Lecture 6 accounting - Prof. Hongping Tan PDF

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Prof. Hongping Tan...

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Lecture #6 Sept 26th Accrual Basis vs. Cash Basis Cash Basis  Record transactions only when cash paid or received  Revenue is recorded only when cash is received  Expenses are recorded only when cash is paid  Can lead to misleading information for decision-making o Revenue and expenses can be manipulated by timing the receipt and payment of cash o Can increase or decrease profit

Accrual Basis  Recognize the impact of a business event as it occurs o Revenues are recorded as they are earned o Expenses are recorded as they are incurred  Is required because it gives a more complete picture of the business  Does not require a cash transaction  Provides immediate feedback on how well a company is doing  Transactions affecting a company’s financial statements are recorded in the period the events occur, rather than when cash is received or paid o Revenue is recorded when earned rather than when cash is received  Receiving cash and earning revenue are 2 distinct transactions o Expenses are recorded when goods or services are consumed or used  Spending cash and incurring costs are 2 distinct transactions Principles of Accrual Accounting  An attempt to measure firm performance in a particular period regardless of when cash is exchanged  Revenue Recognition and the Matching Principle are cornerstones of accrual accounting o Revenue recognition  Earnings process must be substantially complete  Cash collection must be reasonably assured o Matching principle for expenses  Match efforts to the benefits generated  Capitalize expenditures that will benefit future periods, expense as benefits realized  Recognize liabilities when efforts benefitting the current period required cash payment in the future Cost Asset (if it has future value) Cost is split into 2, asset or expense Later the asset ----> expense as value is lost. Link between balance sheet and income statement

Expense (if no future value)

The Matching Principle  Basis for recording an expense  Match an expense with the appropriate revenue  Directs accountants to o Identify all the expenses incurred during the accounting period o Record expenses during the same period when we record related revenue 1. Product expenses (direct) 1. If expenses depend on the number of units sold 2. Natural link exists between revenues and expenses 1. Sales commissions, costs of good sold Product expenses are variable. Carried into the future if the related revenues are recognized in the future If recording product revenue, must record product expenses 2. Period Expenses (indirect expenses) a. Go beyond the costs associated with creating a particular product to include the price of maintaining the entire company b. While these items contribute to the company as a whole they are not assigned to the creation of any one item/service c. Expenses linked with a particular time period i. Rent ii. Salary iii. Insurance b. Can be variable and fixed periods c. Recorded in the relevant time period (even though benefits may occur in the future) because we can't establish a direct link d. Match revenues and expenses with a particular time period Revenue Recognition  Revenue is earned (recognized) when o Sales or performance effort is substantially complete o Amount is determinable (measurable) o Collection is reasonably assured  In a merchandising company : when sold (point of sale)  In a service company: when performed  It is important to determine when to recognize period expenses The Adjustment Process  The Accrual Basis requires adjustment at the end of the time period to produce correct balances for the financial statements o At the end of the period we must account for implicit transactions to align revenues and expenses (matching) o These journal entries always affect both the income statement and the balance sheet o Usually NO document flow to trigger recording  The event are implicit so it is your responsibility to determine when adjusting is required Periodic Adjustments  Adjusting entries

Assign revenues to the period in which theya re earned and expenses to the period in which they are incured  Matching pricniple o Update the asset and liability accounts  Can be grouped into 3 categories 1. Deferrals: delayed income statement recognition 1. Business paid or received cash in advance of incurring expense or earning revenue 1. Prepaid account, unearned revenue b. Accruals: accelerated income statement recognition i. Business incurred expense or reane revenue before paying or receiving cash 1. Payable accounts, receivable accounts b. Revaluation adjustments i. To estimate the amount of a reserve such as the allowance for doubtful accounts or the inventory obsolescence reserve o

Deferrals  They relate to the concept of asset capitalization and the matching principle  Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset it recognized at that time  As the asset contributes to the generation of revenue (revenue recognition), the related cost is recognized as an expense (matching)

