Chapter 3 Homework The Expense Recognition Principle Requires That Efforts

CHAPTER 3

ADJUSTING THE ACCOUNTS

LEARNING OBJECTIVES

1. EXPLAIN THE ACCRUAL BASIS OF ACCOUNTING

AND THE REASONS FOR ADJUSTING ENTRIES.

2. PREPARE ADJUSTING ENTRIES FOR DEFERRALS.

3. PREPARE ADJUSTING ENTRIES FOR ACCRUALS.

4. DESCRIBE THE NATURE AND PURPOSE OF AN

ADJUSTED TRIAL BALANCE.

*5. PREPARE ADJUSTING ENTRIES FOR THE ALTERNA-

TIVE TREATMENT OF DEFERRALS.

*6. DISCUSS FINANCIAL REPORTING CONCEPTS.

*7. COMPARE THE PROCEDURES FOR RECORDING

ADJUSTING ENTRIES UNDER GAAP AND IFRS.

CHAPTER REVIEW

Timing Issues

1. (L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a

business can be divided into artificial time periods.

2. Accounting time periods are generally a month, a quarter, or a year. An accounting time period

that is one year in length is a fiscal year.

Accrual Basis of Accounting

3. The revenue recognition and expense recognition principles are used under the accrual basis of

Revenue Recognition Principle

The Expense Recognition Principle

6. The expense recognition principle requires that efforts (expenses) be matched with results

(revenues).

Adjusting Entries

7. Adjusting entries are made in order for:

Deferrals

9. (L.O. 2) Prepaid expenses are expenses paid in cash before they are used or consumed.

a. Prepaid expenses expire with the passage of time or through use and consumption.

b. An asset-expense account relationship exists with prepaid expenses.

10. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a

rational and systematic manner.

a. The purchase of equipment or a building is viewed as a long-term prepayment of services

and, therefore, is allocated in the same manner as other prepaid expenses.

11. Unearned revenues are cash received before services are performed.

a. Unearned revenues are subsequently recognized by performing the service for a customer.

b. A liability-revenue account relationship exists with unearned revenues.

Accruals

12. (L.O. 3) Accrued revenues are revenues for services performed but not yet received in cash or

recorded.

a. Accrued revenues may accumulate with the passing of time as in the case of interest and rent,

or through services performed but for which payment has not been collected.

13. Accrued expenses are expenses incurred but not yet paid in cash or recorded.

a. Accrued expenses result from the same causes as accrued revenues and include interest,

rent, taxes, and salaries.

b. A liability-expense account relationship exists with accrued expenses.

c. Prior to adjustment, both liabilities and expenses are understated.

14. Each adjusting entry affects one balance sheet account and one income statement account.

Adjusted Trial Balance

15. (L.O. 4) After all adjusting entries have been journalized and posted an adjusted trial balance

is prepared. This trial balance shows the balances of all accounts, including those that have been

adjusted, at the end of the accounting period.

Alternative Treatment

*18. (L.O. 5) Under the alternative treatment, at the time an expense is prepaid, an expense account

is debited, and when unearned revenues are received a revenue account is credited.

*19. The alternative treatment of prepaid expenses and unearned revenues has the same effect on the

financial statements as the procedures described in the chapter.

*20. When a prepaid expense is initially debited to an expense account,

a. No adjusting entry will be required if the prepayment is fully expired or consumed before the

next financial statement date.

*21. When an unearned revenue is initially credited to a revenue account, the procedures are similar to

those described above for prepaid expenses. In this case, however,

Financial Reporting Concepts

*22. (L.O.6) According to the FASB, to be useful, information should have two fundamental

qualities: relevance and faithful representation. Accounting information has relevance if it makes

a difference in a business decision. If relevant, accounting information has predictive value

and confirmatory value. In addition, materiality is a company-specific aspect of relevance.

*24. To be relevant, accounting information must be presented on a timely basis, meaning that it must

be available to decision makers before it loses its capacity to influence decisions. Accounting

information is understandable if it is presented in a clear and concise fashion so that a

reasonably informed user can interpret and use it. Accounting information is verifiable if it can be

proven to be free from error.

*27. GAAP generally uses one of two measurement principles. The historical cost principle

states that assets are record at their cost. Cost is used because it is easy to verify: usually there is

documentation when an asset is purchased. The fair value principle indicates that assets and

liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

Compare the Procedures for Adjusting Entries Under GAAP and IFRS

*30. The similarities and differences between GAAP and IFRS are:

a. Similarities

(1) Both use accrual-basis accounting

(2) Neither allows the cash-basis of accounting

LECTURE OUTLINE

A. Timing Issues.

1. The assumption that the economic life of a business can be divided into

artificial time periods.

B. Accrual- vs. Cash-Basis Accounting.

1. Using the accrual basis to determine net income means companies rec-

ognize revenues when they actually perform the services (rather than

C. Recognizing Revenues and Expenses.

1. The revenue recognition principle requires that companies recognize reve-

nue in the accounting period in which the performance obligation is

satisfied.

ETHICS INSIGHT

Allegations of abuse of the revenue recognition principle have become all too

common in recent years. One company was accused of saying that a sale that

occurred at the beginning of one quarter occurred at the end of the previous

quarter in order to achieve the previous quarters sales targets.

What motivates sales executives and finance and accounting executives to

participate in activities that result in inaccurate reporting of revenues?

