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Revenue Recognition Principle
Companies recognize revenue in the accounting period in which the performance obligation is satisfied.
Customer requests service —> service is performed → cash is received
How is the Revenue Recognition Principle recorded?
Expense Recognition Principle
Companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue.
Expense Recognition Principle rule of thumb
Let the expenses follow the revenues
Match expenses with revenues in the period when the company makes efforts to generate those revenues.
How is the Expense Recognition Principle recorded?
Periodicity assumption
Economic life of business can be divided into artificial time periods.
Going Concern Assumption
A company will remain operating into the foreseeable future rather than undergo a liquidation.
Historical Cost Principle
Businesses record the original cost of an asset on their balance sheet instead of its current market value.
Economic Entity Assumption
An accounting principle that separates the transactions carried out from its owners.
Accrual-basis accounting
Transactions recorded in the period in which the events occur.
revenues are recognized when services performed, even if cash was not received.
In Accrual-basis accounting . . .
expenses are recognized when incurred even if cash was not paid.
Also in Accrual-basis accounting . . .
revenues are recognized only when cash is received.
In Cash-basis accounting . . .
expenses are recognized only when cash is paid.
Also in Cash-basis accounting . . .
under GAAP
Cash-basis accounting is prohibited . . .
Revenue ($80,000) - Expenses ($50,000) = net income ($300)
Suppose that Fresh Colors paints a large building in 2013. In 2013, it incurs and pays total expenses (salaries and painter costs) of $50,000. It bills the customer $80,000 but does not receive payment until 2014. How is net income calculated in Accrual-basis accounting?
Revenue ($0) - Expenses ($50,000) = net income ($-50,000)
Suppose that Fresh Colors paints a large building in 2013. In 2013, it incurs and pays total expenses (salaries and painter costs) of $50,000. It bills the customer $80,000 but does not receive payment until 2014. How is net income calculated in Cash-basis accounting?
Adjusting Entries purpose
Ensure that the revenue recognition principle and expense recognition principle are followed.
Every time a company prepares financial statements.
When are adjusted entries requires?
one income statement account and one balance sheet account.
Adjusted entries INCLUDE . . .
cash.
Adjusted entries NEVER INCLUDE . . .
Deferrals prepaid expenses
Expenses paid in cash and recorded as assets before they are used or consumed.
Deferrals Unearned revenues
Cash received before services are performed.
Accruals Accrued revenues
Revenues for services performed but not yet received in cash or recorded.
Accruals Accrued expenses
Expenses incurred but not yet paid in cash or recorded.
Supplies Expense
Supplies
Insurance Expense
Prepaid Expense
Depreciation Expense
Accumulated Depreciation
Deferrals: Expenses paid in cash and recorded as assets before they are used or consumed. Now the expense has incurred and needs recorded. What is the journal entry adjustment example(s)?
Unearned Service Revenue
Service Revenue
Deferral: Cash received and recorded as liabilities before revenue is earned. Now the revenue has been earned and needs recorded. What is the journal entry after adjustment example(s)?
Accounts Receivable
Service Revenue
Accruals: Revenues earned but not yet received in cash or recorded. Now it needs recorded. What is the journal entry after adjustment example(s)?
Salaries and Wages Expense
Salaries and wages payable
Utilities Expense
Accounts Payable
Interest Expense
Interest Payable
Accrual: Expenses incurred but not yet paid in cash or recorded. Now it needs recorded. What is the journal entry after adjustment example(s)?
Prepaid expenses examples
Supplies, Prepaid insurance, Depreciation
Depreciation
Companies report a portion of the cost of a long-lived asset as an expense during each period of the asset’s useful life.
Unearned revenues examples
Rent, magazine, subscriptions, customer deposits services in the future
Accrued revenues examples
Performed services, but not billed to client, season ticket sports team
Accrues expense example
Interest
Interest Rate equation
Face Value of Note X Interest Rate X Time in Terms of One Year =
Purpose of Adjusted Trial Balance
Proves the equality of debit balances and credit balances in the ledger.
Adjusted Trial Balance
After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts.
Use of Adjusted Trial Balance
U) It is the primary basis for the preparation of the financial statements.
Quality of earnings
Company provides full and transparent information.
Earnings Management
The planned timing of revenues, expenses, gains, and loses to smooth out bumps in net income.
one-time items
inflate revenue
improper adjusting entries
Companies manage earnings by (3)
prop up earnings numbers
One-time items . . .
At the end of the fiscal year
When are closing entries prepared?
Closing entries process
At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account - Retained Earnings
All revenue accounts, all expense accounts, dividends
Temporary accounts
0
In closing entries, dividends close out to ___
All asset accounts, all revenue accounts, stockholders’ equity accounts
Permanent accounts
produce 0 balance in temporary accounts
updates retained earnings to its correct ending
What do closing entries do?
