Timing Issues

No adjustment would be necessary if we could wait until a copy ended its

operations to prepare for its financial statements. At that point, we can
easily determine its final balance sheet and the amount of lifetime income it
earned.
Selecting an Accounting Time Period
It is impractical to wait so long for the results of operations. That is why
management usually wants monthly financial statements. Investors want to
view the results of publicly traded companies at least quarterly. The
Canada Customs Revenue Agency wants annual financial statements filed
with annual income tax returns. To meet these needs, accountants make
the assumption that the economic life of a business can be divided into
artificial time periods. This assumption is referred to as the time period
assumption. Business transactions on the other hand affect more than one
of these arbitrary time periods. We must, therefore, determine the
relevance of each business transaction to specific accounting periods. This
may involve subjective judgment and estimates.
Fiscal and Calendar Years
All companies prepare Financial statements periodically in order to assess
their financial condition and results of operations. Accounting time periods
are generally one month, one quarter, or one year. Time periods of less
than one year are called interim periods. Most large companies are
required to report both quarterly and annually. An accounting time period
that is one year in length is referred to as a fiscal year. Many businesses
coincide with the calendar year (January 1 - December 31). However there
are companies who don't coincide with the calendar year as well.
Recognizing Revenues and Expenses
Determining the amount of revenues and expenses to report specific
accounting periods can be difficult.
Generally accepted accounting principles
● The revenue recognition principle
● The matching principle
The revenue recognition principle states that revenue must be recognized in the
accounting period in which it is earned. In a service enterprise revenue is
considered earned at the time the service is performed. Accountants follow the
approach of ‘let expenses follow the revenues.” That is expense recognition
depends on revenue recognition. The issue in expense recognition is the period
when efforts are made to generate revenues. This may or may not be the same
period in which the expense is paid. The practice of expense recognition is called
the matching principle because it matches efforts (expenses) with
accomplishments(revenues).
Accrual Versus Cash Basis Accounting
If you follow revenue recognition and matching principles, you are using the
accrual basis of accounting. Transactions that change a company’s
financial statements are recorded in the periods in which the events occur.
For example service revenue is recognized when it is earned, rather that
when cash is received. The critical event is collection of service not
collection of cash. Expenses are recognized when services such as salary
or goods such as supplies are used or consumed rather than when the
cash is paid. This results ub revenues that have been earned being
matched with the expenses to earn these same revenues.

Under the Cash basis accounting, revenue is recorded when cash is

received, and expenses recorded when cash is paid. The cash basis often
leads to misleading financial statements. It fails to record revenue which
has been earned if the cash has not been received. This violates the
revenue recognition principle. In addition expenses are matched with
revenues, which violates the matching principle. The cash basis of
accounting is not in accordance with generally accepted accounting
principles. Although companies use the accrual basis of accounting, some
small companies use the cash basis of accounting as well as farmers and
fisherman. Cash basis accounting is justified for these types of businesses
because they have few receivables and payables.
The Basics of Adjusting Entries
For revenues to be recorded in the period in which they are earned, and for
expenses to be matched with the revenues they generate, adjusting entries
are made at the end of the accounting period.
Accrual basis of accounting, adjusting entries are needed to ensure
that the revenue recognition and matching principles are followed.
Adjusting entries ensure all financial statements are accurate.
1. Some events are not journalized daily because it is not efficient
to do so
2. Same costs are not journalized during the accounting period
because they expire with the passage of time rather than
through recurring daily transactions
3. Some items may be used unrecorded. An example is a utility
service bill that will not be received until the next accounting
period.

