CONCEPTUAL
The value of information is often
linked to its timeliness. To provide timely information, accounting systems
prepare periodic reports at regular intervals. The time period
assumption presumes that an organization’s activities
can be divided into specific time periods for periodic reporting.
Accrual accounting recognizes revenue
when earned and expenses when incurred—not necessarily when
cash inflows and outflows occur. This information is valuable in
assessing a company’s financial position and performance.
Adjustments can be grouped according to the
timing of cash receipts and cash payments relative to when
they are recognized as revenues or expenses as follows: prepaid expenses, unearned
revenues, accrued expenses, and accrued revenues. Adjusting entries
are necessary so that revenues, expenses, assets, and liabilities are
correctly reported.
ANALYTICAL
Accounting adjustments bring an asset or
liability account balance to its correct amount. They also update related
expense or revenue accounts. Every adjusting entry affects one or more income
statement accounts and one or more balance sheet accounts. An
adjusting entry never affects the Cash account.
Profit margin is defined as the
reporting period’s net income divided by its net sales. Profit margin reflects on a company’s earnings activities by showing how
much income is in each dollar of sales.
PROCEDURAL
Prepaid expenses refer
to items paid for in advance of receiving their benefits. Prepaid expenses
are assets. Adjusting entries for prepaids involve increasing (debiting) expenses and decreasing (crediting)
assets. Unearned (or prepaid) revenues refer to cash
received in advance of providing products and services. Unearned revenues are
liabilities. Adjusting entries for unearned revenues involve increasing (crediting) revenues and decreasing (debiting)
unearned revenues. Accrued expenses refer to costs incurred in a period
that are both unpaid and unrecorded. Adjusting entries for
recording accrued expenses involve increasing (debiting) expenses and increasing (crediting) liabilities.
Accrued revenues refer to revenues earned in a period that are both unrecorded and not yet received in cash. Adjusting
entries for recording accrued revenues involve increasing (debiting)
assets and increasing (crediting) revenues.
An adjusted trial balance is a list of accounts
and balances prepared after recording and posting adjusting entries. Financial statements
are often prepared from the adjusted trial balance.
Revenue and expense balances are reported on the
income statement. Asset, liability, and equity balances are reported
on the balance sheet. We usually prepare statements in the following
order: income statement, statement of owner’s equity, balance
sheet, and statement of cash flows.
Charging all prepaid expenses to expense
accounts when they are purchased is acceptable. When this is done, adjusting
entries must transfer any unexpired amounts from expense accounts to
asset accounts. Crediting all unearned revenues to revenue accounts
when cash is received is also acceptable. In this case, the adjusting entries must transfer any
unearned amounts from revenue accounts to unearned revenue accounts.
Guidance
Answers to Decision Maker and Decision Ethics
Investor
Prepaid expenses are items paid for in advance of receiving
their benefits. They are assets and
are expensed as they are used
up. The publishing company’s treatment of the signing bonus is acceptable provided future
book sales can at least match the $500,000
expense. As an
investor, you are concerned about the risk of future book sales. The riskier
the likelihood of
future book sales
is, the more likely your analysis is to treat the $500,000, or a portion of it, as an expense, not a prepaid
expense (asset).
Loan Officer
Your concern in lending to this store arises from analysis of current-year
sales. While increased revenues and
income are fine, your concern is with collectibility of these promotional sales. If the owner
sold products to customers with poor
records of paying bills, then collectibility
of these sales is low.
Your analysis must assess this possibility and recognize any expected losses.
Financial Officer
Omitting accrued expenses and recognizing revenue early can
mislead financial statement users.
One action is to request a second meeting with the president so you can explain that accruing expenses when incurred
and recognizing revenue
when earned are required practices.
If the president persists, you might discuss the situation with legal counsel
and any auditors
involved. Your ethical action might cost you this job, but the potential pitfalls for
falsification of statements, reputation and personal integrity loss, and other
costs are too great.
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