate.
T/12: Time, indicating the number of months out of 12 since the last accrual.
Accuracy: Provides an accurate calculation of interest accrued for a specific period, aligning with accounting principles.
Accruals and Deferrals in Financial Analysis
Analysis Focus: Adjusting entries, like prepaid insurance allocation and accrued interest revenue determination, involve calculations and minimal judgment.
Complex Estimates: Later adjustments include intricate estimates like customers’ payment abilities, new machine useful lives, and future obligations for warranty claims, significantly impacting reported earnings.
Impact on Earnings: Estimates affect the net earnings stream reported over time, leading to variations in financial performance evaluation.
Management’s Judgment and Earnings Quality
Prudent Management: Managers making conservative estimates, reducing current net earnings, are seen as prudent. Financial reports are considered more reliable.
Higher Quality Earnings: Conservative estimates lead to higher quality earnings, indicating less influence from management’s optimism and providing reliable financial indicators.
Aggressive Management: Companies making optimistic estimates resulting in higher net earnings are considered aggressive.
Lower Quality Earnings: Aggressive estimates indicate lower quality earnings, suggesting a higher influence of management’s optimism, leading to a less reliable financial picture.
Analyst Evaluation and Financial Reporting Strategies
Analyst Assessment: Analysts evaluate the basis of adjustments, considering the prudence or aggressiveness of estimates.
Credibility: Financial reports from managers with conservative estimates are deemed more credible and trustworthy.
Consistency: Consistent optimistic estimates may raise questions about the reliability of a company’s financial reporting.
Strategic Impact: Financial reporting strategies influence how companies are perceived by analysts and investors, impacting their investment decisions.
Materiality in Financial Reporting
Definition: Materiality refers to the relative significance of financial information in influencing decisions made by users of financial statements.
Influence on Decisions: Information or aggregates are material if their omission or misstatement could influence a decision.
Qualitative Factor: Materiality is qualitative, allowing accountants to apply the constraint that the benefit to users should outweigh the cost of reporting.
Professional Judgment: Accountants use professional judgment to estimate and report amounts, considering materiality to provide a faithful representation and relevance in financial statements.
Materiality and Adjusting Entries
Simplification: Adjusting entries can be simplified by accounting for immaterial items in the most relevant and cost-effective manner.
Example: Assets with very low costs, such as wastebaskets, can be directly charged to expense accounts instead of asset accounts, eliminating the need for adjusting entries.
Accountant’s Decision: Treatment of an item as immaterial depends on various factors and professional judgment.
Guidelines: Traditionally, an item is material if it exceeds 1 to 1.5 percent of total assets or total sales, or 5 to 10 percent of net earnings. Materiality depends on the item’s nature and monetary value.
Considerations in Materiality Judgment
Nature and Value: Materiality assessment considers both the nature of the item and its monetary value.
Internal Control Weakness: Even small amounts, like those stolen systematically by an employee, might not be judged as immaterial if they indicate a weakness in the company’s internal control system.
Combined Effect: The combined effect of numerous immaterial events can be material. Accountants consider the collective impact of multiple immaterial items on the financial statements.
Professional Judgment and Audit Process
Audit Significance: Materiality is vital in the audit process. Auditors use professional judgment to decide whether financial statements are relevant and provide a complete report of all material transactions.
Preventing Misstatements: Auditors aim to prevent any material misstatement in the company’s financial position by carefully evaluating the materiality of individual and aggregated items.
Importance: Materiality judgments are critical to ensuring the integrity and reliability of financial statements, helping auditors and accountants maintain transparency and accuracy.
Impact of Financial Statements on Stakeholders
Affected Parties: Owners and managers of companies are directly influenced by financial statements.
Positive Performance: Strong financial performance raises share prices, leading to increased shareholder dividends and investment value.
Managerial Compensation: Managers receive bonuses based on financial performance and may have stock options tied to market value.
Manipulation Risks: Managers might manipulate accruals and deferrals to meet expectations; accountants and auditors have a duty to prevent such practices.
Manipulation of Accruals and Deferrals
Manipulation Techniques: Managers might record unearned cash as revenue or omit certain expenses to bridge performance gaps.
Professional Duty: Accountants and external auditors are responsible for preventing and eliminating these manipulative practices.
Consequences: Companies engaging in such practices face significant penalties, legal expenses, and damage to their reputation.
Stakeholder Impact: Current investors, creditors, and employees suffer due to financial penalties and decreased share prices following investigations.
Enforcement and Consequences
Securities Commissions: Enforcement actions by securities commissions against companies and auditors result in financial penalties.
Penalties: Firms face substantial financial penalties, often in millions, for engaging in manipulative practices.
Impact on Assets: Penalties, legal expenses, and class action lawsuits deplete company assets.
Share Price: News of investigations can lead to decreased share prices, impacting existing and potential investors, further affecting the company’s financial health.
