FAR CHAPTER 4 REVIEWER

ACCRUAL BASIS

  • The financial statements, except for the cash flow statement, are prepared on the accrual basis of accounting.

  • Under the accrual basis, the effect of transactions and other events are recognized when they occur and not as cash is received or paid.

  • This means that the accountant records revenues as they are earned and expenses as they are incurred. The timing of cash flows is relatively immaterial for determining when to recognize revenues and expenses.

  • Financial statements prepared on the accrual basis inform users not only of past transactions involving the payment and receipt of cash, but also of obligations to pay cash in the future, and of resources that represent cash to be received in the future

  • Generally accepted accounting principles require that a business use the accrual basis.

CASH BASIS

  • the accountant does not record a transaction until cash is received or paid.

  • cash receipts are treated as revenues and cash payments as expenses.

  • Cash basis income is the difference between operating cash receipts and disbursement (NET INCOME = REVENUES - EXPENSES)

PERIODICITY CONCEPT

  • accounting information is valued when it is communicated early enough to be used for economic decision-making.

  • to provide timely information, accountants have divided the economic life of a business into artificial time periods. this assumptions if referred to as the periodicity concept.

  • the most basic accounting period is one year

  • a fiscal year is a period of any twelve consecutive months

  • a calendar year is an annual period ending on december 31

  • a natural business year is a twelve-month period that ends when business activities are at their lowest level of the annual cycle

  • a period of less than a year is an interim period. some even adopt an annual reporting period of 52 weeks

  • business need periodic reports to assess their financial condition snd performance.

  • the periodicity concept ensures that accounting information is reported at regular intervals. it interacts with the recognition and derecognition principles to underlie the use of accruals.

  • To measure profit in a fair manner, the entities update the income and expense accounts immediately before the end of the period

RECOGNITION AND DERECOGNITION

  • recognition is the process of capturing for inclusion in the statement of financial position or the statement(s) of financial performance an item that meets the definiton of an asset, a liability, equity, income, or expenses.

  • the amount at which an asset, a liability or equity is recognized in the statement of financial position is referred to as its “carrying amount"

  • the statement of financial position and statements of financial performance depict an entity's recognized assets, liabilities, equity, income, and expenses in structured summaries that are designed to make financial informations comparable and understandable.

  • recognition links the elements, the statement of financial position and the statement of financial performance. The statements are linked because the recognition of one item requires the recognition or derecognition of one or more other items.

  • the simultaneous recognition of income and related expenses is sometimes reffered to as the matching of costs with income (matching principle - cause & effect. in every gain, there's a related cost).

  • Recognition is appropriate if it results in both relevant information about assets, liabilities, income, and expenses and a faithful representation of those items, because the aim is to provide information that is useful to investors, lenders and other creditors.

  • derecognition is the removal of all or part of a recognized asset or liability from an entity's statement of financial position.

  • derecognition normally occurs when that item no longer meets the definiton of an asset or of a liability.

  • for an asset, derecognition normally occurs when the entity loses control of all or part of the recognized asset

  • for a liability, derecognition normally occurs when the entity no longer has a present obligation for all or part of the recognized liability

THE NEED FOR ADJUSTMENTS

  • accountants make adjusting entries to reflect in the accounts information on economic activities that have occured but not yet been recorded.

  • adjusting entries involve changing account balances at the end of the period from what is the current balance of the account to what is the correct balance for proper financial reporting

  • without adjusting entries, financial statements may not fairly show the solvency of the entity in the balance sheet and the profitability in the income statement

PROCESS:

  1. end of the period - adjusting entries recorded in the general journal

  2. posting to the ledger or T-accounts

  3. adjusted trial balance

DEFERRALS AND ACCRUALS

  • accountants use adjusting entries to apply accrual accounting to transactions that cover more than one accounting period

  • each adjusting entry affects a balance sheet account (an asset or a liability account) and an income statement account (income or expense account)

  • deferral is the postponement of the recognition of “an expense already paid but not yet incurred" or of “revenue already collected but not yet earned". this adjustment deals with an amount already recorded in a balance sheet account; the entry, in effect, decreases the balance sheet account and increases an income statement account. For example: prepaid insurance to insurance expense and unearned service revenue to service revenue.

  • accrual is the recognition of “an expense already incurred but unpaid" or “revenue earned but uncollected". this adjustment deals with an amount unrecorded in any account (no initial entry); the entry, in effect, increases both a balance sheet and an income statement account. For example: debit to Salaries Expense and credit to salaries payable and debit to accounts receivable and credit to Service revenue.

