Summary of the Accounting Principles book, written by Needles, Powers et al. for the Financial Management 2 course in the first year of International Business and Management Studies / International Business. Chapters included are: chapter 3, 5, 6, 7, 9 and 12
Financial Management 2 – Chapters 3, 5, 6, 7, 9, and 12
Chapter 3 – Measuring Business Income
Net income (=profit): revenues – expenses (net increase in owner’s equity)
Revenues are increases in owner’s equity resulting from selling goods or rendering services.
Expenses are decreases in owner’s equity resulting from the cost of selling goods/rendering services
and the cost of the activities necessary to carry on a business.
- Choosing the number of accounting periods raises the issue of continuity, the continuity
concern is:
Unless there is evidence to the contrary, the accountant that assumes that the business will continue to
operate indefinitely.
We assign revenues
- The portion of the cost of the building that is assigned to each period depends on this
and expenses to
estimate (how long an asset will be in use) and requires an assumption about specific accounting
periodicity. Assumption of periodicity: periods
Although the lifetime of a business is uncertain, it is nonetheless useful to estimate the
business’s net income in terms of accounting periods. Revenues and
- To measure net income adequately, revenues and expenses must be assigned to the expenses must
accounting period in which they occur, regardless of when cash is received or paid. be assigned to
This is an application of the matching rule: the period in
which they
Revenues must be assigned to the accounting period in which the goods are sold or the services were incurred
performed, and expenses must be assigned to the accounting period in which they are used to
produce revenue.
Accrual accounting
- Transactions recorded in the periods in which the events occur
- Recording revenues when they are earned
Example 1:
Ø Persuasive evidence of an arrangement exists Sell $100,000 in December 2007
Ø A product or service has been delivered Paid in January 2008
Ø The seller’s price to the buyer is fixed or determinable $100,000 recorded in sales revenue for 2007
Ø Collectability is reasonably assured
- Recording expenses when they are incurred Example 2:
Ø Agreement to purchase the goods or services Owe employees salary for December 2007 of
Ø The goods have been delivered or the services rendered $250,00, which is paid in January 2008
$250,000 recorded in salary expense for 2007
Ø A price has been established or can be determined
- Adjusting the accounts
Ø Are necessary because the accounting period ends on a particular day
- In accordance with generally accepted accounting principles (GAAP).
Accrual accounting requires adjusting entries, which take place “manually” at the end of the
accounting period
Asset Liability
Expense 1. Allocating recorded costs between two or 2. Recording unrecorded, incurred expenses
more accounting periods
Revenue 3. Recognizing unrecorded, earned revenues 4. Allocating recorded, unearned revenues
between two or more accounting periods
1
, 1.
• Prepaid expenses are costs paid in advance.
By the end of the accounting period, a
portion will have been used.
• Depreciation of plant and equipment is the amount
of their cost allocated to any one accounting period.
(Accumulated depreciation is a contra account)
2. Accrued expenses accumulate and need to
be recorded (interest, wages, and utilities).
3. When a company receives revenues in
advance, it has an obligation to perform.
Unearned revenues are therefore shown
in a liability account.
4. Accrued revenues are revenues that a
company has earned but for which no
entry has been made in the accounting
periods
Type of account Potential Payment or Receipt Not Paid or Received Result
Prepaid Expense Ending Balance + Expense for the Period – Beginning Balance = Cash Payments for Expenses
Unearned Revenue Ending Balance + Revenue for the Period – Beginning Balance = Cash Receipts from Revenues
Accrued Expense Beginning Balance + Expense for the Period – Ending Balance = Cash Payments for Expenses
Accrued Revenue Beginning Balance + Revenue for the Period – Ending Balance = Cash Receipts from Revenues
2
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