Examples of deferrals … 1. Purchase of supplies 1. On july 1st purchased 1900 of office supplies with cash. On september 30th statements were prepared. Account of office supplied indicates 1400 worth. Record the purchase of supplies and any adjustment necessary that may be necessary 1. Supplies increase (debit) , cash decrease (credit) 2. Need for an adjusting entry, implicit change in supplied (-500) 3. Supplies (new) = Supplies (old) - Supplied Expense 4. Debit supplies expense, credit supplies 2. Purchase of Inventory

a. On July 3rd company purchased 8200 of inventory on account. On August 2nd sold 5 units for 5000. Customers paid the full amount in cash. These 5 units costed 3,200 to the company. Record all necessary journal entries i. Increase in inventory (debit) , increase in accounts payable (credit) ii. August 2nd sale= explicit transactions, increase in cash (debit) , increase in revenue (debit) iii. There is an implicit change in inventory that should be reflected on financial statements iv. Inventory decreased therefore Inventory (new) = Inventory (old) - COGS v. Debit COGS 3,200 and credit inventory 3,200 Prepaid Expenses (Deferral)  Prepaid expenses are expenses paid in advance (rent, insurance, ads)  They arise as a result of the business making payments for goods and services to be received in the future (rent is a good of being able to occupy the building)  Prepaid expenses represent an asset because there is still probably future value  They become expense accounts on the income statements over time as the benefit is consumed 3. Purchase of Insurance a. Purchased 12,000 worth of insurance on july 1st , in cash. Will cover a july 1st june 30th On september 30 they are preparing financial statements. Record necessary entries i. Increased in prepaid insurance (debit) , decrease in cash (credit) ii. This is an explicit transaction but there is also an implicit change in prepaid insurance that should be reflected through adjusting entries iii. 12000/12 = 1000, 1000x3= 3000 therefore 12000-3000=9000 iv. Prepaid insurance (new) = prepaid insurance (old) - insurance expense 1. Debit insurance expense (3000) and credit prepaid insurance (3000) If company was using cash basis vs. accrual basis, the company would simply record insurance expense (debit) and cash (credit). Does not take into account capitalization, not prepaid insurance 4. Unearned Revenue a. Also known as deferred revenue. Obligation arising from receiving cash in advance of providing a product or a service b. It is a liability initially recorded on the balance sheet and recognized as revenue in the income statement as it is earned i. Subscriptions paid in full in advance ii. Service providers/ service contracts iii. Legal retainers iv. Rent paid in advance (for tenant) v. Insurance (prepaid) (for insurance provider) vi. Selling tickets vii. Deposits placed for future services viii. gift/loyalty cards b. On May 31st a singer signed a contract and received a check for 60,000 to perform concerts in June, July and August

i. What is her unearned revenue on may 31st: 60,000 ii. What is her unearned revenue on june 30th: 40,000 iii. How much revenue will she record from may 31st to july 31st: 40,000 b. On July 1st a company purchased a 1 year subscription to a magazine. Paid up front in full 24$. Will end on June 30th. Magazine prepared monthly statements i. Account name= unearned revenue, liability, increase (credit) ii. Duality account being affected= cash, increase (debit) iii. After one month, unearned revenue becomes 22 because on month (2) has passed. iv. Debit unearned revenue, credit revenue (2$ each) v. Unearned revenue (new) = unearned revenue (old) - revenue 5. Depreciation a. Buildings, machinery, equipment, furniture, fixtures, computers, outdoor lighting, parking lots, cars, and trucks are examples of assets that will last for more than one year, they are called plant assets (tangible long term assets) i. Will not last indefinitely. During each accounting period (year, quarter, month etc.) a portion of the cost of these assets is being used up. They lose their value over time ii. The potion being used up is reported as Depreciation expense on the income statement. In effect depreciation is the transfer of a portion of the asset’s cost from the balance sheet to the income statement during each year of the asset’s life. b. There are several depreciation methods allowed for achieving the matching principle. 6. Amortization a. Intangible assets may also have a definite useful life. If sho, these assets too will lose their values over time b. The term depreciation is used for tangible assets and amortization is used to refer the decrease in values of intangible assets (trademarks, copyrights) c. Reflects the consumption of an intangible asset over its useful life Exception to Depreciation and Amortization  If an item is considered to have an indefinite useful life, it cannot be depreciated/amortized  Land is considered to have an indefinite useful life so never depreciated  Some intangible assets (depending on their legal definitions) may also have indefinite useful lives...