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Summary - Book "Accounting Principles" | Accounting

Accounting (Erasmus Universiteit Rotterdam)

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Chapter 3. Adeusting the Accounts

Accrual-basis accounting: companies record transactions that change a company’s
financial statements in the periods in which the events occur. So they recognize revenues
when they perform the actual service, rather than when they receive cash. It also means
recognizing expenses when incurred, rather than when it’s paid.
Cash-basis accounting: companies record revenue when they receive cash. They
record an expense when they pay out cash.

Accrual-basis accounting is in accordance with the Generally Accepted

Accounting Principles (GAAP), and cash-basis accounting is not (you can only
use it internal)!

Revenue recognition principle: companies recognize revenue in the accounting period

in which the performance obligation is satisfied.

EXAMPLE: Dave’s Dry Cleaning cleans clothing on June 30, but customers do not claim
and pay for their clothes until the first week of July. Dave’s should record revenue in June
when it performed the service (satisfied the performance obligation) rather than in July
when it received the cash. At June 30, Dave’s would report a receivable on its balance
sheet and revenue in its income statement for the service performed.

Expense recognition principle (matching principlen: dictates that efforts (expenses)

be matched with results (revenues)

EXAMPLE: In the dry cleaning example, this means that Dave’s should report the salary
expense incurred in performing the June 30 cleaning service in the same period in which
it recognizes the service revenue. 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.

Adjusting entries: ensure that the revenue recognition and expense recognition
principles are followed. Adjusting entries are required every time a company prepares
financial statements. Every adjusting entry will include one income statement account
and one balance sheet account.

Adjusting entries are classified as either deferrals or accruals:

Deferrals:
1. Prepaid expenses: expenses paid in cash before they are used or consumed, for
example with supplies, insurance or depreciation.

SUPPLIES EXAMPLE: Pioneer Advertising purchased supplies costing $2500 on October

5. Pioneer recorded the purchase by increasing (debiting) the asset Supplies. This account
shows a balance of $2500 in the October 31 trial balance. An inventory count at the close
of business on October 31 reveals that $1000 of supplies are still on hand at the
statement date. In addition, Supplies Expense shows a balance of $1500, which equals
the cost of supplies used in October.

JE: Oct. 31 Supplies Expense 1500

Supplies 1500

INSURANCE EXAMPLE: On October 4, Pioneer Advertising paid $600 for a one-year fire
insurance policy. Coverage began on October 1. Pioneer recorded the payment by
increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the
October 31 trial balance. Insurance of $50 ($600/12) expires each month. The expiration
of prepaid insurance decreases an asset, Prepaid Insurance. It also decreases Owner’s
Equity by increasing an expense account, Insurance Expense.

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JE: Oct 31. Insurance Expense 50

Prepaid Insurance 50

Depreciation: depreciation is the process of allocating the cost of an asset to expense

over its useful life.

Depreciation is an allocation concept, not a valuation concept. That is,

depreciation allocates an asset’s cost to the periods in which it is used.
Depreciation does not attempt to report the actual change in the value of the
asset.

DEPRECIATION EXAMPLE: For Pioneer Advertising, assume that depreciation on the

equipment is $480 a year, or $40 per month. Rather than decrease the asset account
directly, Pioneer instead credits ‘Accumulated Depreciation – Equipment’. This is called a
‘contra asset account’. Such an account is offset against an asset account on the
balance sheet. Thus, the Accumulated Depreciation – Equipment account offsets the
asset Equipment. This account keeps track of the total amount of depreciation
expense taken over the life of the asset.

JE: Oct 31. Depreciation Expense 40

Accumulated Depreciation – Equipment 40

yook value: is the difference between the cost of any depreciable asset and its related
accumulated depreciation.

2. Unearned revenues: cash received before services are performed

The adjusting entry for unearned revenues results in a decrease (debit) to a liability
account and an increase (credit) to a revenue account.

EXAMPLE: Pioneer Advertising received $1200 on October 2 from R. Knox for advertising
services expected to be completed by December 31. Pioneer credited the payment to
Unearned Service Revenue. This liability account shows a balance of $1200 in the
October 31 trial balance. From an evaluation of the services Pioneer performed for Knox
during October, the company determines that it should recognize $400 of revenue in
October. The liability (Unearned Service Revenue) is therefore decreased, and Owner’s
Equity (Service Revenue) is increased.

JE: Oct 2. Cash 1200

Unearned Service Revenue 1200

Oct 31. Unearned Service Revenue 400

Service Revenue 400

Accruals:
1. Accrued revenues: revenues for services performed but not yet received in cash or
recorded
An adjusting entry for accrued revenues results in an increase (debit) to an asset account
and an increase (credit) to a revenue account.

