Chapter 3 Adjusting the Accounts

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1 Bennett S. LeBow College of Business Financial Accounting Professor Jane Kaplan Professor Notes Chapter 3 Adjusting the Accounts Measuring Revenues and Expenses o Accrual accounting is a form of accounting in which revenues are recognized when they are earned and expenses are recognized when they are incurred. o Accrual accounting focuses on business activities to determine when to record revenues and expenses. Revenue Transactions o Let s consider some examples for Happy Feet Dance Studio Happy Feet Dance Studios o During the Week of February 20, 2004, Happy Feet dance instructors gave lessons to a group of students for $1000 on credit. o These students paid for these lessons on March 3, o Because the revenue was earned in February when the service was performed, Happy Feet will recognize the revenue in February. o The transaction to record this service is as follows: o Cash was not received at the time that the service was performed; it will be received in the future. Chapter 3 Measuring Revenues and Expenses Page 1

2 Accounts Receivable is an asset account that increases when goods are sold or services are performed on credit, and cash will be received in the future Service Revenue o The service revenue transaction is linked to a second transaction that takes place on March 10 when cash is collected. o When the students remit payment for their lessons, Happy Feet records the following: o Revenue is not recognized at the time cash is received because it was recognized when the service was delivered in February. o Because the performance occurs at one time, and cash is received at a different time, two transactions are necessary to record (1) the service, and (2) the subsequent cash receipt o Sometimes a company receives cash from a customer before a sale is made or a service is performed. o For example, Happy Feet receives $500 from students on February 17, but did not deliver the dance lessons to these students until March 1. o The cash receipt is recorded in February. Chapter 3 Measuring Revenues and Expenses Page 2

3 o Cash increases by the amount received from the students, but revenue is not yet earned because no lessons have been provided. o Instead, Happy Feet has incurred a liability, unearned revenue. o This account results when a company receives cash in advance of performance. o Happy Feet received cash before they provided the dance lessons, so they have an obligation to deliver the lessons in the future. o On March 1, when the service is performed (the dance lessons are provided), Happy Feet will recognize the discharge of the liability and the service revenue o Again, this process results in revenue being recognized in the period in which it is earned regardless of when the cash is received. o To summarize, businesses recognize revenues in the period in which they are earned. o Typically, the earnings process is considered to be complete at the time goods are transferred to customers or services are provided to customers o Three possibilities exist concerning this relationship 1. Cash may be received at the time revenue is earned. Here, revenue and cash are the only accounts necessary for the transaction. 2. Revenue may be earned prior to cash being received. Accrued revenue is revenue recognized prior to the receipt of cash. Here, Accounts Receivable is used to connect revenue and cash. 3. Revenue may be earned after cash is received. Deferred Revenue is revenue recognized after cash has been received. Here, unearned revenue is used to connect revenue and cash. Chapter 3 Measuring Revenues and Expenses Page 3

4 Expense Transactions o We may recognize expenses at the time cash is paid. o For example, we will record payment for February s rent. o Expenses may also be accrued or deferred. o Accrued expenses result when expenses are recognized prior to the disbursement of cash. o Deferred expenses result when expenses are recognized after the disbursement of cash. o For example, Happy Feet Dance Studios purchased $500 of supplies on February 10, o Happy Feet purchased them on credit, agreeing to pay the supplier by March 10. o On March 7, Happy Feet sends a check to the supplier. o Happy Feet records the purchase as follows: o This transaction records the supplies as an asset and the amount owed to the supplier as a liability. Chapter 3 Measuring Revenues and Expenses Page 4

