Business Administration 2257 Chapter Notes - Chapter 4: Deferral, Accrual, Canada Revenue Agency
25 Sep 2017
School
Department
Professor
Page 88-121:
Management needs monthly reports on financial results, public traded corporations present
quarterly and annual financial statements to shareholders, and CRA (Canada Revenue Agency)
requires these businesses to file monthly sales tax reports and annual income tax returns
○
Companies need immediate feedback on how well they are doing
•
Periods typically 1 month, 1 quarter, or a year
○
Periods that are not "fiscal years" are known to be interim periods
○
Accounting divides economic life of a business into artificial time periods
•
Timing Issues:
Revenue is generally considered to be earned (recognized) when goods/services are exchanged for
cash or claims to cash (A/R)
•
Revenues arise in course of ordinary activities like the sale of products/services
•
Rent, investment income, gains on sale etc.
○
Revenues can come from other activities:
•
Sales/Performance effort is substantially complete (complete sale of service/product)
1.
Revenue amount is determinable (measurable) - (measure the amount)
2.
Collection of revenue is reasonably assured - (assurance)
3.
Occurs when 3 conditions are met:
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Revenue Recognition:
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In merchandising company, revenue is recognized (recorded) when merchandise is sold
•
In service company, revenue is recognized (recorded) when service is completed
•
Revenue Recognition:
Commonly known as matching as the expenses are match with the revenues
○
Linked to revenue recognition when there is a direct association between the expense incurred and
the generation of revenue
•
Similar to revenue recognition, expense recognition is not tied to the payment of cash.
•
Expenses are recognized when incurred regardless of whether cash is paid or not
•
Revenues and expenses are always recognized at the same time
•
Expense Recognition:
Combined application of revenue recognition and expense recognition results in accrual basis
accounting
•
Recognizes revenues when they are earned rather than only when cash is received
○
Accrual basis accounting = means that transactions affecting a company's financial statements are
recorded in the periods in which the events occur, rather than when the company actually receives or
pays cash
•
Expenses are recorded in which goods are consumed/services are used rather than only when cash is
paid
•
Alternative to accrual basis is the cash basis
•
Cash basis accounting = revenue is recorded only when cash is received and an expense is recorded
only when cash is paid
•
Accrual Basis = report revenue when it is earned/ completed (year 1)
▪
Cash Basis = report revenue in year 2 and expenses in year 1
▪
Example: Company completed a paint service in year 1, with expenses incurred during year 1 and
customer was billed during year 1, but not paid until year 2
○
Though appearing simple, can result in misleading information for decision-making because it leaves a
time gap between matching of expenses and revenues
•
Accrual versus Cash Basis of Accounting:
Accrual Basis
Cash Basis
Chapter 4 - Accrual Accounting Concepts
Wednesday, September 13, 2017
7:04 PM
Textbook Notes Page 1
Accrual Basis
Cash Basis
Revenue is recognized
When earned
When received
Expense is recognized
When incurred (goods are consumed or services used)
When paid
Adjusting entries = update the accounts at the end of the accounting period
•
They ensure that revenue recognition and expense recognition are properly applied and make it
possible to produce up-to-date and relevant financial information at the end of the accounting period
•
The Basics of Adjusting Entries:
Analyze business transactions
1.
Journalize the transactions
2.
Post to ledger accounts
3.
Prepare a trial balance
4.
Journalize/post adjusting entries: Prepayments/accruals
5.
Steps of the Accounting Cycle:
Some events not recorded daily - not be useful/efficient to do so (Ex: Use of supplies and earnings of
salaries by employees)
1.
Some costs are not recorded bc the costs expire with the passage of time rather than as a result of
recurring daily transactions (Ex: rent, insurance, depreciation)
2.
Items may be unrecorded (Ex: utility service bill that will not be received until next accounting period -
bill covers services delivered in the current accounting period)
3.
