Expert answer:Accounting Cycle, homework help
Answer & Explanation:Financial statements are a product of the accounting cycle. Think about two different companies: a manufacturing company, and a retail company. Why would different companies have different accounting cycles? Would you expect the steps of the accounting cycle to be the same for each company? Why, or why not?Must reference the attached chapters and any in-text citations used as:K Wainwright, S. (Ed.). (2012). Principles of Accounting: Volume I . San Diego, CA: Bridgepoint Education, Inc.Must reference videos that are used in the instructions doc.instructions.docx03ch_accounting_volumei.pdf04ch_accounting_volumei.pdf
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Instructions
Welcome to Week 2 Gang. This week we tackle chapters 3 & 4 from our text relating to the
Accounting Cycle, Cash, Receivables and the various controls that are necessary to manage these
assets.
Picking up where we left off in week 1, which brought us to the point of creating the Trial Balance,
the accounting cycle continues with adjusting entries. The adjustments we are referring to relate to
recognizing revenues and expenses that go with the current accounting period. Items like
depreciation expense (to allocate the cost of machinery over its useful life), use of supplies taken
from inventory, the use of a prepaid item like prepaid rent or prepaid insurance, wages owed but not
yet paid and so on (See table 3.2). The following video is also worth a quick look:
https://www.youtube.com/watch?v=KyjAUyS4Lk&list=PL_KGEFWqEaTD7bVk8pXZhfpLZvmQXSJtk
GAAP requires that accountants be conservative and use the historical cost of an item to indicate
that asset’s value. This is called the historical cost principle, appropriately, and can be substantiated
via invoices received or checks written at the time of purpose. These would be our source
documents for the value of the items. The accruals we make would relate to a specific time period,
hence, the invention of the periodicity assumption by GAAP.
Accrual basis accounting, which is required by GAAP, sets out to recognize revenues when they are
earned and expenses when incurred, regardless of when the firm actually gets paid or, alternatively,
pays for these items. Expenses are recognized either when the revenue that the expense is
associated with is recognized via sales revenue (for products or services typically), called the
matching principle; when the period has passed if the expense is like a utility bill or property taxes,
for example, or immediate recognition if the expense serves no useful purpose for later periods.
Once the adjusting entries are made the accounting cycle continues with an adjusted trial balance,
which would reflect all the accounts the firm uses and would include any adjustments made to
accounts after the initial trial balance was created. Keep in mind that both the trial balance and the
adjusted trial balance will list each and every account the firm has as part of their chart of
accounts. Only the account balance would be listed, which means we would net the debits with the
credits in each account and just list that result. Once the adjusted trial balance is completed we can
use it to create our financial statements.
The financial statements are always created in a particular order. The income statement is created
first, because the net income or loss that results would be carried over to the Statement of Owners
Equity (the text calls this the Statement of Retained Earnings, but that is an incorrect title). The final
retained earnings balance that shows on the Statement of Retained Earnings would then be
transferred to the Balance sheet, where it will show up in the Equity section. Once the Balance
Sheet is completed the Statement of Cash Flows can be prepared.
Once financial statements are prepared, assuming the accountant is not exhausted (just kidding),
the Closing journal entries are prepared. The closing entries are done to transfer the values from
our temporary accounts (dividends, revenues and expenses) to retained earnings. This is done so
that these temporary accounts are zeroed out and the firm can start the new accounting year with
zero balances in these accounts. Then we create what is called a post closing trial balance, which
would be the firm’s permanent account balances (all from the balance sheet). This becomes the
firm’s opening balance in the permanent accounts for the next accounting cycle.
We would be remiss if we didn’t at least touch on the cash basis of accounting. GAAP does not
recognize the cash basis, but the IRS does. Under the cash basis there would be no adjusting
entries because only transactions where cash changes hands would be recognized. So, for
example, there would be no accounts receivable or accounts payable under the cash basis. This
does leave the door open for some potential fraud if not used carefully though.
