Lecture 3-Adjusting the Accounts

Question 1

Accrual-Basis Accounting and Adjusting Entries

Answer 1

Time period (or periodicity) assumption: Accountants divide the economic life of a business into artificial time periods

Question 2

Fiscal and Calendar Years

Answer 2

• Accounting time periods are generally a month, a quarter, or a year. *
  Monthly and quarterly time periods are called interim periods.
  Most large companies must prepare both quarterly and annual financial statements.
• Fiscal Year = Accounting time period that is one year in length. *
  Calendar Year = January 1 to December 31.
• Sometimes a company’s year-end will vary from year to year, resulting in accounting periods of either 52 or 53 weeks.

Question 3

Accrual- versus Cash-Basis Accounting

Answer 3

Accrual-Basis Accounting
* Transactions are recorded in the periods in which the events occur.
-Companies recognize revenues when they perform services (rather than when they receive cash).
* Expenses are recognized when incurred (rather than when paid).
* Accrual-basis accounting is in accordance with IFRS.

Cash-Basis Accounting
* Revenues are recorded when cash is received.
* Expenses are recorded when cash is paid.
* Cash-basis accounting is not in accordance with IFRS.

Question 4

Recognizing Revenues and Expenses

Answer 4

Time Period Assumption-Economic life of business can be divided into actual time periods

Expense Recognition Principle- Recognize expense in the period that efforts are made to generate revenue

Revenue Recognition Principle-Recognize revenue in the accounting period in which the performance obligation is satisfied

Revenue and Expense Recognition-In accordance with International Financial Reporting Standards (IFRS)

Question 5

The Need for Adjusting Entries-how?

Answer 5

Adjusting entries ensure that the revenue recognition and expense recognition principles are followed.
* Required every time a company prepares financial statements.
* Will include one income statement account and one statement of financial position account.

Question 6

The Need for Adjusting Entries-why?

Answer 6

1. Some events are not recorded daily because it is not efficient to do so.
2. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions.
3. Some items may be unrecorded.

Question 7

Types of Adjusting Entries

Answer 7

Deferrals:
1.Prepaid expenses- Expenses paid in cash before they are used or consumed
2.Unearned revenues- Cash received before services are performed

Accruals
1.Accrued revenues: Revenues for services performed but not yet received in cash or recorded
2.Accrued expenses- Expenses incurred but not yet paid in cash or recorded

Question 8

Adjusting Entries for Deferrals

Answer 8

Deferrals are expenses or revenues that are recognized at a date later than the point when cash was originally exchanged.
There are two types:
* Prepaid expenses, and * Unearned revenues.

Question 9

Prepaid Expenses

Answer 9

Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). Prior to adjustment, assets are overstated and expenses are understated.

Question 10

Supplies

Answer 10

Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period.

Question 11

Depreciation

Answer 11

Depreciation is the process of allocating the cost of an asset to expense over its useful life. Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset’s cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset.

Question 12

Unearned revenues

Answer 12

When companies receive cash before services are performed, they record a liability by increasing (crediting) a liability account called unearned revenues. Prior to adjustment, liabilities are overstated and revenues are understated.

Question 13

Adjusting Entries for Accruals

Answer 13

Accruals are made to record the following:
* Revenues for services performed but not yet recorded at the statement date – accrued revenues or
* Expenses incurred but not yet paid or recorded at the statement date – accrued expenses

An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account.

An adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account.

Question 14

Adjusting Entries-must dos

Answer 14

1) Adjusting entries should not involve debits or credits to Cash.
2) Evaluate whether the adjustment makes sense. For example, an adjustment to recognize supplies used should increase Supplies Expense. 3) Double-check all computations.
4) Each adjusting entry affects one statement of financial position account and one income statement account.

Question 15

Adjusted Trial Balance and Financial Statements

Answer 15

Adjusted trial balance:
* Proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments.
* Primary basis for the preparation of financial statements.

Question 16

Alternative Treatment of Deferrals

Answer 16

Alternative treatment:
(1) When a company prepays an expense, it debits that amount to an expense account.
(2) When it receives payment for future services, it credits the amount to a revenue account.

Question 17

Cost Constraint

Answer 17

It weighs the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the information available.