Why do companies wait until the end of the accounting period to make adjustments to record related revenues and expenses in the correct period?
Because recording many operating activities that take place over a period of time or several periods daily such as using insurance that has been prepaid or owing wages to employees for past work is very costly
What are adjusting entries?
Entries necessary at the end of the accounting period to measure all revenues and expenses of that period. They are required every time a company wants to prepare financial statements for external users.
What are the 4 kinds of adjustments?
2 in which cash was already received or paid and 2 in which cash will be received or paid
What are the 2 kinds of entries that derive from these 4 adjustments?
One for the cash receipt or payment either before or after the end of the period and one for the adjustment to record the revenue or expense in the proper period (the adjusting entry)
What is deferred revenue?
Previously recorded liabilities that were created when cash was received in advance, and that must be reduced for the amount of revenue actually earned during the period. Recognition of (recording) the revenue is postponed (deferred) until the company meets its obligation
What are examples of unearned revenues?
Magazine subscription sales by publishing companies, season tickets sold in advance to sporting events, air flight tickets sold in advance by airlines, and rent received in advance by landlords. Each of these requires an adjusting entry at the end of the accounting period to report the amount of revenue earned during the period.
What are accrued revenues?
Previously unrecorded revenues that need to be adjusted at the end of the accounting period to reflect the amount earned and the related receivable account. Cash will be received after the services are performed or goods are delivered
What are deferred expenses?
Previously recorded assets such as Prepaid rent, supplies and equipment that were created when cash was paid in advance and that must be adjusted at the end of the accounting period to reflect the amount of expense incurred during the period in using the assets to generate revenue
How are buildings and equipment different from supplies?
They represent deferred expenses that will be used over many years. Buildings and equipment accounts increase by the cost of the assets when they are acquired and decrease by the cost of the assets when they are sold. However, these assets are also used over time to generate revenue. Thus, a part of their costs should be expensed in the same period. (Expense matching) Accountants say that buildings and equipment depreciate over time as they are used. In accounting, depreciation= allocation of an asset's cost over its estimated useful life to the organization.
What is done to keep track of an asset's historical cost?
The amount that has been used is not subtracted directly from the asset account. Instead, it's accumulated in a contra account.
What is a contra account?
An account that is offset to or reduction of the primary account. They are directly linked to another account but with the opposite balance.
What is the contra account for property and equipment?
Accumulated Depreciation
What are contra accounts designated with?
An X in front of the type of account to which it's related. EX: Accumulated Depreciation shown as XA
Since assets have debit balances, what does accumulated depreciation have?
A credit balance
What is net book value (carrying value, book value)?
Difference between its acquisition cost and accumulated depreciation, its related contra account. This is the amount reported on the balance sheet. EX: For Property and Equipment, this equals the ending balance in the Property and Equipment account (cost) minus the ending balance in the Accumulated Depreciation account (used cost)
What is never included in the adjusting entry?
Cash b/c it was recorded already in the past or will be recorded in the future
What are accrued expenses?
Previously unrecorded expenses that need to be adjusted at the end of the accounting period to reflect the amount incurred and the related payable account. Numerous expenses are incurred in the current period w/o being paid for until the next period. These accrued expenses accumulate (accrue) over time but are not recognized until the end of the period in an adjusting entry. EX: Salaries Expense for the wages owed to employees, Utilities Expense for the water, gas, and electricity used during the period, and the Interest Expense incurred on debt.
What are the 2 components of borrowing and lending money?
Principal (the amount borrowed or loaned) and interest (the cost of borrowing or lending). Notes Payable (the principal) was recorded properly when the money was borrowed. Its balance does not need to be adjusted. However, interest expense is incurred by Chipotle over time as the money is used.
How is the interest rate on loans and borrowings to others calculated?
Unless told otherwise, it's always given as an annual percentage. To compute interest expense on notes payable for less than a full year, the number of months needed in the calculation is divided by 12.
What is the final adjusting entry?
To record the accrual of income taxes that will be paid in the next quarter. This requires computing adjusted pre tax income-the balance in the revenue and expense accounts from the unadjusted trial balance plus the effect of all of the other adjustments
What does each adjusting entry include?
One balance sheet account and one income statement account
What is the incentive behind stock options?
Top management is compensated w/ options to buy their companys' stock at prices below market value. The higher the market value, the more compensation they earn.
How might management attempt to manipulate accruals and deferrals?
Managers may record cash received in advance of being earned as revenue in the current period or may fail to accrue certain expenses at year end.
If a number changes on the income statement,
It will impact the other statements
Why is the income statement prepared first?
B/c net income is a component of retained earnings
What is the only ratio reported on the income statement?