Revenue accounts and Expense Accounts → Income summary → Retained Earnings
Dividends → Retained Earnings
Chapter 4 flow chart
The purpose of post-closing trial balance
To prove the equality of the permanent account balances that the company carries forward into the next accounting period.
1
Accounting Cycle Step #: Analyze Business Transactions
2
Accounting Cycle Step #: Journalize the transactions
3
Accounting Cycle Step #: Post to ledger accounts
4
Accounting Cycle Step #: Prepare a trial balance
5
Accounting Cycle Step #: Journalize and post adjusting entries-deferrals/accruals
6
Accounting Cycle Step #: Prepare an adjusted trial balance
7
Accounting Cycle Step #: Prepare financial statements
8
Accounting Cycle Step #: Journalize and post closing entries
9
Accounting Cycle Step #: Prepare a post-closing trial balance
Flow of costs
Companies use of perpetual inventory system or periodic inventory system to account for inventory.
Perpetual Inventory System functions
maintains detailed records of the cost of each inventory purchase and sale
records continuously show inventory that should be on hand for every item
Company determines cost of goods sold each time a sale occurs
Periodic inventory system function
Do not keep detailed records of the goods on hand
Cost of goods sold is determined at the end of the accounting period
Calculation of Cost of Goods Sold
Beginning inventory + purchases, net = goods available for sale - ending inventory =
How are purchases recorded?
Made using cash or credit on account
Normally recorded when goods are received from the seller
Purchase invoice should support each credit purchase
Inventory
Accounts Payable
How are purchases recorded? Journal entry
FOB Shipping Point
Ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller
Inventory
cash
FOB Destination
Ownership of the goods remains with the seller until the goods reach the buyer
Freight-out
cash
How are purchase returns and allowances handled?
Purchaser may be dissatisfied because goods are damaged or defective, or inferior quality, or do not meet specifications
Purchase return
Return goods for credit if the sale was made on credit, or for cash refund if the purchase was for cash.
Accounts payable
Inventory
Purchase allowance
May choose to keep merchandise if the seller will grant a reduction of the purchase price
2% discount if paid in ten days, or full price if paid in 30 days
What does 2/10, net 30 mean?
Accounts Payable 3500
Inventory (3500 × 2%) 70
Cash. 3430
Assume Sauk Stereo pays the balance due of $3,500 (gross invoice price of $3,800 less purchase returns and allowances of $300) on May 14, the last day of the discount period. Prepare the journal entry Sauk Stereo makes on May 14 to record the payment.
How are sales recorded?
Made using cash or credit on account
Sales revenue is recorded when the performance obligation is satisfied
Performance obligation is satisfied when the goods are transferred from the seller to the buyer
Sales invoice should support each credit sale
Cash or accounts receivable
Sales revenue
Cost of Goods Sold
Inventory
How are sales recorded under the perpetual system?
They are recorded inventory along with the cost of goods sold.
How are transportation costs handled?
Sales returns and allowances
Accounts receivable
Inventory
Cost of Goods Sold
Sales returns and allowance journal entry examples
To promote payment of balance due
Why are payment terms offered?
Cash
Sales Discounts
Accounts receivable
Discounts and payments journal entries example
Net sales calculation
Sales revenue - sales returns and allowances - sales discounts =
Single-step income statement reasons
Company does not realize any type of profit or income until total revenues exceed total expenses
Form is simple and easy to read
Multiple step income statement reason
Highlights the components of net income
gross profit
income from operations
net income
What are the three important line-items for a Multiple Step income statement?
Net purchases calculations
Purchases - purchase returns and allowance - purchase discounts =
Cost of Goods Purchases calculation
Net purchases + freight in =
Cost of goods available for sale calculation
Inventory + cost of goods purchase =
Profit Margin
Measures the percentage of each dollar of sales that results in net income.
Profit margin calculation
Net income/net sales =
Gross profit rate function
Measures the margin by which selling price exceeds cost of goods sold.
Profit margin ratio function
Measures the extent by which selling price covers all expenses (including COGS)
Gross profit rate calculation
gross profit/net sales =
Gross profit rate
May be expressed as a percentage by dividing the amount of gross profit by net sales.
Selling products with a lower “markup”
Increased competition may result in a lower selling price
Company forced to pay higher prices to its suppliers without being able to pass these costs on to its customers
When gross profit rate declines, what 3 things happen?
Perpetual inventory system. This system:
checks accuracy of inventory record
Determine amount of inventory lose due to wasted raw materials shoplifting, or employer theft
Periodic inventory system. This system:
Determine the inventory on hand
Determine the cost of goods sold for the period
when the business is closed or slow
at the end of the accounting period
When is physical inventory taken?
To hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods.
When are consigned goods included in inventory?
Management
Who decides to use FIFO or LIFO?
FIFO calculation
Cost of oldest inventory x amount of inventory sold =
LIFO calculations
Cost of most recent inventory x amount of inventory sold =
Average cost calculation
Total cost/number of units of a good produced =
Note
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