Textbook_E-Book_ Read Pages 103 - 109, Chapter 3

When preparing financial statements, the economic life of a business is divided into time periods.
The accounting period concept requires revenues and expenses to be reported in the proper period.
Accountants use Generally Accepted Accounting Principles (GAAP) to determine the proper period.
GAAP requires the accrual basis of accounting.
Under the accrual basis of accounting, revenues are reported on the income statement in the period in which they are earned.
- Revenue is reported when services are provided to customers.
- Cash may or may not be received during this period.
The accounting concept supporting this reporting of revenues is called the revenue recognition concept.
Under accrual accounting, revenues are recognized when services have been performed or products have been delivered to customers.
Revenue is measured as assets received (cash or accounts receivable) in exchange for a service or product.
The process of recording revenues is called revenue recognition.
The accounting concept supporting reporting revenues and related expenses in the same period is called the matching concept.

GAAP requires the accrual basis of accounting.
Some businesses use the cash basis of accounting.
Under the cash basis of accounting, revenues and expenses are reported on the income statement when cash is received or paid.
- Fees are recorded when cash is received from clients.
- Wages are recorded when cash is paid to employees.
Net income (or net loss) is the difference between cash receipts (revenues) and cash payments (expenses).
Small service businesses may use the cash basis because they have few receivables and payables.
For most large businesses, the cash basis will not provide accurate financial statements.

At the end of the accounting period, some accounts require updating.
Reasons for updating accounts:
- Some expenses are not recorded daily.
- Some revenues and expenses are incurred as time passes.
- Some revenues and expenses may be unrecorded.
The analysis and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process.
Journal entries that bring the accounts up to date are called adjusting entries.
All adjusting entries affect at least one income statement account and one balance sheet account.
An adjusting entry will always involve a revenue or an expense account and an asset or a liability account.

The following basic types of accounts require adjusting entries:

Prepaid expenses are advance payments of future expenses and are recorded as assets when cash is paid.
Prepaid expenses become expenses over time or during normal operations.
Example: NetSolutions paid $2,400$ for a one-year insurance policy on December 1.
- Debit Prepaid Insurance, credit Cash for $2,400$ .
- At the end of December, $200$ ( $\frac{2,400}{12}$ ) of the insurance premium has expired and become an expense.

Unearned revenues are advance receipts of future revenues and are recorded as liabilities when cash is received.
Unearned revenues become earned revenues over time or during normal operations.
Example: NetSolutions received $360$ from a local retailer to rent land for three months on December 1.
- Debit Cash, credit Unearned Rent for $360$ .
- At the end of December, $120$ ( $\frac{360}{3}$ ) of the unearned rent has been earned.

Accrued revenues are unrecorded revenues that have been earned but for which cash has yet to be received.
Example: NetSolutions provided 25 hours of service to Dankner Co. at $20$ per hour from December 16-31.
- Revenue of $500$ ( $25 \times 20$ ) has been earned but not billed until January 15.
- The $500$ of accrued revenue and the $500$ of fees earned should be recorded with an adjusting entry on December 31.

Accrued expenses are unrecorded expenses that have been incurred but for which cash has yet to be paid.
Example: NetSolutions owes its employees $250$ for wages for Monday and Tuesday, December 30 and 31.
- The wages of $250$ will be paid on January 10, 2016; however, they are an expense of December.
- The $250$ of accrued wages should be recorded with an adjusting entry on December 31.

Accrued revenues are earned revenues that are unrecorded. Cash receipts are normally received in the next accounting period.
Accrued expenses are expenses that have been incurred but are unrecorded. Cash payments are normally paid in the next accounting period.
Prepaid expenses and unearned revenues are sometimes referred to as deferrals because the recording of the related expense or revenue is deferred to a future period.
Accrued revenues and accrued expenses are sometimes referred to as accruals because the related revenue or expense should be recorded or accrued in the current period.