EXAMPLE: Pioneer Advertising performed services worth $200 that were not billed to
clients on or before October 31. Because these services are not billed, they are not
recorded. The accrual of unrecorded service revenue increases an asset account,
Accounts Receivable. It also increases Owner’s Equity by increasing a revenue account,
Service Revenue.
JE: Oct 31. Accounts Receivable 200
Service Revenue 200

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The asset Accounts Receivable shows that clients owe Pioneer $200 at the balance sheet
date. On November 10, Pioneer receives cash of $200 for the services performed in
October.

JE: Nov 10. Cash 200

Accounts Receivable 200

2. Accrued expenses: expenses incurred but not yet paid in cash or recorded. Interest,
taxes and salaries are common examples of accrued expenses. An adjusting entry for
accrued expenses results in an increase (debit) to an expense account and an increase
(credit) to a liability account.

Computing interest:

Face Valueof Note∗Annual Interest Rate∗Time∈Terms of One Year=Interest

INTEREST EXAMPLE: Pioneer advertising signed a three-month note payable in the

amount of $5000 on October 1. The note requires Pioneer to pay interest at an annual
rate of 12%. The amount of the interest recorded is determined by three factors: (1) the
face value of the note; (2) the interest rate, which is always expressed as an annual rate;
and (3) the length of time the note is outstanding.
For Pioneer, the total interest due on the $5000 note at its maturity date three months in
3
the future is $150 ($5000 * 12% * ), or $50 for one month.
12
JE: Oct 31. Interest Expense 50
Interest Payable 50

ACCRUED SALARIES AND WAGES EXAMPLE: Pioneer Advertising paid salaries and
wages on October 26 for its employees’ first two weeks of work. The next payment of
salaries will not occur until November 9. Three working days remain in October (October
29, 30 and 31).
At October 31, the salaries and wages for these three days represent an accrued expense
and a related liability to Pioneer. The employees receive total salaries and wages of
$2000 for a five-day work week, or $400 per day. Thus, accrued salaries and wages at
October 31 are $1200 ($400*3). This accrual increases a liability, Salaries and Wages
Payable. It also decreases Owner’s Equity by increasing an expense account, Salaries and
Wages Expense.

JE: Oct 31. Salaries and Wages Expense 1200

Salaries and Wages Payable 1200

Summary of Basic Relationships

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

Type of Adeustment Accounts yefore Adeusting Entry

Adeustment
Prepaid expenses Assets overstated Dr. Expenses
Expenses understated Cr. Assets or Contra
Assets
Unearned revenues Liabilities overstated Dr. Liabilities
Revenues understated Cr. Revenues
Accrued revenues Assets understated Dr. Assets
Revenues understated Cr. Revenues
Accrued expenses Expenses understated Dr. Expenses
Liabilities understated Cr. Liabilities

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Historical Cost Principle: dictates that companies record assets at their cost. This is
true not only at the time the asset is purchased but also over the time the asset is held.
For example, if land that was purchased for $30000 increases in value to $40000, it
continues to be reported at $30000

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). Fair value information may be
more useful than historical cost for certain types of assets and liabilities. Only in
situations where assets are actively traded, such as investment securities, is the fair
value principle applied.

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Chapter 4. Completing the Accounting Cycle

Steps in Preparing a Worksheet:
1. Prepare a trial balance on the worksheet
2. Enter adjustment data
3. Enter adjusted balances
4. Extend adjusted balances to appropriate statement columns
5. Total the statement columns, compute net income (or net loss), and complete
worksheet.

Temporary accounts: relate only to a given accounting period. The company closes all
these temporary accounts at the end of the period.
- All revenue accounts
- All expense accounts
- Owner’s Drawings account

Permanent accounts: relate to one or more future accounting periods. These accounts
are not closed from period to period.
- All asset accounts
- All liability accounts
- Owner’s Capital account

Preparing closing entries + journal entries:

1. Debit each revenue account for its balance, and credit Income Summary for
total revenues.

JE: Revenue 100

Income Summary 100

2. Debit Income Summary for total expenses, and credit each expense account
for its balance.

JE: Income Summary 30

Expenses 30

3. Debit Income Summary and credit Owner’s Capital for the amount of net
income.

JE: Income Summary 70

Owner’s Capital 70

4. Debit Owner’s Capital for the balance in the Owner’s Drawings account, and
credit Owner’s Drawings for the same amount.

JE: Owner’s Drawings 70

Owner’s Capital 70

Correcting Entries: If errors occur in the recording process, companies should correct
errors, as soon as they discover them, by journalizing and posting correcting entries.
Correcting entries must be posted before closing entries!

