Unit 1 Week 3 Lecture and Notes (CH4 & 2)

Explain the Concepts and Guidelines Affecting Adjusting Entries

To understand why these stages 5, 6, and 7 occur, it is first necessary to understand the following concepts: accrual accounting, accounting period, and calendar versus fiscal year.

 

• Public companies use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed by the Securities and Exchange Commission (SEC) regulations.
• Companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual accounting.
  • With accrual basis accounting, revenues and expenses are recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. Individually, these are the revenue recognition principle and the expense recognition principle. Collectively they are known as the matching principle.
• The accrual method standardizes reporting information for comparability purposes.
  • Comparable information is important to external users of information trying to make investment or lending decisions, and to internal users trying to make decisions about company performance, budgeting, and growth strategies.
• Some nonpublic companies may choose to use cash basis accounting rather than accrual basis accounting to report financial information.

 

An accounting period breaks down company financial information into specific time spans and can cover a month, a quarter, a half-year, or a full year.

 

• Public companies governed by GAAP are required to present quarterly (three-month) accounting period financial statements called 10-Qs.
• Most public and private companies keep monthly, quarterly, and yearly (annual) period information. This is helpful for users needing up-to-date financial data to make decisions about company investment and growth.

Fiscal Year versus Calendar Year

A company may choose its yearly reporting period to be based on a calendar or fiscal year.

• A calendar year shows financial data from January 1 to December 31 of a specific year.
• A fiscal year is a twelve-month reporting cycle that can begin in any month and records financial data for that consecutive twelve-month period.
• An interim period is any reporting period shorter than a full year (fiscal or calendar). They can be monthly, quarterly, or half-year statements. The information contained on these statements is timelier than waiting for a yearly accounting period to end. The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock exchange, meaning these are publicly traded companies, quarterly statements must be filed with the SEC on a Form 10-Q. The companies must file a Form 10-K for their annual statements.

 

Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries

 

 

Guidelines that support the need for adjusting entries

• Revenue recognition principle: Adjusting entries are necessary because the revenue recognition principle requires revenue recognition when earned, thus the need for an update to unearned revenues.

• Expense recognition (matching) principle: This requires matching expenses incurred to generate the revenues earned, which affects accounts such as insurance expense and supplies expense.
• Time period assumption: This requires useful information be presented in shorter time periods, such as years, quarters, or months. This means a company must recognize revenues and expenses in the proper period, requiring adjustment to certain accounts to meet these criteria.

 

Adjusting entries requires updates to specific account types at the end of the period. Not all accounts require updates—only those not naturally triggered by an original source document. There are two main types of adjusting entries that we explore further: deferrals and accruals.

Deferrals

Deferrals are prepaid expenses and revenue accounts that have delayed recognition until they have been used or earned. This recognition may not occur until the end of a period or future periods.

• Prepaid expenses (prepayments) are assets for which advanced payment has occurred, before the company can benefit from use. A company has prepaid for an expense but has not “used” the asset yet, such as paying six months rent expense in advance. That prepaid rent is not an expense until it is used—in other words, until each month passes. The prepaid asset becomes an expense once it is used (appropriate time has passed). Some common examples of prepaid expenses are supplies, depreciation, insurance, and rent.
• Unearned revenues represent a customer’s advanced payment for a product or service that the company has yet to provide. Because the company has not yet provided the product or service, it cannot recognize the customer’s payment as revenue. At the end of a period, the company will review the account to see if any of the unearned revenue has been earned—that is, if the company did the work or delivered the goods during that period. If so, this amount will be recorded as revenue in the current period.

 

Accruals

Accruals are types of adjusting entries that accumulate during a period when amounts were previously unrecorded. The two specific types of adjustments are accrued revenues and accrued expenses.

• Accrued revenues are revenues earned in a period but have yet to be recorded, and no money has been collected. Some examples include interest and services completed where a bill has yet to be sent to the customer.
• Accrued expenses are expenses incurred in a period but have yet to be recorded, and no money has been paid. Some examples include interest, tax, and salary expenses.

 

Record and Post the Common Types of Adjusting Entries

 

 

 

Use the Ledger Balances to Prepare an Adjusted Trial Balance

Step 6: Use the ledger balances to prepare an adjusted trial balance

• Once all of the adjusting entries have been posted to the general ledger, step 6 of the accounting cycle takes place
• An adjusted trial balance is a list of all accounts in the general ledger, including adjusting entries, which have nonzero balances
• The trial balance is an important step in the accounting process because it helps identify any computational errors from prior steps
• The adjusted trial balance leads to the formation of the financial statements.

 

The steps in creating an adjusted trial balance are about the same as for an unadjusted trial balance. However, you are going to look for differences as a result of the adjustments and you will prepare a trail balance with the new adjusted balances.

