Ch. 4 Notes PDF

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Ch. 4 -

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The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. o Conrad records revenue in June when it performs the service, not in July when it receives the cash The critical issue in expense recognition is determining when the expense makes its contribution to revenue. o If Conrad does not pay the salary incurred on June 30 until July, it would report salaries and wages payable on its June 30 balance sheet. o Dictates that efforts (expenses) be matched with results (revenues). Accrual-basis accounting means that transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged. Under cash-basis accounting, companies record revenue when they receive cash. o Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Adjusting entries are necessary because the trial balance—the first pulling together of the transaction data—may not contain up-to-date and complete data Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the trial balance to determine whether it is complete and up-to-date for financial statement purposes. Every adjusting entry will include one income statement account and one balance sheet account. Deferrals: costs or revenues that are recognized at a date later than the point when cash was originally exchanged o Prepaid expenses:  When expenses are prepaid, an asset account is increased (debited) to show the service or benefit that the company will receive in the future.  Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies)  An adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.  Supplies: Rather than record supplies expense as the supplies are used, companies recognize supplies expense at the end of the accounting period.  At the end of the accounting period, the company counts the remaining supplies. The difference between the unadjusted balance in the Supplies (asset) account and the actual cost of supplies on hand represents the supplies used (an expense) for that period.  Use of supplies decreases an asset, Supplies. It also decreases stockholders' equity by increasing an expense account, Supplies Expense

Insurance: At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period.  The expiration of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stockholders' equity by increasing an expense account, Insurance Expense.  Depreciation: To follow the expense recognition principle, companies allocate a portion of this cost as an expense during each period of the asset's 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.  Contra asset account: An account that is offset against an asset account on the balance sheet.  But using the contra account is preferable for a simple reason: It discloses both the original cost of the equipment and the total cost that has expired to date.  The book value and the fair value of the asset are generally two different values. As noted earlier, the purpose of depreciation is not valuation but a means of cost allocation.  All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate. o Unearned revenues:  Unearned revenues are the opposite of prepaid expenses.  Unearned revenue is a liability account used to recognize the obligation that exists.  Instead, the company delays recognition of revenue until the adjustment process. Accruals: o Accrued revenue: not yet received in cash or recorded o Accrued expenses: not yet pad in cash or recorded Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Companies manage earnings in a variety of ways. One way is through the use of onetime items to prop up earnings numbers. Another way is to inflate revenue numbers in the short-run to the detriment of the longrun. Because revenues, expenses, and dividends relate only to a given accounting period, they are considered temporary accounts. 

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In contrast, all balance sheet accounts are considered permanent accounts because their balances are carried forward into future accounting periods. Closing entries: Entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders' equity account, Retained Earnings. Closing entries produce a zero balance in each temporary account. o As a result, these accounts are ready to accumulate data about revenues, expenses, and dividends that occur in the next accounting period. Permanent accounts are not closed. Companies close the revenue and expense accounts to another temporary account, Income Summary. The balance in Income Summary is the net income or loss for the year. A post-closing trial balance is a list of all permanent accounts and their balances after closing entries are journalized and posted. o The purpose of this trial balance is to prove the equality of the total debit balances and total credit balances of the permanent account balances that the company carries forward into the next accounting period. o Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—balance sheet—accounts....