5 o Accounts Payable is a liability that identifies an open obligation to pay suppliers in the future. o When Happy Feet uses the supplies, they will record an expense and a decrease to supplies. o If Happy Feet uses the supplies by the end of February, they will record: o This transaction records the expense in the fiscal period in which the resources were consumed. o Another transaction is necessary to record the payment for the supplies. o If Happy Feet remits payment to the supplier on March 5, they will record: o Accounts Payable is an example of a general category of liabilities known as accrued liabilities. o Accrued liabilities record the obligation to make payments for expenses that have been incurred or for assets that have been acquired but for which payment has not yet been made. o Other examples of accrued liabilities include Wages Payable, Interest Payable and Income Taxes Payable. Chapter 3 Measuring Revenues and Expenses Page 5

6 o Note: In chapter 2, we recorded the purchase of supplies as an expense at the time the supplies were acquired because the supplies were used in January. o In theory, it is preferable to record the purchase as an asset and then expense the supplies when they are used. o Practically, however, it does not matter when the supplies are recorded as an asset initially if all of the supplies are consumed in the same fiscal period in which they were acquired. o Either way, the amount will be an expense by the end of the fiscal period. o On February 15, Happy Feet pays $300 for March rent. o Prepaid Rent is an example of a prepaid expense account. o A prepaid expense is an asset that identifies a resource that has been paid for but not used. o The purchase is an asset because a resource has been acquired that will be used in the future. o The expense should be recognized in March when the resource is consumed, not in February when the resource is paid for. o The expense has been deferred from the date of payment to March when the building is used. o By the end of March, the rental service has been consumed, and we can record the increase to expense and the decrease to the asset. Chapter 3 Measuring Revenues and Expenses Page 6

7 o In summary, accrual accounting records expenses when assets are used, not necessarily when cash is paid for them. o Three possibilities exist concerning expenses. o In all three, expense is recognized when it is incurred 1. Cash may be paid at the time expense is incurred. Here, expense and cash are the only accounts necessary for the transaction. 2. If an expense is incurred before cash is paid, the expense is accrued. Here, a payable account is used to connect expense and cash. 3. If cash is paid before an expense is incurred the expense is deferred. Here, prepaid expense is used to connect expense and cash. o By recording revenues when earned and expenses when incurred, a company matches resources consumed by business activities with revenues created by those activities. o Net income (revenue - expenses) measures business activities for a fiscal period. o It is not a measure of how much cash a company received or paid. o An important concept in accounting is the matching principle, which requires businesses to recognize the expenses used to generate revenues in the same accounting period in which the revenues are recorded. Adjusting Account Balances o Some revenues and many expenses are associated with the passage of time. o Rent, Insurance, and equipment are assets that are purchased in one period and used in future periods. Chapter 3 Measuring Revenues and Expenses Page 7

8 o Wages relate to those periods in which employees work, regardless of whether or not they are paid during those periods. o Interest on debt accumulates as time passes. o These activities may result in an expense or revenue that must be recognized for a reporting period even though no specific event occurs to create the revenue or expense other than the passage of time. o A business must adjust its accounts at the end of a reporting period to record the revenues and expenses that should be recognized for that period. o Let s look at some examples of adjustments for Happy Feet Dance Studio. o In mid-february, Happy Feet decided to move into a new studio on April 1. o The rent for the new studio is $700 per month. o On February 26, rent is paid for April, May, and June. o The transaction for February would be: o At the end of April, May, and June, Happy feet must record Rent Expense for each month. Chapter 3 Measuring Revenues and Expenses Page 8

9 o The journal entries for April, May, and June are adjusting entries which are transactions recorded to ensure that the correct account balances are reported for a reporting period. o Another example of an adjusting entry is for interest. o As shown in chapter 2, Happy Feet borrowed $8,000 in January. o The bank charges $50 of interest each month, but the interest only needs to be paid the day after the end of each quarter. o Therefore, Happy Feet s first interest payment is not due until April 1, o However, interest expense accrues each month and should be recorded in the fiscal period in which it is incurred. o Happy Feet records these adjusting journal entries at the end of January, February, and March. o Every adjusting entry always includes at least one balance sheet account and one income statement account. o Cash is never part of an adjusting journal entry Chapter 3 Measuring Revenues and Expenses Page 9

