Chapter 3 Notes
TIME PERIOD ASSUMPTION
? The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year.
? Periods of less than one year are called interim periods. ? The accounting time period of one year in length is usually known as a fiscal year.
REVENUE RECOGNITION PRINCIPLE
? The revenue recognition principle states that revenue should be recognized in the
accounting period in which it is earned.
? In a service business, revenue is usually considered to be earned at the time the
service is performed.
? In a merchandising business, revenue is usually earned at the time the goods are
THE MATCHING PRINCIPLE
? The practice of expense recognition is referred to as the matching principle.
? The matching principle dictates that efforts (expenses) be matched with
ACCRUAL BASIS OF ACCOUNTING
? Adheres to the
? Revenue recognition principle
? Matching principle
? Revenue recorded when earned, not only when cash received.
? Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid.
? Adjusting entries are required each time financial statements are prepared.
? Adjusting entries can be classified as
1. prepayments (prepaid expenses or unearned revenues),
2. accruals (accrued revenues or accrued expenses), or
3. estimates (amortization).
TYPES OF ADJUSTING ENTRIES
1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are
used or consumed.
2. Unearned Revenues — Revenues received in cash and recorded as liabilities
before they are earned.
TYPES OF ADJUSTING ENTRIES
1. Accrued Revenues — Revenues earned but not yet received in cash or recorded. 2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.
1. Amortization — Allocation of the cost of capital assets to expense over their
PREPAYMENTS ? Prepayments are either prepaid expenses or unearned revenues.
? Adjusting entries for prepayments are required to record the portion of the
prepayment that represents
1. the expense incurred or,
2. the revenue earned in the current accounting period.
PREPAID EXPENSES ? Prepaid expenses are expenses paid in cash and recorded as assets before they are
used or consumed.
? Prepaid expenses expire with the passage of time or through use and
? Anasset-expense account relationship exists with prepaid expenses.
? Prior to adjustment, assets are overstated and expenses are understated.
? The adjusting entry results in a debit to an expense account and a credit to an
? Examples of prepaid expenses include supplies, rent, insurance, and property tax.
UNEARNED REVENUES ? Unearned revenues are revenues received and recorded as liabilities before they are earned.
? Unearned revenues are subsequently earned by performing a service or
providing a good to a customer.
? A liability-revenue account relationship exists with unearned revenues.
? Prior to adjustment, liabilities are overstated and revenues are understated.
? The adjusting entry results in a debit to a liability account and a credit to a
? Examples of unearned revenues include rent, magazine subscriptions, airplane
tickets, and tuition.
ACCRUALS ? A different type of adjusting entry is accruals.
? Adjusting entries for accruals are required to record revenues earned and
expenses incurred in the current period.
? The adjusting entry for accruals will increase both a balance sheet and an income
? Accrued revenues may accumulate with the passing of time or through services
performed but not billed or collected.
? An asset-revenue account relationship exists with accrued revenues.
? Prior to adjustment, assets and revenues are understated.
? The adjusting entry requires a debit to an asset account and a credit to a revenue
? Examples of accrued revenues include accounts receivable, rent receivable, and
? Accrued expenses are expenses incurred but not yet paid.
? A liability-expense account relationship exists.
? Prior to adjustment, liabilities and expenses are understated.
? The adjusting entry results in a debit to an expense account and a credit to a
? Examples of accrued expenses include accounts payable, rent payable, salaries
payable, and interest payable.
? Amortization is the process of allocating the cost of certain capital assets to
expense over their useful life in a rational and systematic manner.
? Amortization attempts to match the cost of a long-term, capital asset to the
revenue it generates each period.
? Amortization is an estimate rather than a factual measurement of the cost that
has expired. ? In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited.
? The difference between the cost of the asset and its related accumulated
amortization is referred to as the net book value of the asset.
ADJUSTED TRIAL BALANCE ? An Adjusted Trial Balance is prepared after all adjusting entries have been
journalized and posted.
? It shows the balances of all accounts at the end of the accounting period and the
effects of all financial events that have occurred during the period.
? It proves the equality of the total debit and credit balances in the ledger after all
adjustments have been made.
? Financial statements can be prepared directly from the adjusted trial balance.
PREPARING FINANCIAL STATEMENTS PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from an adjusted trial balance.
1. The income statement is prepared from the revenue and expense accounts. 2. The statement of owner’s equity is derived from the owner’s capital and drawings
accounts and the net income (or net loss) shown in the income statement. 3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.