Fundamentals of Accounting for Non-ABM

Control No. 100-006

Chapter Title Measuring Business Income

Cash versus accrual basis of accounting

The cash basis of accounting recognizes revenue when cash is received and recognizes expenses when
cash is paid. Because of these improper assignments of revenues and expenses, the cash basis of
accounting is generally considered unacceptable. There is no need for adjusting entries under this basis.

The accrual basis of accounting recognizes revenues when sales are made or services are performed,
regardless of when cash is received. It also recognizes expenses when incurred, whether or not cash is
paid out. No revenue or expense is recorded later when cash is received or paid out because it has
already been recorded. Under the accrual basis, adjusting entries are used to bring the accounts up-to-
date for economic activity that has taken place but has not yet been recorded.

Accounting period

Accounting period is the period of time, normally one month, one quarter or one year into which an
entity’s life is arbitrarily divided for financial statement purposes. The length of an entity’s accounting
period depends on how frequent the internal and external users require information about the entity’s
performance.

The twelve-month accounting period used by an entity is called its fiscal year. The fiscal year used by
most entities coincides with its calendar year which is December 31. However, some entities elect to use
a fiscal year which ended on some other date. It may be convenient for an entity to end its fiscal year
during the slack season rather than during a time of peak activity.

Revenue principle

The revenue principle is the basis for recording revenues. It says to record revenues when it has been
earned – but not before. In most cases, revenue is earned when an entity has delivered the goods or
services to a customer.

Matching principle

The matching principle guides accounting for expenses. It identifies all expenses incurred during the
period, measures the expenses, and match them against the revenues earned during the same period.

Timing is an important factor in matching (offsetting revenues with the related expenses). This also to
show the cause and effect relationship between the revenues and expenses.

Time-period concept

The time-period concept ensures that information is reported at regular intervals. To measure income
accurately, companies update their accounts at the end of period. Much expenditures made by an entity
benefit two or more accounting periods.

Not all transactions can be precisely divided by the accounting periods. The purchase of property, plant
and equipment (except land) provides benefits to the entity over all the years to which an asset is used.
In measuring the net income of an entity for the period, the accountants estimate what portion of the
cost of the building and other long-lived assets is applicable to the current year. Since the allocations of
these costs are estimates rather than precise measurements, it follows that income statements should be
regarded as useful approximations of net income rather than an absolutely exact measurement.

1
 Fundamentals of Accounting for Non-ABM

For some expenses, it is not possible to estimate objectively the number of accounting periods over
which revenue is more likely to be produced. In such cases, GAAP requires that the expenses be charged
immediately to expense.

Adjusting process

The balances of the accounts shown in the trial balance are not up to date. Some of these accounts do
not reflect economic activities that have taken place and no proper recording by the entity. These
activities are not yet recorded because it is more convenient and economical to wait until the end of the
period to record it. Another reason is that no source documents concerning the activity have yet to come
to the attention of the accountant.

Adjusting entries assign revenues to the period in which they are earned and expenses to the period in
which they are incurred. Adjusting entries are needed because of the following reasons:

- measure properly the income for the period

- bring related asset and liability accounts to correct balances for financial statements

The two basic categories of adjustments are prepayments or deferrals and accruals.

• Prepaid expenses

Prepaid expenses are advance payment of expenses. It includes the following:

o Supplies
o Rent
o Insurance
o Property taxes

The portion of the asset that they have used during the period will become an expense; the
remainder will become an expense in the future. It is because of this deferral of benefits that
they are sometimes called deferred charges.

The two methods of accounting for prepaid expenses are the asset method and expense method.
The asset method is used when prepaid expense is recorded initially as an asset, the asset
account is debited at the date of the purchase. The expense method is used when the prepaid
expense is recorded initially as an expense and an expense account is debited at the date of
purchase.

Asset Method Expense Method

Initial entry Record the payment by debiting Record the payment by debiting the
the asset account. expense account.
Adjusting entry Transfer the amount used to the Transfer amounts unused to the
appropriate expense account. appropriate asset account,

Regardless of which method the accountants employed in any particular case, the amount
reported as expense in the income statement, and the amount reported as an asset in the
balance sheet will be the same. To avoid confusion and waste of time, the accountant must
consistently follow the method adopted for each particular type of prepayment every year.