As we move on to Chapter 4 we shift gears and begin to look at the individual components that
make up the financial statements. In the current assets section the most liquid assets most firms
have are cash and accounts receivable. Since cash is so easily concealed, the proper control of
cash is a must if a firm is to survive and prosper. We refer to this as internal controls, which is a
series of checks and balances designed to reduce the opportunity to steal cash from the firm. These
controls include things like separating physical control from the recording function, as an example, or
keeping checks and cash locked up to avoid theft, making daily bank deposits and regularly
reconciling the bank accounts, among other things. Section 4.2 in the text demonstrates how to
reconcile a bank account since many of you may never have had to balance a bank account thanks
to online banking. Cash assets also include the petty cash account, which can be a source for
thieves if not properly controlled.
Accounts Receivable (A/R) is next in line in terms of liquidity. These are balances owed to the firm
by its customers for sales to the customer of either products or services. It may surprise you to learn
that most sales between businesses are done on account rather than paying at time of
purchase. Unfortunately some customers will stiff us in the end and we have to write off their
account. While not recognized by GAAP, the direct write-off method charges (debits) Bad Debt
Expense and credits A/R for the dollar value of the deadbeat customer’s account. This method
might be used by a small firm who infrequently loses an account.
Most firms would use the Allowance for Doubtful Accounts method to write off an account gone
bad. This method is GAAP approved and involves estimating at the beginning of the period that a
certain dollar value of bad accounts will be written off based on historical data. Use of this method
has one primary advantage which is properly matching revenues and the resulting bad debt expense
in the same period (matching principle). Once an estimate of potential bad debt expense is made a
journal entry is made to debit bad debt expense and credit the allowance for doubtful
accounts. Then, when an actual account goes bad, we credit A/R and debit the Allowance for
Doubtful Accounts. Check out this short video on the topic:
The text gives some good examples of transactions impacting the cash and receivables accounts,
so spend some quality time reading and studying this information before attempting this week’s
homework.
This week’s deliverables include:
Read Chapters 3 & 4 in the text.
chapter 3
Income Measurement and
the Accounting Cycle
Copyright Barbara Chase/Corbis/AP Images
Learning Goals
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•
Understand fundamental concepts of income measurement and the accrual basis
of accounting.
•
Apply the core principles that define revenue and expense recognition methods.
•
Know why adjusting entries are needed and prepare them for the illustrated types
of transaction and events.
•
Implement the accounting cycle and the steps that lead to preparing correct
financial statements.
•
Construct a worksheet to aid in preparing financial statements.
•
Cite examples of alternative reporting periods and show how the closing process is
used at the end of a typical accounting year.
•
Calculate income under the cash basis of accounting and know when it is an acceptable
alternative to the accrual basis.
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Section 3.1 An Emphasis on Transactions and Events
CHAPTER 3
Chapter Outline
3.1 An Emphasis on Transactions and Events
3.2 The Periodicity Assumption
3.3 Revenue Recognition
3.4 Expense Recognition
3.5 Adjusting Entries
The Adjusting Process for Revenues
The Adjusting Process for Expenses
Understanding When to Adjust
3.6 The Accounting Cycle
A Comprehensive Example
The Adjusted Trial Balance
Financial Statement Preparation
3.7 Reporting Periods and Worksheets
Closing the Accounts
Classified Balance Sheets
Notes to the Financial Statements
3.8 Cash Basis of Accounting
C
hapter 2 showed how transactions are entered into the journal and posted to the
ledger. The resulting ledger balances were drawn into a trial balance to verify that
debit and credit figures matched. In some cases, the trial balance can be used to prepare
financial statements. Also pointed out was that accountants often need to adjust certain
accounts before up-to-date and correct financial statements can be prepared.
3.1 An Emphasis on Transactions and Events
T
he basis for determining which accounts require adjustment is tied to understanding
the fundamental nature of accounting income. Accounting income is primarily tied
to a model based on transactions and events. This means that accountants are not necessarily measuring all changes in value as they occur. The historical cost principle is the
foundation to many accounting rules. For example, land is recorded at its purchase price,
and that historical cost price is maintained in the balance sheet, even though market value
may increase over time. Historical cost data are viewed as objective and verifiable. The
prevailing income measurement model is primarily driven by a transactions-and-events,
historical cost-based approach.
