C HAP TE R Adjusting the Accounts Principles of Accounting 12e Needles Powers Crosson © human/iStockphoto Net Income Net income is the net increase in owner’s equity that results from a company’s operations – In its simplest form, net income results when revenues exceed expenses Net Income = Revenues − Expenses – When expenses exceed revenues a net loss occurs Revenues are increases in owner’s equity that result from performing business activities Expenses are decreases in owner’s equity resulting from the cost of doing business ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Continuity The majority of companies present annual financial statements on the assumption that the business will continue to operate indefinitely— that is, that the company is a going concern The continuity assumption states that unless there is evidence to the contrary, the accountant assumes that the business is a going concern and will continue to operate indefinitely – The continuity assumption allows certain expense and revenue transactions to be allocated over several accounting periods ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Periodicity The periodicity assumption states that although the lifetime of a business is uncertain, it is nonetheless useful to estimate the business’s net income in terms of accounting periods A 12-month accounting period is called a fiscal year – The fiscal year may be the same as the calendar year or some other 12-month period Accounting periods of less than a year are called interim periods ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Accrual Accounting (Matching Rule) Under accrual accounting (often referred to as the matching rule) net income is measured by assigning: – Revenues to the accounting period in which the goods are sold or the services performed – Expenses to the accounting period in which they are used to produce revenue When there is no direct means of connecting expenses and revenues, costs are allocated among the accounting periods that benefit from the costs ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Concepts Underlying Accrual Accounting The cash basis of accounting is the practice of accounting for revenues in the period in which cash is received and for expenses in the period in which cash is paid – With this method, taxable income is calculated as the difference between cash receipts from revenues and cash payments for expenses In accrual accounting, revenues and expenses are recorded when they are earned or incurred rather than when they are received or paid ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Recognizing Revenues The process of determining when revenue should be recorded is called revenue recognition The Securities and Exchange Commission requires that all the following conditions be met before revenue is recognized: – Persuasive evidence of an arrangement exists – A product or service has been delivered – The seller’s price to the buyer is fixed or determinable – Collectibility is reasonably ensured ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Recognizing Expenses Expenses are recorded when all of the following conditions are met: – There is an agreement to purchase goods or services – The goods have been delivered or the services rendered – A price has been determined or can be determined – The goods or services have been used to produce revenue The recognition of the expense does not depend on the payment of cash ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part The Adjustment Process Accrual accounting involves adjusting the accounts – Adjustments are necessary because the accounting period, by definition, ends on a particular day Some transactions invariably span the cutoff point, and therefore, some accounts need adjustment – When transactions span more than one accounting period, accrual accounting requires the use of adjusting entries These are either deferrals or accruals A deferral is the postponement of the recognition of an expense already paid or of revenue received in advance The cash payment or receipt is recorded before the adjusting entry is made An accrual is the recognition of an expense or a revenue that has arisen but not been recorded during the accounting period The cash payment or receipt occurs in a future accounting period ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Type Adjustment: Allocating Recorded Costs (Deferred Expenses) Companies often make expenditures that benefit more than one period – These costs are debited to an asset account – At the end of the accounting period, the amount of the asset that has been used is transferred from the asset account to an expense account Prepaid expenses are costs that companies pay in advance, such as rent, supplies, and insurance ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Depreciation of Plant and Equipment When a company buys a long-term asset, it is paying for the usefulness of that asset for as long as it benefits the company The accountant must allocate the cost of the asset over its estimated useful life The amount allocated to any one accounting period is called depreciation – To maintain historical costs, Accumulated Depreciation accounts are used to accumulate the depreciation on each long-term asset These accounts are called contra accounts The balance of a contra account is shown on a financial statement as a deduction from its related account (for example, an asset account) The net amount is called the carrying value (or book value) of the asset ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Type Adjustment: Recognizing Unrecorded Expenses (Accrued Expenses) At the end of an accounting period, some expenses incurred during the period have not been recorded These expenses require adjusting entries Examples include: – Interest on borrowed money – Wages – Utilities These expenses are called accrued expenses because, as the expense and the corresponding liability accumulate, they are said to accrue ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Type Adjustment: Allocating Recorded, Unearned Revenues (Deferred Revenues) When a company receives revenues in advance, it has an obligation to deliver goods or perform services These unearned revenues are shown in a liability account – As a company delivers part of the goods or performs part of the services, it earns a part of the advance receipts – The earned portion must be transferred from the liability account to a revenue account ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Type Adjustment: Recognizing Unrecorded, Earned Revenues (Accrued Revenues) Accrued revenues are revenues that a company has earned by performing a service or delivering goods but for which no entry has been made in the accounting records – Any revenues earned but not recorded during an accounting period require an adjusting entry that debits an asset account and credits a revenue account ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Using the Adjusted Trial Balance to Prepare Financial Statements After adjusting entries have been recorded and posted, an adjusted trial balance is prepared by listing all accounts and their balances – The revenue and expense accounts are used to prepare the income statement, and the asset and liability accounts are used to prepare the balance sheet – Net income from the income statement is combined with the Withdrawals account on the statement of owner’s equity to give the net change in the Capital account – The balance of the Capital account is used in preparing the balance sheet ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Net Income: Ethical Measurement and Cash Flows Adjusting entries affect net income and the assets and liabilities on the balance sheet that are used to assess the need for cash Because judgment underlies the adjusting entries, there is potential for abuse The manipulation of revenue and expenses to achieve a specific outcome is called earnings management – When estimates move outside a reasonable range, financial statements become misleading ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part Determination of Cash Flows from AccrualBased Information The general rule for determining the cash flow received from any revenue or paid for any expense is to determine the potential cash payments or cash receipts and deduct the amount not paid or not received The application of the general rule by account type is shown below: ©2014 Cengage Learning All Rights Reserved May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part ... or in part Accrual Accounting (Matching Rule) Under accrual accounting (often referred to as the matching rule) net income is measured by assigning: – Revenues to the accounting period in... accessible website, in whole or in part Concepts Underlying Accrual Accounting The cash basis of accounting is the practice of accounting for revenues in the period in which cash is received and... more than one accounting period, accrual accounting requires the use of adjusting entries These are either deferrals or accruals A deferral is the postponement of the recognition of an expense