ACG 2021 Chapter Notes - Chapter 3: Trial Balance, Income Statement, Accounts Payable

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5 Feb 2017

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Accrual Accounting & Income
Explain how accrual accounting differs from cash-basis accounting
o Accounting can be based either on the accrual basis, or the cash basis
o Accrual accounting
Records the impact of a business transaction as it occurs
The business records the transaction even if the company receives or pays no cash
o Cash-basis accounting
Records only cash transactions
Cash receipts are treated as revenues and cash payments are handled as expenses
o Generally accepted accounting principles (GAAP) requires accrual accounting
Business records revenues as the revenues are earned expenses as the expenses incurred
The basic defect of cash-basis accounting is that it ignores important information making
the financial statement incomplete. Using this incomplete information to make decisions
it could lead to mistakes
if a company makes a sale and they do not get paid with cash right away then the
company would ignore the transaction until they get the cash.
This causes 2 defects one on the balance sheet and another on the income
o Balance-sheet defect
When failing to record a sale on an account there is no accounts receivable recorded
This is bad because the assets are understated on the balance sheet because the future
income of cash isn’t recorded.
o Income statement defect
A sale on account provides revenue that increase the company’s wealth. Ignoring the sale
understates the net income and revenue on the income statement
o Companies that use the cash basis of accounting do not follow GAAP. Their financial statements
omit important information
o All but the smallest businesses use the accrual basis of accounting
The time-period concept
o The only way to be certain about the situation of the company is to liquidate everything and go
out of business. Instead, they use regular progress report instead of going out of business.
o Accountants prepare financial statements for the period needed
o Time-period concept ensures that accounting information is reported in regular intervals.
o Basic accounting period is one year from Jan. 1 to Dec. 31
o A fiscal year end on a date after December 31 usually near Jan. 31
o Companies also do financial statements for the interim period of 1,3(quarter),6(semiannual)
Apply the revenue and expense recognition principles
The revenue principles
o Two principles
When to record (recognize) revenue
recognize revenue after it is earned from delivering goods or performing a
service for a customer
What amount of revenue to record
Revenue is recognized when the business transfers promised goods or services to
a customer in an amount that reflects the cash that the entity expects to receive in
exchange for those goods or services
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o Ways to record revenue
Situation 1 no transaction has occurred, so no contract exists
Situation 2 customer places an order (transactions happening) that produces a contract
that both parties must fulfill. The company recognizes revenue when the product is
delivered and the customer receives and pays for the product, this fill both sides of the
o Sometimes there are contracts where the company has to perform a service by a certain date, but
the revenue isn’t recognized until the job is finished
o The amount of revenue to record is the cash value of the goods or services transferred to the
customer. (if you by coffee for $2 and its usually $4 the company only records that they earned
$2 from the transaction)
The expense recognition principle
o The basis for recording expenses [the cost of used up assets, and created liability] in earned
o Expenses have no future benefit and include 2 steps
Identify all the expenses incurred during the accounting period
Measure the expense and recognize them in the same period in which any related
revenues are earned
Ethical issues in accrual accounting
o When a company pays for something in advance it is considered an asset, but if the service or
product they pay for is used immediately they have to put it on the next fiscal year balance when
at the end of a period. If the company thinks that the period is not going to go well, then they will
be tempted to put it on the current year’s balance. The ethical thing to do is to put the rest of the
balance on next year’s statement.
Adjust the accounts
o The financial statement process begins with the trial balance that is unadjusted because the
accounts are not yet ready for the financial statement
Which accounts need to be updated [adjusted]
o Unadjusted means the financial statement is not up-to-date
o Assets and stockholder’s equity don’t need adjustments because the transactions provide all the
data on the account
o Expenses are different because there are some transactions that haven’t been recorded yet
Categories of adjusting entries
o Deferrals
Adjustment for payment of an item or receipt in advance
Supplies expense is an adjustment done for supplies that has been used and is no longer an asset
Unearned sales revenue is when the company gets paid in advance for the service they are going
to provide at a future time.
When the goods are delivered to the customer, they[company] earn sales revenue that shows an
adjustment at the end of the period. This adjustment decreases liabilities and increases revenue.
o Depreciation
Allocates the cost of a plant asset to expense over the assets useful life
Most common long-term referral
Records the depreciation expense and decreases the assets’ book value over its life
The same as deferral, but has different type of assets
o Accruals
Opposite of a deferral
Accrued expense the company records the expense before paying cash
Accrued revenue the company records the revenue before collecting cash
Salary expense can create an accrual adjustment
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