The historical cost information incorporated into the accounting system is drawn from
exchange transactions. Exchange transactions generally signify that independent buyers
and sellers have agreed on the price for which goods are services are to be delivered.
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CHAPTER 3
Section 3.2 The Periodicity Assumption
These exchanges are often termed arm’s length exchange transactions, and the amount
of consideration forms the basis for accounting measurement. Business revenues are the
resource (generally, cash and receivables) inflows from exchange transactions. Business
expenses are the exchange-related resource outflows arising from the production of goods
and services. Income is generally regarded as revenues minus expenses.
One seemingly unavoidable problem with the approach based on transactions and events
is the dynamic nature of business activity. Revenue- and expense-generating activities are
in constant flux. Each day a business may provide services to customers, but payment
occurs only on a specified billing cycle. When is the revenue viewed as being earned
for purposes of inclusion in an income statement? Similarly, many business expenses are
being continuously generated. Consider the consumption of electricity. At the moment
you are reading this, you may be sitting in a heated or air conditioned room, illuminated
by an overhead light, with your computer on. Electricity is being consumed constantly.
From a business perspective, the cost associated the electricity usage is constantly ongoing. How should the measure of electricity expense be pulled into the measure of accounting income?
3.2 The Periodicity Assumption
T
he periodicity assumption holds that that business activity can be divided into specific time intervals, such as months, quarters, and years. Indeed, recall that an income
statement measures income for a specific time period. Furthermore, a balance sheet reflects
the financial condition as of a specific date.
The significance of the periodicity assumption and the related financial statement dating cannot be underestimated. The transactional basis of accounting measurement is not
to be interpreted as measuring only the exchange of cash. The cash basis of accounting
will be discussed later in this chapter. For now, the focus is on the accrual basis. Accrual
is a term that means “to accumulate over time, based on a natural observable increase.”
For example, a business will constantly use utilities. The cost of those utilities accrues, or
accumulates, with the passage of time. The accrual basis attempts to measure these costs
as they accumulate. In contrast, the cash basis would measure the utilities expense only
when the utility bill is paid. A key challenge of the accrual basis of accounting is properly
identifying the portion of ongoing business activity that occurred during a particular
accounting period, as Exhibit 3.1 shows.
Exhibit 3.1: Measuring ongoing activity
BUSINESS ACTIVITY
Accounting Year
55
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CHAPTER 3
Section 3.3 Revenue Recognition
Identifying the amount of business activity to measure in each period involves both revenue and expense issues. Principles that guide the measurement of each are discussed in
the following sections of this chapter.
3.3 Revenue Recognition
U
nder the accrual basis of accounting, revenues are to be recorded when they are
earned. The measurement of revenue is called revenue recognition and is synonymous with recording revenues into the accounts. Revenue recognition normally occurs at
the time when services are rendered or when goods are sold and delivered to a customer.
Revenue recognition normally requires both an exchange transaction and the earnings
process to be complete (Exhibit 3.2).
Exhibit 3.2: Revenue recognition
+
Production
Earnings Process
Complete
=
Salesman
Customer
Exchange
Transaction
Accounting
Revenue
Recognition
For a manufactured product, revenue should not be recorded until the product is sold and
delivered to an end customer. Payment can occur before, after, or at the time of product
delivery. What matters is that the customer has accepted the product and the associated
duty to pay for it. It is also imperative that the product be completed, such that the manufacturer has no significant remaining duties (other than honoring routine commitments
related to warranty services or occasional estimable returns). Service revenue is not as
closely tied to the handoff to an end customer. A law firm may have a large staff that
is researching a unique problem. The work is ongoing, and the client is being regularly
updated on findings. So long as the law firm reasonably expects to be paid, the earnings
process and the related revenue recognition is continuous.
Business transactions are fraught with complexity and give rise to numerous revenue
recognition challenges. A majority of significant accounting mistakes relate to misapplication of generally accepted accounting principles related to revenue recognition issues.
Consider the complexity of revenue recognition for cases like those related to long-term
service agreements. Perhaps you have had an offer for a $99 cell phone, satellite dish, or
burglar alarm system. The item you are buying likely costs more than $99, and the terms
of the offer probably require you to agree to a multiyear monthly service contract. How
should the seller record such transactions?