Adjusting entries are needed every time financial statements are

prepared. We first analyze each accounting in the trial balance to see if it is
complete and up to date. The analysis requires a thorough understanding
of the company’s operations and the interrelationship of accounts.
Adjusting Entries for Prepayments
Prepayments are either prepaid expenses or unearned revenues. Adjusting
entries are used to record the portion of the prepayment that is for the
expense incurred on the revenue earned in the current accounting period.
Prepaid expenses
Costs paid in cash and recorded as assets before they are used or
consumed are called prepaid expenses.
Prepaid expenses expire either with the passage of time (e.g., rent and
insurance) or through use and consumption(e.g., supplies)
Prior to adjustments, assets are overstated and expenses are understated.
Thus the prepaid expense adjusting entry results in a debit (increase) to an
expense outlook account and a credit (decrease) to an asset account.
Insurance
Most companies have fire and theft insurance for merchandise, and
equipment personal liability insurance for accidents suffered by customers
on the company's premises, and automobile insurance for company cars
and trucks the term of coverage is usually one year.
Unearned Revenues
Revenues received in cash that has not yet been earned or called
unearned revenues such items as Renta magazine subscriptions and
customer deposits for future service may result in unearned revenues
Then an adjusting entry is made to record the revenue that has been
earned. I want to show the liability that remains. In the typical case liabilities
are overstated and revenues are understated prior to adjustment. Thus, the
adjusting entry for unearned revenue results in a debit (decrease) to a
liability account and a credit (increase) to a revenue account.
Adjusting Entries for Accruals
These adjustments record revenues earned and related expenses in the
current accounting. That has not yet been recognized (recorded) through
daily journal entries the revenue account (and their related asset account)
are understated the expense account (and the related liability account) are
also understated does the adjusting entry for accruals will increase both a
balance sheet and an income statement account.
Accrued Revenues
Revenues earned but not yet received in cash or recorded at the statement
date are accrued revenues. Have accrued revenues may accumulate
(accrue) with the passage of time as in the case of interest revenue and
rent revenue. Or they may result from services that have been performed
but neither built nor collected as in the case of commissions and fees.
Adjusting entry is required
1. To show the receivable that exists at the balance sheet date
2. To record the revenue that has been earned during the period.
Prior to adjustments, both assets and revenues are understated. An
adjusting entry for accrued revenues results in a debit (increase) to an
asset account and a credit (increase) to a revenue account.
If the adjusting entry is not made, assets and owner’s equity on the balance
sheet, and revenues and net income on the income statement, will be
understated
Accrued Expenses
● Expenses incurred but not yet paid or recorded at the statement date
are called accrued expenses. Interest, rent, property taxes, and
 salaries can be accrued expenses resulting from the same causes as
accrued revenues.
● The adjusting entry for accrued expenses results in a debit (increase)
to an expense account and a credit (increase) to a liability account.
*Interest rates are always expressed as an annual rate
● If the adjusting entry is not made, liabilities and expenses will be
understated. Net income and owner’s equity will be overstated.
● Accrued salaries some types of expenses Such as employee salaries
and commissions are paid after the work has been performed
Adjusting Entries for Estimates
Estimates are required in accounting because we do not always know what
will happen in the future.If the current period will be affected by these future
events subjective estimates must be made.
Amortization
A business usually owns productive facilities such as land, buildings,
equipment, and vehicles.Each is recorded as an asset, rather than as an
expense, in the year it is acquired because these capital assets provide a
service for a number of years.The time of service is referred to as useful
life.
According to the matching principle, a portion of the cost of the capital
asset should be reported as an expense during each period of the asset's
useful life. Amortization is the allocation of the cost of these types of assets
to expense over their useful lives.
*All capital assets except land are amortized. land is not amortized as it has
an unlimited useful life.
The reason for amortization adjustment from the accounting standpoint,
acquiring productive facilities is essentially a long term prepayment for
services.
*Amortization is an estimate rather than a factual measurement of the cost
that has expired. A common procedure for calculating amortization
expense is to divide the cost of the asset by its useful life.

A contra account is offset against related accounts on the income

statement or balance sheet. On the balance sheet, it can be a Contra asset
account (offset against an asset) or a Contra liability account (offset against
the liability).
The net book value Is the difference between the cost of any amortized
balance and its accumulated amortization.
If this adjusting entry is not made total assets, owner is equity, and
net income will be overstated and amortization expense will be
understated.
Summary of Basic accounting Relationships
Each adjusting entry affects one balance sheet account and one income
statement account
The adjusted Trial Balance and Financial Statements
After all adjusting entries have been journalized and posted, another trial
balance is prepared from the ledger accounts. This is called adjusted trial
balance.
Preparing the Adjusted Trial Balance
An adjusted trial balance proves the equality of the total debit
balances and the total credit balances in the ledger, after all
adjustments are made. The proof provided by an adjusted trial
balance, like the proof contained in a trial balance, applies on the
to the mathematical accuracy of the ledger.the adjusted trial
balance provide all data that are needed for the preparation of
financial statements
Preparing Financial Statements
● Financial statements can be prepared directly from the adjusted trial
balance.
● The income statement is prepared from the revenue and expense
accounts.
● The balance sheet is then prepared from the asset and liability
accounts and the ending owners capital balance, as reported in the
statement of owner’s equity
Prepaid Expenses
Prepaid expenses become expired costs through either the passage of
time, as in the case of insurance, or through consumption, as in the case of
advertising supplies.
If at the time of purchase the company expects to consume the supplies
before the next financial statement date it may be more convenient initially
to debit (increase) an expense account rather than an asset account.
Unearned Revenues
Unearned revenues become earned either through the passage of time in
the case of unearned rent or through providing the service as in the case of
unearned fees. Rather than creditting in unearned revenue (liability)
accounts initially a revenue account may be credited (increased) when
cash is received for future services and a different adjusting entry may be
necessary.