ADJUSTMENTS FOR DEFERRALS

  • prepaid expenses are customarily paid in advance. these are assets not expenses. at the end of an accounting period, a portion or all of these prepayments may have expired. the portion of an asset that has expired becomes an expense.

  • prepaid expenses expired either with the passage of time or through use and consumption.

  • Asset method will record the used portion in the adjusting entries. it will debit the expenses and credit the assets.

  • Expense method will record the unused portion in the adjusting entries. it will debit the assets and credit the expenses.

  • depreciation of property and equipment: when an entity acquired long-lived assets such as buildings, service vehicles, computers, or office furnitures, it is basically buying or prepaying for the usefulness of that asset. these assets help generate income for the entity. therefore, a portion of the cost of the assets should be reported as expense in each accounting period.

  • proper accounting requires the allocation of the cost of the asset over its estimated useful life. the estimated amount allocated to any one accounting period is called depreciation or depreciation expense.

THREE FACTORS:

  1. asset cost is the amount an entity paid to acquire that depreciable asset

  2. estimated salvage value is the amount that the asset can probably be sold for at the end of its estimated useful life

  3. estimated useful life is the estimated number of periods that an entity can make use of the asset.

  • accountants estimate periodic depreciation.

  • straight-line method is the simplest procedure or formula for determining the amount of depreciation expense: ASSET COST - SALVAGE VALUE = DEPRECIABLE COST ÷ USEFUL LIFE = DEPRECIATION EXPENSE

  • the asset account is not directly reduced when recording depreciations expense. instead, the reduction is recorded in a contra account called accumulated depreciation.

  • a contra account is used to record reductions in a related account and its normal balance is opposite that of the related account.

  • use of the contra account - accumulated depreciation - allows the disclosure of the original cost of the related asset in the balance sheet. the balance of the contra account is deducted from the cost to obtain the book value of the property and equipment.

  • allocating revenues received in advance to revenues: there are times when an entity receives cash for services or goodse even before service is rendered or goods are delivered. the liability referred to is unearned revenues. if an entity earns part of the advance payments, this earned portion must be transferred from the unearned revenues to revenues account.

DEFERRALS ADJUSMENTS ACCOUNTS:

  1. PREPAID EXPENSES: rent, insurance, and supplies. (ASSET TO EXPENSES)

  2. DEPRECIATION OF PROPERTY AND EQUIPMENT: service vehicles, buildings, computers, and office furnitures. (ASSET TO EXPENSES)

  3. UNEARNED REVENUES: unearned referral revenues and unearned subscription revenues. (LIABILITY TO INCOME)

ADJUSTMENTS FOR ACCRUALS

  • accrued expenses is when an entity often incurs expenses before paying for them.

  • cash payments are usually made at regular intervals of time such as weekly, monthly, quarterly, or annually.

  • if the accounting period ends on a date that does not coincide with the scheduled cash payment date, an adjusting entry is needed to reflect the expense incurred since the last payment. this adjustment helps the entity avoid the impractical preparation of hourly or daily journal entries just to accrue expenses.

  • interest rates are expressed at annual rates, so if interest is being calculated for less than a year, the calculation must express time as a portion of a year.

  • FORMULA: interest = principal × interest rate × length of time. FOR EXAMPLE: interest = 210,000 × 20% × 1/12

  • if it is days you will divide it in 365 but if per annum or annual divide it by 12.

  • n/12 wherein n is the months used and 12 is the year

  • if the date starts at the first day of the month, then that month belongs to the count until the end of the accounting period but if the month starts at 30 or 31 then the count will start at the next month.

  • accrued revenues is when an entity may provide services during the period that are neither paid for by clients nor billed at the end of the period. any revenue that has been earned but not recorded during the accounting period calls for an adjusting entry that debits an asset account and credits an income account.

  • accrual for uncollectible accounts is when entities often allow clients to purchase goods or avail of services on credit. some of these accounts will never be collected; hence, there is a need to reflect these as charges against income.

  • in practice, an expense is recognized for the estimated uncollectible accounts in the current period, rather than when a specific accounts actually become uncollectible.

  • doubtful of collections, the entry would be: debit uncollectible accounts expense and credit allowance for uncollectible accounts

  • definitely uncollectible, the entry would be: debit allowance for uncollectible account and credit accounts receivable

ACCRUALS ADJUSTMENTS ACCOUNTS:

  1. ACCRUED EXPENSES: salaries, utilities, interest, and taxes

  2. ACCRUED REVENUES: accounts receivable and revenues

  3. ACCRUAL FOR UNCOLLECTIBLE ACCOUNTS: uncollectible account expense and allowance for uncollectible account