10 o Another transaction on April 1 records payment of the interest liability that accumulated over the three months. o This entry merely records the payment of the liability. o In January, Happy Feet purchased equipment for $2,000 and furniture and fixtures for $4,000. o Equipment and other physical assets (with the exception of land) wear out over time and need to be replaced. o Because these resources are used up over a number of periods, the usage is recognized as an expense of each period that benefits from that usage. o Depreciation is the allocation of the cost of physical assets to the fiscal periods that benefit from the assets use. o Happy Feet records depreciation as expense at the rate of $100 per month on equipment, and $200 per month on furniture and fixtures. o Depreciation expense identifies the estimated amount of asset consumed. o Accumulated Depreciation is a contra-asset account used to identify the total amount of depreciation recorded for a company s assets. o It is subtracted from the related asset account on the balance sheet. o It has a normal credit balance and is an offsetting account to the related asset. o Happy Feet balance sheet for January and February will report: Chapter 3 Measuring Revenues and Expenses Page 10

11 Ledger Accounts o Business transactions are initially recorded in a journal. o A journal is the book of original entry, a chronological record of a company s transactions. o Once transactions are recorded in a journal, the effect of these transactions needs to be transferred to the appropriate accounts. o A ledger is a file in which each of a company s accounts and the balances of those accounts are maintained. o Posting is the process of transferring transactions to specific accounts in a company s ledger. o After transactions have been posted, the ledger provides a record of the current balance of each of a company s accounts. o These balances are the primary source of data for preparing the company s financial statements Closing Entries and Financial Statements o At the end of each month, Happy Feet Dance studio prepares financial statements. o These financial statements report the company s business activities to help with decision-making. o Before preparing the financial statements, we will look at a summary of all of the general ledger account balances called a trial balance. o The purpose of the trial balance to prove that the total debits = total credits. Chapter 3 Measuring Revenues and Expenses Page 11

12 o Before preparing a Balance sheet, we will close the revenue and expense accounts for January and February. o Closing these accounts will transfer the balances in these accounts to retained earnings. Chapter 3 Measuring Revenues and Expenses Page 12

13 o The closing process includes two transactions. o First: Revenue Account balances are transferred to Retained Earnings, and second, expense account balances are transferred to retained earnings. o The balances, therefore of revenue and expense accounts will be zero to begin the month of March. o If revenues are greater than expenses for the period, Retained Earning increases. o If revenues are less than expenses, Retained Earnings decreases. o Closing entries reset the balances of each revenue and expense account to zero and transfer these balances to Retained Earnings. o Because revenues and expenses are closed at the end of a fiscal period, they are called temporary accounts. o They are used during the reporting period to collect the results of operating activities. o These results are transferred to Retained Earnings at the end of the period. o Retained Earnings and other balance sheet accounts are called permanent accounts because their balances continue to accumulate from period to period. Payments to Owners o Another transaction that affects the balance of Retained Earnings is the payment by a company to its owners. o If the owners of Happy Feet decide to withdraw $100 from the business at the end of February, the transaction will be recorded: Chapter 3 Measuring Revenues and Expenses Page 13

14 o After closing and recording the withdrawal, Happy Feet prepares a post closing trial balance at the end of February. o At this date, the revenue and expense accounts have zero balances. Chapter 3 Measuring Revenues and Expenses Page 14

15 Summary of Accounting Cycle 1. Record transactions in a journal. 2. Post transactions to ledger accounts. 3. Prepare adjusting journal entries at the end of the fiscal period and post to ledger accounts. 4. Prepare a summary of account balances a trial balance. 5. Prepare Income Statement. 6. Close revenue and expense accounts to retained earnings. 7. Prepare post-closing trial balance. 8. Prepare Balance Sheet and Statement of Cash Flows Chapter 3 Measuring Revenues and Expenses Page 15

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