EPS. Calculated as net income/avg # of shares of common stock outstanding during the period. Avg # of shares outstanding=# at beginning of the period plus the number at the end of the period/2
What is the final total from the income statement, net income, carried forward to?
Retained Earnings column of the statement of stockholders' equity
What does the cash flow statement explain the difference between?
The ending and beginning balances in the cash account on the balance sheet during the period. It's a categorized list of all transactions of the period that affected the cash account.
What do many financial analysis texts warn analysts to look for?
Unusual deferrals and accruals. They often suggest that wide disparities between net income and cash flow from operations are a useful warning sign. Accounting accruals determining net income rely on estimates, deferrals, allocations, and valuations. These considerations sometimes allow more subjectivity than do the factors determining cash flows. For this reason, we often relate cash flows from operations to net income in assessing its quality.
When do some users consider earnings of higher quality?
When the ratio of cash flows from operations divided by net income is greater . This derives from a concern with revenue recognition or expense accrual criteria yielding high net income but low cash flows
How is the total asset turnover ratio calculated?
Net Sales (or Operating Revenues)/Average total Assets (To compute average: Beginning balance+ending balance/2)
What does the total asset turnover ratio measure?
The sales generated per dollar of assets. A high asset turnover ratio signifies efficient management of assets and vice versa. A company's products or services and business strategy contribute significantly to its total asset turnover ratio. However, when competitors are similar, management's ability to control the firm's assets is vital in determining its success. Stronger financial performance improves the asset turnover ratio. Creditors expect the ratio to fluctuate on a quarterly basis due to seasonal upswings and downturns. EX: As inventory is built up prior to a heavy sale season, companies need to borrow funds. The asset turnover ratio declines with this increase in assets. Eventually, the season's high sales provide the cash needed to repay the loans. The asset turnover ratio then rises with the increased sales.
While the total asset turnover ratio may decrease due to seasonal fluctuations,
A declining ratio may also be caused by changes in corporate policies leading to a rising level of assets. EX: Relaxing credit policies for new customers or reducing collection efforts in accts receivable.
What are permanent (real) accounts?
The balance sheet accounts that carry their ending balances into the next accounting period. They are not reduced to zero at the end of the accounting period. EX: Cash balance of the prior period is the beginning cash balance of the next accounting period. The ending balance in each of the asset, liability, and stockholders' equity accounts becomes the beginning balance for the next period.
When is the only time a permanent account has a zero balance?
When the item it represents is no longer owned or owed.
What are temporary (nominal) accounts?
Income statement accounts that are closed to Retained Earnings at the end of the accounting period. At the end of each accounting period, the balances inside the temporary accounts are transferred, or closed, to the Retained Earnings account by recording a closing entry. EX: Revenue, expense, gain, and loss accounts are used to accumulate data for the current accounting period only
What is the final step in the accounting cycle?
Closing the books. This is done to prepare the income statement accounts for the next accounting cycle
What are the 2 purposes of a closing entry?
1. To transfer the balances in the temporary accounts (income statement accounts) to Retained Earnings
2. To establish a zero balance in each of the temporary accounts to start the accumulation in the next accounting period.
When is the closing entry dated?
The last day of the accounting period
What is Income Summary?
Companies may close the income statement accounts to a special temporary summary account called the Income Summary, which is then closed to Retained Earnings.
After the closing process is complete,
All income statement accounts have a zero balance. These accounts are then ready for recording revenues and expenses in the new accounting period. The ending balance in Retained Earnings is now up to date and is carried forward as the beginning balance for the next period. As an additional step of the accounting information processing cycle, a post closing trial balance should be prepared.
What is the post closing trial balance?
Should be prepared as an additional step of the accounting cycle to check that debits equal credits and all temporary accounts have been closed.
Where does Retained Earnings appear?
Both on the balance sheet and statement of stockholders' equity
Where does Net income appear?
Both income statement and statement of stockholders' equity
Adjusting entries
Are needed to measure the period's net income or loss and update the accounts to their proper balances
How do many revenues and expenses compare to the balances on an unadjusted trial balance
They are greater
When should supplies be recorded as an expense?
In the period they are used, not necessarily when they are sold
Which account will an adjustment not affect?
What does the post closing trial balance check?
That total debits equal total credits at the end of the period
What do adjustments ensure?
Assets on the balance sheet are reported at amounts that reflect their economic benefit remaining, not the amount that has been used up or expired during the period.
Which account may be credited for interest earned on a notes receivable?
Investment income
What kind of account is Retained Earnings?
What is a good starting point for determining which accounts require adjustments?
Unadjusted trial balance
The adjusting entry to record income taxes owed at the end of the accounting period
Would use pretax income