 

   

 

The following video does a great job explaining the process of using T accounts to determine the new balances and transferring them to an adjusted trial balance 

 

Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate

 

In business—and accounting in particular—it is necessary to distinguish the business entity from the individual owner(s). Accountants should only record business transactions in business records. This separation is also reflected in the legal structure of the business.

 

	Sole Proprietorship	Partnership	Corporation
Number of Owners	Single individual	Two or more individuals	One of more owners
Ease of Formation	Easier to form	Harder to form	Difficult to form
Ability to Raise Capital	Difficult to raise capital	Harder to raise capital	Easier to raise capital
Liability Risk	Unlimited liability	Unlimited liability	Limited liability
Taxation Consideration	Single taxation	Single taxation	Double taxation

 

Do not comingle personal and business transactions

The personal transactions of the owners, employees, and other parties connected to the business should not be recorded in the organization’s records.

 

Income Statement

The income statement shows the organization’s financial performance for a given period of time.

Revenue: the value of goods and services the organization sold or provided to customers

Expenses: a cost associated with providing goods or services to customers

Net Income (Net Loss): determined by comparing revenues and expenses

 

 

Gains and Losses

Revenues and expenses occur from the doing what the business is in business to do.

Gains result from selling ancillary business items for more than the items are worth, such as buildings, land, or equipment that help support the business’s operations.

Losses result from selling ancillary business items for less than the items are worth

 

Statement of Owner’s Equity

The statement of owner’s equity, the second financial statement created by accountants, shows how the equity (or value) of the organization has changed over time. Similar to the income statement, the statement of owner’s equity is for a specific period of time. Equity is the value of an item that remains after considering what is owed for that item.

 

 

 

Possible Changes to Owner’s Equity Other than Net Income Investments by owners: represent an exchange of cash or other assets for which the investor is given an ownership interest in the organization. Distributions to owners: periodic rewards issued to the owners in the form of cash or other assets. Distributions to owners represent some of the value (equity) of the organization.

 

Balance Sheet

Balance sheet is a statement that lists what the organization owns (assets), what it owes (liabilities), and what it is worth (equity) on a specific date.

 

Assets: resources used to generate revenue

Liabilities: amounts owed to others (called creditors)

Equity: refers to book value or net worth, this amount is the ending balance of the Statement of Owner’s Equity

 

The income statement, statement of owner’s equity, and the balance sheet are interrelated. Each statement provides unique information, but the statements are connected.

 

Statement of Cash Flows

Statement of cash flows is a statement that lists the cash inflows and cash outflows for the business for a period of time.

There are two “bases” of accounting. A basis indicates when revenues and expenses will be recorded.

 

Transaction	Under Cash Basis Accounting	Under Accrual Basis Accounting
$200 sale for cash	Recorded in financial statements at time of sale	Recorded in financial statements at time of sale
$200 sale on account	Not recorded in financial statements until cash is received	Recorded in financial statements at time of sale
$160 purchase for cash	Recorded in financial statements at time of purchase	Recorded in financial statements at time of purchase
$160 purchase on account	Not recorded in financial statements until cash is paid	Recorded in financial statements at time of purchase

 

 

Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet

Elements of the financial statements: Those categories or accounts that accountants use to record transactions and prepare financial statements.

• Revenue: value of goods and services the organization sold or provided
• Expenses: costs of providing the goods or services for which the organization earns revenue
• Gains: similar to revenue, but relate to “incidental or peripheral” activities of the organization
• Losses: similar to expenses, but related to “incidental or peripheral” activities of the organization
• Assets: items the organization owns, controls, or has a claim to
• Liabilities: amounts the organization owes to others (also called creditors)
• Equity: net worth (or net assets) of the organization
• Investment by owners: cash or other assets provided to the organization in exchange for an ownership interest
• Distribution to owners: cash, other assets, or ownership interest (equity) provided to owners
• Comprehensive income: defined as the “change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources” (SFAC No. 6, p. 21). While further discussion of comprehensive income is reserved for intermediate and advanced studies in accounting, it is worth noting that comprehensive income has four components, focusing on activities related to foreign currency, derivatives, investments, and pensions.

Trial Balance

A trial balance is a listing of all accounts and their balances.

The trial balance is organized in the following order: Income statement accounts first, balance sheet accounts second, and owner's equity accounts last. Data from the trial balance is then used to prepare each of the financial statements. The statements are prepared in order as they depend on one another.

First, the Income Statement

 

Second, the Statement of Owner's Equity 

 

Third, the Balance Sheet

 

Financial Ratios

In addition to reviewing the financial statements in order to make decisions, owners and other stakeholders also utilize financial ratios to assess the financial health of the organization. There are various ratio categories and different ratios within each of those categories. One category of ratios is liquidity ratios.