2
 Fundamentals of Accounting for Non-ABM

• Unearned revenue

Unearned revenue is revenue received in advance that represents a liability. The amount of
revenue that the entity had earned during the period represents the portion of goods delivered or
services that have been performed; the remainder will be earned in the future. It is because of
this deferment that they are sometimes called deferred credits.

There are two methods of recording unearned revenues: liability method and the revenue
method. Under the liability method, a liability account is credited when the revenue is received in
advance. In the revenue method, a revenue account is credited when the revenue is received in
advance. At the end of the accounting period, the amount earned and unearned is determined
for proper adjusting entry.

Liability Method Revenue Method

Initial entry Record the receipt of cash to Record the receipt of cash to
appropriate liability account. appropriate revenue account.
Adjusting entry Transfer the amount earned to Transfer amounts unearned to the
the appropriate revenue account. appropriate liability account,

• Accrued expenses

Accrued expenses are expenses incurred but are not yet paid at the end of the fiscal period. They
are both an expense and a liability. The most common example of accrued expense is accrued
salaries

• Accrued revenues

Accrued revenues are revenues earned but are not yet received at the end of the period. An
example of this type of adjustment would be services that have been performed but have not
been billed or collected. To present an accurate picture of the affairs of an entity, the revenue
earned must be recognized on the income statement and the asset on the balance sheet.

• Depreciation of property, plant and equipment

The value of property, plant and equipment gradually decreases over time. Depreciation is the
decrease in the value of assets through wear and deterioration, and the passage of time.

Just as prepaid expenses indicate gradual using up of a previously recorded asset, so does
depreciation. The time involved in using up a depreciable asset is much longer that for prepaid
expenses and it involves large sums of money.

The three factors involved in the computation of depreciation expense are:

o Asset cost is the amount paid by the company to purchase the depreciable asset.
o Estimated residual value is the amount that the company can probably sell the asset at
the end of its estimated useful life. The other terms used are salvage value, scrap value
and trade-in value.
o Estimated useful life is the estimated number of time periods that a company can make
use of the asset.

Asset cost - Estimated residual value

Estimated useful life

3
 Fundamentals of Accounting for Non-ABM

Accountants use different methods of computing depreciation. The straight-line method of

depreciation is the most widely used method. Straight-line depreciation assigns the same amount
of depreciation expense to each accounting period over the life of the asset.

The asset’s depreciable amount is the difference between an asset’s cost and its salvage value.
The accountant must allocate the depreciable amount as an expense to the various periods in the
asset’s useful life to satisfy the matching principle.

The depreciation expense account is recorded in the income statement while the accumulated
depreciation account is recorded in the balance sheet as a deduction from the related asset.

The accumulated depreciation account is a contra asset account that shows the total of all
depreciation charges recorded on the asset up through the balance sheet date. A contra asset
account is a deduction from the asset to which it relates in the balance sheet. The purpose of the
contra asset account is to reduce the original cost of the asset down to its undepreciated cost or
book value. Book value is the cost not yet allocated to an expense.

The accumulated depreciation account increases each period by the amount of depreciation
expense until it finally reaches the amount equal to the original cost of the asset less the
estimated residual value.

Effects of failing to prepare the adjusting entries

Failure to prepare adjusting entries causes net income and the balance sheet to be in error.

Failure to recognize Effect on net income Effect on balance sheet

Consumption of prepaid Overstated Assets overstated
expenses Owner’s equity overstated
Earnings of previously Understated Liabilities overstated
unearned revenue Owner’s equity understated
Accrual of assets Understated Assets understated
Owner’s equity understated
Accrual of liabilities Overstated Liabilities understated
Owner’s equity overstated

Adjusted trial balance

After all the necessary adjusting entries have been journalized and posted, an adjusted trial balance is
prepared to prove that the ledger is still in balance.. It also provides a complete listing of the account
balances to be used in preparing the financial statements.