Comprehensive summary of sections 3,4 and 5 of the book Accounting Principles (12th edition). This material is among other things necessary for the midterm exam and the examination of accounting of study Economics and Business Economics at the Erasmus University. The summary contains pictures from ...
Chapter 3: Adjusting the Accounts
1) Explain the accrual basis of accounting and the reasons for adjusting entries.
The Internal Revenue Service (belastingdienst VS) requires all businesses to file annual tax
returns. Therefore, accounts divide the economic life of a business into artificial time
periods. This assumption is referred to as the time period assumption.
Interim periods = montly and quarterly accounting time periods
fiscal year = an accounting time period that is one year in length (mostly a calender year
which starts at January 1 and ends on December 31).
Under accrual-basis accounting, companies record transactions that change a company’s
financial statements in the periods in which the events occur. FE: using the accrual basis to
determine net income means companies recognize revenues when they perform services
(rather than when they receive cash). It also means recognizing expenses when incurred
(rather than when paid).
Under cash-basis accounting, companies record revenue when they receive cash. They
record an expense when they pay out cash. It often produces misleading financial
statements. Accural-basis accounting is therefore in accordance with GAAP.
Revenue recognition principle: when a company agrees to perform a service or sell a
product to a customer, it has a performance obligation. When the company meets this
performance obligation, it recognizes revenue. The revenue recognition principle therefore
requires that companies recognize revenue in the accounting period in which the
performance obligation is satisfied. (Dus: opbrengsten boeken bij de periode waarin ze
worden geleverd i.p.v. wanneer ze worden betaald).
Expense recognition principle: let the expenses follow the revenues. The critical issue in
expense recognition is when the expense makes its contribution to revenue. This may or
may not be the same period in which the expense is paid. If Dave’s does not pay the salary
incurred on June 30 until July, it would report salaries payable on its June 30 balance sheet.
Expense recognition principle is the same as ‘matching principle’.
Adjusting entries ensure hat the revenue recognition and expense recognition principles are
followed. Adjusting entries are necessary because the trial balance may not contain up-to-
date and complete date. This is true for several reasons:
- Some events are not recorded daily because it is not efficient to do so (salaries).
- 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.
Examples are charges related to the use of buildings and equipment, rent, insurance.
- Some items may be unrecorded. Example: a utility service bill that will not be
received until the next accounting period.
Note: every adjusting entry will include one income statement acount and once balance
sheet account.
Adjusting entries are classified as either deferrals or accurals. Each has two subcategories.
Deferrals:
1) Prepaid expenses: expenses paid in cash before they are used or consumed (debited)
2) Unearned revenues: cash received before services are performed.
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