ACCT 1080



ACCT 1080

Fall 2008

Chapter 3 Notes

ACCOUNTING CONCEPTS AND PRINCIPLES

The main accounting principles consist of:

• Accrual accounting versus cash-basis accounting

• The accounting period

• The revenue principle

• The matching principle

Accrual Accounting Versus Cash-Basis Accounting

Two ways to do accounting

• Accrual accounting – records the effect of each transaction as it occurs. Most businesses use the accrual basis as covered in this book.

• Cash-basis accounting – records only cash receipts and cash payments. It ignores receivables, payables, and depreciation. Only very small businesses use the cash basis of accounting.

• Under the cash-basis, all cash receipts are treated as revenues and all expenses are treated as expenses.

• Revenue example: A company performed $10,000 worth of services on account.

▪ Accrual method: ‘Accounts receivable’ is debited and ‘Service revenue’ is credited.

▪ Cash method: No entry is recorded because no cash was received. The entry would not be recorded until the company receives what it is owed in cash.

• Expense example: A company purchased $2,000 of office supplies on account.

▪ Accrual method: ‘Office supplies’ is debited and accounts payable is credited.

▪ Cash method: No entry is recorded because no cash was paid. The entry would not be recorded until the company paid for the supplies.

• Cash-basis accounting is considered faulty accounting by some. Why?

• Under the accrual method, revenue is recorded when earned and an expense is recorded when it is incurred.

• Remember payroll example to understand accrual accounting.

The Accounting Period

• The basic accounting period is one year. As such, businesses prepare annual financial statements.

The Revenue Principle

The revenue principle tells accountants:

• When to record revenue (when to make a journal entry for a revenue)

• The amount of revenue to record

When to Record a Revenue:

• Record revenue when it is EARNED

▪ This occurs when the company has delivered a good or service to the customer.

▪ Cash-basis accounting violated the revenue principle; therefore, it is not GAAP.

The Amount of Revenue to Record

• Record revenue for the cash value of the items transferred to the customer.

• Example: A business cuts a new client a deal. They will offer the client services that would normally cost the $200 for $100. How much revenue is recorded?

The Matching Principle

• The matching principle guides accounting for expenses.

• The matching principle directs accountants to:

▪ Measure all the expenses incurred during the period

▪ Match the expenses against the revenues of the period.

• Example: Toyota pays commission to employees who sell cars. If no cars are sold, no ‘commission expense’ is recorded. If a car is sold, ‘commission expense’ is recorded at the time of that sale.

▪ Dr: Cash………………………………………….20,000

Dr: Commission expense………………………… 2,000

Cr: Service revenue…………………………………...22,000

• Some expenses are not so easy to link to sales or revenues. Rent expense is one of these. No matter if you make a sale or not, rent is still due.

▪ The matching principle states that in these expenses should be recorded with a particular period, such as a month or year. Therefore, rent expense would most likely be recorded on a monthly basis.

The Time-Period Concept

• The time-period concept ensures that information is reported often.

• If you use accrual accounting, information should be recorded timely.

ADJUSTING THE ACCOUNTS

At the end of the period, the accountant prepares financial statements.

• This end-of-period process begins with the trial balance.

• The unadjusted trial balance lists the revenues and expenses of the company for the period. However, these amounts are incomplete because they omit certain revenue and expense transactions. Hence the name ‘unadjusted trial balance’.

• Accrual accounting requires adjusting entries at the end of the period.

▪ Example: At the beginning of the year, the company purchased $500 in supplies. Due to that transaction, the company has an asset on the books of $500. Is it likely that company still has the $500 in supplies sitting around?

← Not likely. As such, we need to make an adjusting entry to record the actual amount of supplies we have on account.

← When we purchased the supplies:

Dr: Office aupplies………………………………$500

Cr: Cash…………………………………………..$500

← At the end of the period, we realize we only have $200 in supplies left. Therefore we need to reduce the Supplies account. In order to do this, we expense the portion of the supplies that we have used.

Dr. Supplies expense…………………………….$300

Cr: Office supplies……………………………….$300

← After the second transaction, the ‘Office supplies’ account only has $200 left in it.

• Adjusting entries are one way that helps accountants assign revenues to the period in which they are earned and expenses to the period in which they are incurred.

• Adjustments are needed to properly measure two things:

▪ Net income on the income statement

▪ Assets and liabilities on the balance sheet

PREPAIDS AND ACCRUALS

See page 131 of your book for the following items:

Prepaid Expenses

• Prepaid expenses are advance payments of expenses. Examples consist of prepaid rent and prepaid insurance.

Prepaid Rent

• The company’s landlord requires the company to pay rent one month in advance.

• What is the entry if the lease specifies that rent for the month of April is due on March 31st?

▪ Entry:

• What is the entry the company should make at the end of April?