• Liquidityrefers to the business’s ability to convert assets into cash in order to meet short-term cash needs. Examples of the most liquid assets include accounts receivable and inventory. These assets can be turned into cash more quickly than land or buildings, for example.
• Working capital is current assets minus current liabilities; it is not a ratio, but it is used to assess the dollar amount of assets a business has available to meet its short-term liabilities.
• The current ratiois closely related to working capital; it represents the current assets divided by current liabilities. The current ratio utilizes the same amounts as working capital (current assets and current liabilities) but presents the amount in ratio, rather than dollar, form.

Current Ratio = Current Assets ÷ Current Liabilities

A positive working capital amount is desirable and indicates the business has sufficient current assets to meet short-term obligations (liabilities) and still has financial flexibility. A negative amount is undesirable and indicates the business should pay particular attention to the composition of the current assets (that is, how liquid the current assets are) and to the timing of the current liabilities. A current ratio of greater than one indicates that the firm has the ability to meet short-term obligations with a buffer, while a ratio of less than one indicates that the firm should pay close attention to the composition of its current assets as well as the timing of the current liabilities.

 

 Prepare Financial Statements Using the Adjusted Trial Balance

• Income statement
• Statement of retained earnings
• Balance sheet
• Ten-column worksheets

 

Connection between Adjusted Trial Balance and Income Statement

 

  

 

Connection between Income Statement and Statement of Retained Earnings

  

 

 

Connection between Adjusted Trial Balance and the Balance Sheet

  

 

I am presenting you two videos, one is for the preparation of a corporate balance sheet and the other is for a sole proprietor

  

Statement of Owners' Equity

 

10-Column Worksheet

The 10-column worksheet is an all-in-one spreadsheet showing the transition of account information from the trial balance through the financial statements. It's use is optional. The worksheet is very useful in seeing the adjustments made and ensuring all adjustments have been captured in the proper accounts. However, it is very tedious to create by hand.

  

 

If you are interested, here is a video on how to create one in Excel.

 

 Summary

• The next three steps in the accounting cycle are adjusting entries (journalizing and posting), preparing an adjusted trial balance, and preparing the financial statements.
• Accrual requires revenues and expenses to be recorded in the accounting period in which they occur, not necessarily where an associated cash event happened. This is unlike cash basis accounting that will delay reporting revenues and expenses until a cash event occurs.
• Accounting periods help companies by breaking down information into months, quarters, half-years, and full years.
• Need for adjustments: Some account adjustments are needed to update records that may not have original source documents or those that do not reflect change on a daily basis.
• Rules for adjusting entries: The rules for recording adjusting entries are as follows: every adjusting entry will have one income statement account and one balance sheet account, cash will never be in an adjusting entry, and the adjusting entry records the change in amount that occurred during the period.
• Posting adjusting entries: Posting adjusting entries is the same process as posting general journal entries. The additional adjustments may add accounts to the end of the period or may change account balances from the earlier journal entry step in the accounting cycle.
• Financial statements provide financial information to stakeholders to help them in making decisions.
• There are four financial statements: income statement, statement of owner’s equity, balance sheet, and statement of cash flows.
• The income statement measures the financial performance of the organization for a period of time. The income statement lists revenues, expenses, gains, and losses, which make up net income (or net loss).
• The statement of owner’s equity shows how the net worth of the organization changes for a period of time. In addition to showing net income or net loss, the statement of owner’s equity shows the investments by and distributions to owners.
• The balance sheet shows the organization’s financial position on a given date. The balance sheet lists assets, liabilities, and owners’ equity.
• The statement of cash flows shows the organization’s cash inflows and cash outflows for a given period of time. The statement of cash flows is necessary because financial statements are usually prepared using accrual accounting, which records transactions when they occur rather than waiting until cash is exchanged.
• Three broad categories of legal business structures are sole proprietorship, partnership, and corporation, with each structure having advantages and disadvantages.
• The accounting equation is Assets = Liabilities + Owner’s Equity. It is important to the study of accounting because it shows what the organization owns and the sources of (or claims against) those resources.
• Owners’ equity can also be thought of as the net worth or value of the business. There are many factors that influence equity, including net income or net loss, investments by and distributions to owners, revenues, gains, losses, expenses, and comprehensive income.
• There are ten financial statement elements: revenues, expenses, gains, losses, assets, liabilities, equity, investments by owners, distributions to owners, and comprehensive income.
• There are standard conventions for the order of preparing financial statements (income statement, statement of owner’s equity, balance sheet, and statement of cash flows) and for the format (three-line heading and columnar structure).
• Financial ratios, which are calculated using financial statement information, are often beneficial to aid in financial decision-making. Ratios allow for comparisons between businesses and determining trends between periods within the same business.
• Income statement: The income statement shows the net income or loss as a result of revenue and expense activities occurring in a period.
• Statement of retained earnings: The statement of retained earnings shows the effects of net income (loss) and dividends on the earnings the company maintains.
• Balance sheet: The balance sheet visually represents the accounting equation, showing that assets balance with liabilities and equity.
• 10-column worksheet: The 10-column worksheet organizes data from the trial balance all the way through the financial statements.