Principles of financial accounting 12e by needles crosson chapter 03

C HAP TE R

3

Adjusting the Accounts

Principles of
Accounting
12e
Needles
Powers
Crosson
© human/iStockphoto


Net Income
 Net income is the net increase in owner’s
equity that results from a company’s operations.
– In its simplest form, net income results when
revenues exceed expenses.
Net Income = Revenues − Expenses
– When expenses exceed revenues a net loss
occurs.
 Revenues are increases in owner’s equity that
result from performing business activities.
 Expenses are decreases in owner’s equity
resulting from the cost of doing business.

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Continuity
 The majority of companies present annual
financial statements on the assumption that the
business will continue to operate indefinitely—
that is, that the company is a going concern.
 The continuity assumption states that unless
there is evidence to the contrary, the
accountant assumes that the business is a
going concern and will continue to operate
indefinitely.
– The continuity assumption allows certain
expense and revenue transactions to be
allocated over several accounting periods.

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Periodicity
 The periodicity assumption states that
although the lifetime of a business is
uncertain, it is nonetheless useful to
estimate the business’s net income in
terms of accounting periods.
 A 12-month accounting period is called a
fiscal year.
– The fiscal year may be the same as the
calendar year or some other 12-month period.

 Accounting periods of less than a year are
called interim periods.

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Accrual Accounting (Matching Rule)
 Under accrual accounting (often
referred to as the matching rule) net
income is measured by assigning:
– Revenues to the accounting period in which
the goods are sold or the services performed.
– Expenses to the accounting period in which
they are used to produce revenue.

 When there is no direct means of
connecting expenses and revenues, costs
are allocated among the accounting
periods that benefit from the costs.
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Concepts Underlying Accrual Accounting
 The cash basis of accounting is the
practice of accounting for revenues in the
period in which cash is received and for
expenses in the period in which cash is
paid.
– With this method, taxable income is calculated
as the difference between cash receipts from
revenues and cash payments for expenses.

 In accrual accounting, revenues and

expenses are recorded when they are
earned or incurred rather than when they
are received or paid.
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Recognizing Revenues
 The process of determining when revenue
should be recorded is called revenue
recognition.
 The Securities and Exchange Commission
requires that all the following conditions
be met before revenue is recognized:
– Persuasive evidence of an arrangement exists.
– A product or service has been delivered.
– The seller’s price to the buyer is fixed or
determinable.
– Collectibility is reasonably ensured.
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Recognizing Expenses
 Expenses are recorded when all of the
following conditions are met:
– There is an agreement to purchase goods or
services.
– The goods have been delivered or the services
rendered.
– A price has been determined or can be
determined.

– The goods or services have been used to
produce revenue.

 The recognition of the expense does not
depend on the payment of cash.
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The Adjustment Process
 Accrual accounting involves adjusting the accounts.
– Adjustments are necessary because the accounting period, by
definition, ends on a particular day. Some transactions
invariably span the cutoff point, and therefore, some accounts
need adjustment.
– When transactions span more than one accounting period,
accrual accounting requires the use of adjusting entries.
These are either deferrals or accruals.
 A deferral is the postponement of the recognition of an expense
already paid or of revenue received in advance. The cash
payment or receipt is recorded before the adjusting entry is
made.
 An accrual is the recognition of an expense or a revenue that has
arisen but not been recorded during the accounting period. The
cash payment or receipt occurs in a future accounting period.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Type 1 Adjustment: Allocating Recorded Costs
(Deferred Expenses)

 Companies often make expenditures
that benefit more than one period.
– These costs are debited to an asset account.
– At the end of the accounting period, the
amount of the asset that has been used is
transferred from the asset account to an
expense account.

 Prepaid expenses are costs that
companies pay in advance, such as rent,
supplies, and insurance.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Depreciation of Plant and Equipment
 When a company buys a long-term asset, it is paying
for the usefulness of that asset for as long as it
benefits the company.
 The accountant must allocate the cost of the asset
over its estimated useful life. The amount allocated
to any one accounting period is called depreciation.
– To maintain historical costs, Accumulated Depreciation
accounts are used to accumulate the depreciation on each
long-term asset.
 These accounts are called contra accounts. The balance of a
contra account is shown on a financial statement as a deduction
from its related account (for example, an asset account).
 The net amount is called the carrying value (or book value) of
the asset.

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Type 2 Adjustment: Recognizing Unrecorded
Expenses (Accrued Expenses)
 At the end of an accounting period, some
expenses incurred during the period have
not been recorded. These expenses require
adjusting entries. Examples include:
– Interest on borrowed money
– Wages
– Utilities

 These expenses are called accrued
expenses because, as the expense and
the corresponding liability accumulate,
they are said to accrue.
©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Type 3 Adjustment: Allocating Recorded,
Unearned Revenues (Deferred Revenues)
 When a company receives revenues in
advance, it has an obligation to deliver
goods or perform services. These
unearned revenues are shown in a
liability account.
– As a company delivers part of the goods or
performs part of the services, it earns a part

of the advance receipts.
– The earned portion must be transferred from
the liability account to a revenue account.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Type 4 Adjustment: Recognizing Unrecorded,
Earned Revenues (Accrued Revenues)
 Accrued revenues are revenues that
a company has earned by performing a
service or delivering goods but for
which no entry has been made in the
accounting records.
– Any revenues earned but not recorded
during an accounting period require an
adjusting entry that debits an asset account
and credits a revenue account.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Using the Adjusted Trial Balance to Prepare
Financial Statements
 After adjusting entries have been recorded and
posted, an adjusted trial balance is prepared
by listing all accounts and their balances.
– The revenue and expense accounts are used to prepare
the income statement, and the asset and liability
accounts are used to prepare the balance sheet.

– Net income from the income statement is combined with
the Withdrawals account on the statement of owner’s
equity to give the net change in the Capital account.
– The balance of the Capital account is used in preparing
the balance sheet.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Net Income: Ethical Measurement and Cash
Flows
 Adjusting entries affect net income and the
assets and liabilities on the balance sheet
that are used to assess the need for cash.
 Because judgment underlies the adjusting
entries, there is potential for abuse.
 The manipulation of revenue and expenses
to achieve a specific outcome is called
earnings management.
– When estimates move outside a reasonable
range, financial statements become misleading.

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


Determination of Cash Flows from AccrualBased Information
 The general rule for determining the cash flow
received from any revenue or paid for any
expense is to determine the potential cash
payments or cash receipts and deduct the

amount not paid or not received. The
application of the general rule by account
type is shown below:

©2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.