D. The Basics of Adjusting Entries.

1. In order for revenues and expenses to be reported in the correct period,

companies make adjusting entries at the end of the accounting period.

Adjusting entries ensure that revenues are recognized in the period in

which services are performed, and that expenses are recognized in the

period in which they are incurred.

b. Depreciation Adjustment.

(1) Depreciation is the process of allocating the cost of an asset to

expense over its useful life in a rational and systematic manner.

c. When companies receive cash before services are performed, they

record a liability called unearned revenues (magazine subscriptions,

customer deposits).

ACCOUNTING ACROSS THE ORGANIZATION

Gift cards are popular with marketing executives, but they create accounting

questions. Should revenue be recorded at the time the gift card is sold, or when it

is used by the customer?

Suppose a customer purchases a $100 gift card at Best Buy on December 24,

2014, and gives it to his wife on December 25, 2014. On January 3, 2015, the

customer’s wife uses the card to purchase CDs. When do you think Best Buy

should recognize revenue, and why?

4. Accruals (accrued revenues and accrued expenses).

a. Revenues for services performed but not yet recorded at the

statement date are accrued revenues (interest, rent, commissions).

E. The Adjusted Trial Balance and Financial Statements.

1. The adjusted trial balance is prepared after all adjusting entries have

been journalized and posted.

*F. Alternative Treatment of Prepaid Expenses and Unearned Revenue.

1. Companies may initially debit prepaid expenses to an expense account

instead of an asset account. The adjusting entry requires recording an

asset for the unexpired portion and crediting the expense account so

that its balance will reflect the amount consumed.

*G. Discuss Financial Reporting Concepts.

1. To be useful, information should possess two fundamental qualities:

relevance and faithful representation.

a. Relevance – if information has the ability to make a difference in a

decision scenario, it is relevant.

2. Enhancing Qualities – include comparability, consistency, verifiability,

timeliness, and understandability.

a. Comparability—when different companies use the same accounting

principles.

3. Monetary Unit Assumption – states that only transactions expressed

in money are included in the accounting records.

4. Economic Entity Assumption

5. Time Period (Periodicity) Assumption – allows the business to be

divided into artificial time periods that are useful for reporting.

a. Historical Cost Principle – requires assets to be recorded at original

cost because that amount is verifiable.

IFRS

A Look at IFRS

It is often difficult for companies to determine in what time period they should

report particular revenues and expenses. Both the IASB and FASB are working

on a joint project to develop a common conceptual framework, as well as a

revenue recognition project, that will enable companies to better use the same

principles to record transactions consistently over time.

KEY POINTS

Similarities

• In this chapter, you learned accrual-basis accounting

applied under GAAP. Companies applying IFRS also use

accrual-basis accounting to ensure that they record

transactions that change a company’s financial statements

in the period in which events occur.

Differences

• Under IFRS, revaluation of items such as land and buildings

is permitted. IFRS allows depreciation based on revaluation

of assets, which is not permitted under GAAP.

LOOKING TO THE FUTURE

The IASB and FASB have recently completed a joint project on revenue

recognition. The purpose of this project was to develop comprehensive guidance

on when to recognize revenue.

20 MINUTE QUIZ

Circle the correct answer.

True/False

1. Since companies find it desirable and necessary to report the results of their activities

frequently, the time period assumption assumes that the economic life of a business can

be divided into artificial time periods.

True False

2. The revenue recognition principle requires that companies recognize revenue in the period

in which cash was received rather than when the performance obligation is satisfied.

True False

3. Monthly and quarterly time periods are commonly referred to as fiscal periods.

True False

4. Payments of expenses that will benefit more than one accounting period are referred to

as prepaid expenses.

True False

5. Cost less accumulated depreciation is a measurement of the current value of an asset

such as equipment or a building.

True False

6. Depreciation is the process of allocating the cost of an asset to expense over its useful

life in a rational and systematic manner.

True False

7. The adjusting entry for unearned revenues results in a debit to an asset account and a

credit to a revenue account.

True False

8. A contra-asset account is an account whose balance is deducted from a related asset in

the financial statements.

True False

9. When accrual-basis accounting is applied, adjusting entries are not necessary.

True False

10. Adjustments for accrued expenses are necessary to record the obligations that exist at

the balance sheet date and to recognize the expenses that are applicable to the current

accounting period.

True False

Multiple Choice

1. The recording of salaries and wages earned but not yet paid is an example of an

adjustment that

a. recognizes an accrued expense.

b. recognizes an unrecorded revenue.

c. apportions revenues between two or more periods.

d. apportions costs between two or more periods.

2. A list of the accounts and their balances after all adjustments have been made is known as

a. adjusting entries.

b. adjusted trial balance.

c. book values.

d. accrued accounts.

3. Prior to recording adjusting entries, revenues exceed expenses by $60,000. Adjusting

entries for accrued salaries and wages of $10,000 and depreciation expense of $10,000

were made. Net income for the year would be

a. $60,000.

b. $50,000.

c. $40,000.

d. none of the above.

4. The adjustment for depreciation is an example of

a. recognizing an accrued expense.

b. apportioning costs between two or more periods.

c. apportioning revenues between two or more periods.

d. recognizing an unrecorded revenue.

5. Most businesses choose fiscal years which correspond to

a. the calendar year.

b. any twelve-month period.

c. their natural business year.

d. any of the above.

ANSWERS TO QUIZ

True/False

Multiple Choice