EXAMPLE: On May 10, Mercato Co. journalized and posted a $50 cash collection on
account from a customer as a debit to Cash $50 and a credit to Service Revenue $50. The
company discovered the error on May 20, when the customer paid the remaining balance
in full.

Incorrect JE: May 10. Cash 50

Service Revenue 50

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Correct JE: May 10. Cash 50

Accounts Receivable 50

Correcting JE: May 20. Service Revenue 50

Accounts Receivable 50

EXAMPLE: On May 18, Mercato Co. purchased on account equipment costing $450. The
transaction was journalized and posted as a debit to Equipment $45 and a credit to
Accounts Payable $45. The error was discovered on June 3, when Mercato received the
monthly statement for May from the creditor.

Incorrect JE: May 18. Equipment 45

Accounts Payable 45

Correct JE: May 18. Equipment 450

Accounts Payable 450

Correcting JE: June 3. Equipments 405

Accounts Payable 405

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Chapter 5. Accounting for Merchandising Operations

Sales Revenue−Cost of Goods Sold=Gross Profit

Gross Profit−Operating Expenses=Net Income∨Net Loss

Beginning Inventory +Cost of Goods Purchased=Cost of Goods Available for Sale

Cost of Goods Available for Sale−Cost of Goods Sold =Ending Inventory

Perpetual Inventory System: in this system, companies keep detailed records of the
cost of each inventory purchase and sale. These records continuously – perpetually- show
the inventory that should be on hand for every item. Under this system, a company
determines the cost of goods sold each time a sale occurs.

Periodic Inventory System: in this system, companies do not keep detailed inventory
records of the goods on hand throughout the period. Instead, they determine the cost of
goods sold only at the end of the accounting period- that is, periodically. To determine the
cost of goods sold under a periodic inventory system, the following steps are necessary:

1. Determine the beginning inventory

2. Add: Cost of Goods Purchased
3. Less: ending inventory

Freight Costs:
- FOy shipping point: buyer pays freight costs

EXAMPLE: The buyer pays the seller $150 for freight charges;

JE: Inventory 150

Cash 150

- FOy destination: seller pays freight costs -> operating expense to a seller

EXAMPLE: If the freight terms require the seller to pay the freight charges ($150), the
entry for the seller would be;

JE: Freight-Out Charges (or Delivery Expense) 150

Cash 150

Purchase Returns and Allowances: A purchaser may be dissatisfied with the

merchandise received because the goods are damaged or defective, of inferior quality or
do not meet the purchaser’s specifications. In such cases the purchaser may return the
goods to the seller for credit if the sale was made on credit, or for a cash refund if the
purchase was for cash. This transaction is known as a purchase return. Alternatively, the
purchaser may choose to keep the merchandise if the seller is willing to grant an
allowance (deduction) from the purchase price. This transaction is known as a purchase
allowance.

EXAMPLE: Assume that Sauk Stereo returned goods costing $300 (that was made on
account) to PW Audio Supply on May 8. The following entry by Sauk Stereo for the
returned merchandise is made:

JE: May 8. Accounts Payable 300

Inventory 300

Purchase Discounts: The credit terms of a purchase on account may permit the buyer
to claim a cash discount for prompt payment. The buyer calls this cash discount a
purchase discount.

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2/10, n/30 -> this means, if the buyer pays in 10 days, he will get a 2% discount on the
purchase price, but if he doesn’t pay in 10 days, he has to pay within 30 days.

JE: Accounts Payable 3500

Cash 3430
Inventory 70
(To record payment within discount period)

JE: Accounts Payable 3500

Cash 3500
(To record payment with no discount taken)

The seller makes two entries for each sale under a perpetual system

EXAMPLE: PW Audio Supply records its sale of $3800 to Sauk Stereo as follows (assume
the merchandise cost PW Audio Supply $2400).

JE:
1) Accounts Receivable 3800
Sales Revenue 3800

2) Cost of Goods Sold 2400

Inventory 2400

Sales Returns and Allowances: we now look at the ‘flip side’ of purchase returns and
allowances, which the seller records as sales returns and allowances. These are
transactions where the seller either accepts goods back from the buyer (a return) or
grants a reduction in the purchase price (an allowance) so the buyer will keep the goods.
Sales Returns and Allowances is a contra account to Sales Revenue.

JE:

1) Sales Returns and Allowances xx

Accounts Receivable xx

2) Inventory xx
Cost of Goods Sold xx

Sales Discounts: is also a contra account to Sales Revenue, it makes Sales Revenue
decrease as it increases.

JE: Cash 3430

Sales Discount 70
Accounts Receivable 3500

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