Adjusting entries are important because the trial balance - may not contain complete and up to date data
(BECAUSE):
Adjusting entries required every time financial statements are prepared
•
Public corporations means at least quarterly they are required to issue financial statements
•
Private corporations at least annually
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Adjustment data often not available until after end of the period
•
Unadjusted trial balance = A trial balance that was prepared before adjusting entries have been made
•
Adjusting entries classified either prepayments or accruals
•
Types of Adjusting Entries:
Prepayments
Accruals
Prepaid Expenses:
Expenses paid in cash and recorded as assets before
they are used
Accrued Revenues:
Revenues earned but not yet received in cash or
recorded
Unearned Revenues:
Cash received and recorded as liabilities before revenue
is earned
Accrued Expenses:
Expenses incurred but not ye paid in cash or
recorded
Note: If a trial balance has no preceding adjective in title like "adjusted or post-closing" it is assumed to be an
unadjusted trial balance
Also be received rather than paid where the prepayment increases current liabilities like
unearend revenue
○
Prepayments = increase current assets like prepaid expenses and affect certain types of non-current
assets like buildings and equipment
•
Adjusting Entries for Prepayments:
An asset (prepaid) account is increased to show the service/benefit that will be received in
future and cash is decreased
○
Prepaid Expenses = Costs paid for in cash before they are used
•
Prepaid Expenses:
Textbook Notes Page 2
future and cash is decreased
Costs that expire either with time or through use (not practical to record expiration date)
•
Record Expenses (expired costs)
1.
Show Remaining Amounts (unexpired costs) in asset accounts
2.
Adjusting entries are made with 2 purposes:
•
(Debit) to an expense account
○
(Credit) to an asset account
○
Adjusting entry for prepaid expense:
•
If expenses are understated, equity and profit will be overstated
○
Until prepaid expenses are adjusted, assets are overstated and expenses are understated
•
Purchase of supplies results in an increase to supplies - supplies used results in an expense
•
Prepaid Supplies:
If adjusting entry is not made, assets will be overstated, expenses will be understated, equity will be
overstated
•
Adjustment
October 31: $1500 (2500-1000) of supplies were used during the month
Basic Analysis
Use of supplies decreases the Supplies account by $1500 and increases Supplies
Expense, which decreases equity by $1500
Debit/Credit
Analysis
Debits increases supplies expense $1500
-
Credits decreases assets: credit supplies $1500
-
Adjusting Journal
Entry
Supplies 1500
Supplies Expense 1500
Posting
Supplies = 2500-1500 Supplies Expense = 1500
= 1000
Purchase insurance to protect themselves from losses caused by fire theft and other accidents
•
Must be paid in advance, often for one year
•
Companies purchase insurance to protect themselves from losses caused by fire, theft, and
unforeseen accidents
•
(Debit) Prepaid Insurance Expense
○
(Credit) Prepaid Insurance
○
Recorded as Prepaid Insurance (when consuming service)
•
Insurance:
If adjustment was not made, Prepaid Insurance would be overstated, Prepaid insurance expense
would be understated, and profit/equity would be overstated
•
Adjustment
October 31: $50 (600/12) of insurance has expired this month
Basic Analysis
Expiration of insurance decreases Prepaid Insurance by $50 and increases Insurance
Expense - decreases shareholders' equity by $50
Debit/Credit
Analysis
Debits Prepaid Insurance Expense: $50
-
Credits Prepaid Insurance: $50
-
Adjusting Journal
Entry
Prepaid Insurance $50
Prepaid Insurance Expense $50
Posting
Prepaid Insurance = 600-50 Prepaid Insurance Expense = $50
= $550
Period of service of an asset is called useful life
•
Depreciation = process of allocating the cost of a long lived or non-current asset such as buildings and
equipment to expense over its useful life
•
Assets with specified useful lives are depreciated (depreciable assets)
•
Depreciation is used in relation to property, plant, equipment, amortization used in relation to
•
Depreciation:
Textbook Notes Page 3