▪ Entry:

Supplies

• Supplies are accounted for as prepaid expenses.

• See supplies example under the caption ‘Adjusting the Accounts’.

Depreciation

• Accrual accounting is clearly illustrated by depreciation.

• Plant assets (Property, Plant & Equipment) are long-lived tangible assets used in the operation of business.

• The allocation of a plant asset’s cost to expense during a period is called depreciation.

• Land is the only exception – there is never depreciation on land.

Similarity to Prepaid Expenses

• The accounting for plant assets is the same as for a prepaid expense, the accounts are just different.

• The company makes a purchase of $18,000 in furniture

▪ Entry:

• The company believes the furniture will remain useful for 5 years, and then be worthless.

▪ Compute depreciation: $18,000 / 5 years = $3,600 per year. $36,000 / 12 months = $300 per month.

▪ Therefore, we will depreciate the asset by $300 per month.

• Record depreciation for the month of April:

▪ Entry:

The Accumulated Depreciation Account

• Accumulated depreciation is credited, not furniture…

▪ Why?

• Accumulated depreciation is a contra asset, which means it has a normal credit balance. A contra account has two major characteristics:

▪ A contra account follows a companion account

▪ A contra accounts normal balance is opposite that of the companion accounts balance.

Book Value

• The balance sheet (remember, this is the financial statement that shows a ‘snapshot’ view of the company at a specific time) reports both ‘Furniture’ and ‘Accumulated depreciation’.

• Because ‘Accumulated depreciation’ is a contra account, it is subtracted from furniture. The result is the net amount of the furniture or the book value.

• Refer back to the depreciation entry we recorded above.

▪ Balance sheet presentation:

ACCRUED EXPENSES

Accrued expenses are expenses the company has incurred, but not yet paid. An accrued expense always creates a liability. When you accrue for something, you are setting up a payable, which is a liability. Don’t be tricked when we discuss accruing expenses. When we accrue an expense we debit the expense and credit the payable account.

Remember that prepaids and accruals are opposites?

• A prepaid expense (asset) is paid first and expensed later

• An accrued expense (liability) is expensed first and paid later.

Accruing Salary Expense

• The company pays its only employee a monthly salary of $1,800, half on the 15th and half on the last day of the month.

• Assume that the last day of the month falls on a Saturday, which means the employee won’t get his check until Monday. Since the company owes the employee for work performed through Saturday, the company would make an entry to record an accrual under the account ‘Salary payable’.

• Entry on the 15th of the month:

• Entry on the last day of the month:

Accruing Interest Expense

• Borrowing money creates a liability for a note payable (long-term).

• The company borrows $20,000 from the bank on December 1, 2008.

▪ Entry:

• Interest is due yearly on this note. So, the first interest payment will be due on December 1, 2009.

• Assume that one month’s worth of interest is $100 and that the company’s accounting period ends on December 31st.

• An entry must be made at the end of the year for the accrued interest.

▪ Entry:

ACCRUED REVENUES

Just like a company can incur an expense before it pays it, a company can also earn revenue before payment is received.

• A company performs $400 in consulting services to a client, on account.

▪ Entry:

• Cash is received as payment for the clients account.

▪ Entry:

UNEARNED REVENUES

Unearned revenue – Receiving cash before earning it. This occurs when a client prepays the company for a service or good.

• A client engages the company to perform monthly consulting services agreeing to pay $600 to cover the next three months of service. The client pays immediately.

▪ Entry:

• An entry must be made at the end of the month. What is that entry?

▪ Entry:

• Remember: An unearned revenue is a liability, not a revenue.

• An unearned revenue to one company is a prepaid expense to the other company.

SUMMARY OF THE ADJUSTING PROCESS

The adjusting process has two purposes:

• Measure net income or net loss on the income statement. Every adjustment affects a revenue or expense.

• Update the balance sheet. Every adjustment affects an asset or a liability.

THE ADJUSTED TRIAL BALANCE

A useful step in preparing the financial statements is to list the accounts, along with their adjusted balances, on an adjusted trial balance.

See pate 143 in your text for an example of the set-up.

THE FINANCIAL STATEMENTS

The financial statements can be prepared from the adjusted trial balance.

• The income statement reports revenues and expenses

• The statement of owner’s equity shows why owner’s capital changed during the period.

• The balance sheet reports assets, liabilities, and owner’s equity.

Preparing the Statements

• The financial statements should be prepared in this order:

▪ Income statement

▪ Statement of owner’s equity

▪ Balance sheet

Relationships Among the Financial Statements

• Net income from the income statement increases owner’s equity. A net loss decreases owner’s equity

• Ending capital from the statement of owner’s equity goes to the balance sheet and makes total liabilities plus owner’s equity equal total assets.

• See page 144 and 145 of your text to see an example using a set of financials.

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