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Chapter 4

Chapter 4 notes

Financial Accounting
Course Code
G.Quan Fun

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Chapter 4 Accrual Accounting Concepts Notes
Timing Issues
x many accounting transactions affect more than one arbitrary time period
x determining the amount of revenue and expenses to report in a particular accounting period an be difficult
Revenue Recognition Principle
x revenue recognition principle : principle that states that revenue must be recognized in accounting period in which it is earned
x revenue recognition is governed by guidelines, which sometimes require a significant amount of professional judgment to apply
x in general, though, revenue is recognized when the sales or performance effort is substantially complete, the amount is
determinable (measurable), and collection is reasonably assured
Matching Principle
x matching principle : principle of expense recognition that states that efforts (expenses) must be matched with accomplishments
(revenues), whenever possible
x some expenses are easy to match with revenues; others are more difficult to directly associate with revenue
Accrual versus Cash Basis of Accounting
x accrual basis accounting : an accounting basis in which transactions that change a company’s financial statements are recorded
in the periods in which the events occur, rather than in the period in which the company receives or pays cash
x cash basis accounting : an accounting basis in which revenue is recorded only when cash is received, and an expense is
recorded only when cash is paid
x the cash basis accounting violates the revenue recognition principle and matching principle
The Basics of Adjusting Entries
x adjusting entries : journal entries made at the end of an accounting period because of the time period assumption and to ensure
that the revenue recognition and matching principles are followed
x adjusting entries are necessary because the trial balance may not contain complete and up-to-date data, which is true for reasons:
1. some events are not recorded daily, because it would not be useful or 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
Types of Adjusting Entries
x entries can be classified as prepayments (prepaid expenses and unearned revenue) or accruals (accrued revenues/expenses)
Adjusting Entries for Prepayments
Prepaid Expenses
x prepaid expenses : expenses that are generally paid in cash and recorded as assets before they are used or consumed
x adjusting entry for prepaid expenses results in increase (debit) to expense account and decrease (credit) to asset account
x types of prepaid expenses include supplies, insurance, depreciation
x useful life : the length of service of a depreciable asset
x depreciation : the process of allocating the cost of a depreciable asset over its useful life; also known as amortization
x straight-line method of depreciation : a depreciation method in which depreciation expense is calculated as the cost of an asset
divided by its useful life
x contra asset account : an account that is offset against (reduces) an asset account on the balance sheet
x carrying amount : difference between cost of depreciable asset and its accumulated depreciation; also known as book value
Unearned Revenue
x unearned revenues : cash, or a promise to pay cash, that is received before revenue is earned and is therefore recorded as a
liability until it is earned
x adjusting entry for unearned revenues results in decrease (debit) to liability account and increase (credit) to revenue account
Adjusting Entries for Accruals
Accrued Revenues
x accrued revenues : revenues earned but not yet received in cash or recorded
x adjusting entry for accrued revenues results in increase (debit) to asset account and increase (credit) to revenue account
Accrued Expenses
x accrued expenses : expenses incurred but not yet paid in cash or recorded
x adjusting entry for accrued expenses results in increase (debit) to expense account and increase (credit) to liability account
x accrued expenses include supplies, salaries, income taxes
The Adjusted Trial Balance and Financial Statements
x adjusted trial balance : a list of accounts and their balances after all adjustments have been made
Closing the Books
x temporary accounts : revenue, expense, and dividend accounts whose balances are transferred to Retained Earnings at the end
of an accounting period
x permanent accounts : balance sheet accounts whose balances are carried forward to the next accounting period
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