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Section 3.4 Expense Recognition
CHAPTER 3
What about an online retailer whose business model only requires routing a customer
order to a supplier who handles all logistics? If an item is sold for $100, but the online company only retains $2 of the total as a marketing fee, how much revenue is to be reported
on the income statement? These are complex questions, which can lead to more complex
questions. It is no wonder that many accounting failures involve misapplication of revenue recognition concepts. Accountants have literally thousands of specific rules to draw
on in reaching correct accounting conclusions. Those specific rules are generally framed
around the principles in Table 3.1, all of which should be satisfied.
Table 3.1: General principles for revenue recognition
There is persuasive evidence of an arrangement.
Delivery of goods has occurred or services have been rendered.
The seller’s price is fixed or determinable.
Collectability is reasonably assured.
Remember from Chapter 2 that accounting is not bookkeeping. Perhaps you are now beginning to appreciate the difference. Accountants are highly skilled professionals who are
trained to research and apply proper accounting solutions to complex measurement issues.
For now, it bears repeating that payment is not a criterion for initial revenue recognition.
Revenues are recognized at the point of sale, whether that sale is for cash or a receivable.
Accrual basis accounting contemplates more than just recording cash receipts. Severe misrepresentations of income could result if the focus was simply on cash receipts.
3.4 Expense Recognition
A
ccrual accounting principles also apply to expense recognition. Expense recognition
principles have a slightly different theoretical framework. There are three alternative
models to apply, depending on the nature of a particular cost.
Some costs are created by and directly associated with a particular revenue-producing
event. For example, the sale of an inventory item produces revenue, and it makes sense
to offset the revenue by the cost of the inventory. Remember, income is equal to revenues
minus expenses. Failure to record the expenses associated with producing revenue would
overstate income. Sales commissions would similarly be recorded in the same period as
a sale. Many costs bear a direct relationship to revenue and are to be recorded concurrent
with the revenue recognition. This concept is referred to as the matching principle. The
matching principle explains the manner in which a large proportion of business costs are
to be recorded.
Some costs occur on an ongoing basis without regard to the level of revenue production. Rent, insurance, depreciation of equipment, and so forth are costs that display this
pattern. As such, accountants adopt systematic allocation schemes. These schemes can
be as simple as recording an equal portion of cost each period. Other patterns might be
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CHAPTER 3
Section 3.5 Adjusting Entries
deployed, such as accounting for long-term assets (see Chapter 6). Therefore, accountants
use defined allocation models to systematically attribute some costs to expense over time.
Lastly, some costs occur that are not seen as benefiting any future periods and are not
linked to any revenue production. If a business asset is consumed by fire, its cost would be
expensed immediately; there is no future benefit and no discernible revenue! Therefore,
the third approach to recording expenses is immediate recognition.
Recapping, expenses are recognized by matching, systematic allocation, or immediate recognition, as shown in Exhibit 3.3.
Exhibit 3.3: T he three approaches to expense allocation
Year 1
Year 2
Year 8
20XX
Year 3
Year 7
$
Expenses
$$$
$
Revenues
Year 4
Year 6
Year 5
Matching
Allocation
Immediate
Accountants use the logic just described in trying to decide which approach to apply to a
particular cost. As was the case with revenue recognition, note that expense recognition
guidelines look well beyond just the payment of cash. Many costs are charged to expense
in advance of or after the date of the related cash payment. For instance, the purchase of
equipment for cash is initially recorded as follows:
7-1-X2
Equipment
Cash
1,000.00
1,000.00
To record purchase of equipment
Over time, the equipment cost will be transferred to expense in a systematic fashion that
approximates the consumption of the equipment via its usage. This process is called
depreciation and is discussed later in this chapter.
3.5 Adjusting Entries
T
he revenue and expense recognition principles provide a foundation for understanding
the potential need to adjust account balances prior to preparing financial statements.
Revenues may have been earned and expenses incurred that have not yet been recorded.
waL80144_03_c03_053-088.indd …
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