REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned.
In a service business, revenue is considered to be earned at the time the service is performed.
THE MATCHING PRINCIPLE
The practice of expense recognition is referred to as the matching principle.
The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).
ADJUSTING ENTRIES
Adjusting entries are made in order for:
1 Revenues to be recorded in the period in which they are earned, and for......
2 Expenses to be recognized in the period in which they are incurred.
ADJUSTING ENTRIES
Adjusting entries are required each time financial statements are prepared.
Adjusting entries can be classified as
1 prepayments (prepaid expenses or unearned revenues) or
2 accruals (accrued revenues or accrued expenses)
TYPES OF ADJUSTING ENTRIES
Prepayments
1 Prepaid Expenses - expenses paid in cash and recorded as assets before they are used or consumed
2 Unearned Revenues - revenues received in cash and recorded as liabilities before they are earned
TYPES OF ADJUSTING ENTRIES
Accruals
1 Accrued Revenues - revenues earned but not yet received in cash or recorded
2 Accrued Expenses - expenses incurred but not yet paid in cash or recorded
The Trial Balance is the starting place for adjusting entries.
PREPAYMENTS
Prepayments are either prepaid expenses or unearned revenues.
Adjusting entries for prepayments are required to record the portion of the prepayment that represents
1 the expense incurred or
2 the revenue earned in the current accounting period.
PREPAID EXPENSES
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed.
Prepaid expenses expire with the passage of time or through use and consumption.
An asset-expense account relationship exists with prepaid expenses.
PREPAID EXPENSES
Prior to adjustment, assets are overstated and expenses are understated.
The adjusting entry results in a debit to an expense account and a credit to an asset account.
Examples of prepaid expenses include supplies, insurance, and depreciation.
October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.
October 31, an analysis of the policy reveals that $50 of insurance expires each month.
DEPRECIATION
Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner.
The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.
DEPRECIATION
Depreciation is an estimate rather than a factual measurement of the cost that has expired.
In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited
xxx xxx
DEPRECIATION
In the balance sheet, Accumulated Depreciation is offset against the asset account.
The difference between the cost of the asset and its related accumulated depreciation is referred to as the book value of the asset.
October 31, depreciation on the office equipment is estimated to be $480 a year, or $40 per month.
UNEARNED REVENUES
Unearned revenues are revenues received and recorded as liabilities before they are earned.
Unearned revenues are subsequently earned by rendering a service to a customer.
A liability-revenue account relationship exists with unearned revenues.
UNEARNED REVENUES
Prior to adjustment, liabilities are overstated and revenues are understated.
The adjusting entry results in a debit to a liability account and a credit to a revenue account.
Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future services.
October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.
ACCRUALS
The second category of adjusting entries is accruals.
Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period.
The adjusting entry for accruals will increase both a balance sheet and an income statement account.
ACCRUED REVENUES
Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected.
An asset-revenue account relationship exists with accrued revenues.
Prior to adjustment, assets and revenues are understated.
The adjusting entry requires a debit to an asset account and a credit to a revenue account.
October 31, the agency earned $200 in fees for advertising services that were not billed to clients before October 31.
ACCRUED EXPENSES
Accrued expenses are expenses incurred but not paid yet.
A liability-expense account relationship exists
Prior to adjustment, liabilities and expenses are understated
The Adjusting Entry results in a debit to an expense account and a credit to a liability account
October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.
October 31, accrued salaries are calculated to be $1,200.
1 Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets
2 Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues
3 Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understated Cr. Revenues
4 Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities
ADJUSTED TRIAL BALANCE
An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted.
It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period.
It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made.
Financial statements can be prepared directly from the adjusted trial balance.
ACCRUAL BASIS OF ACCOUNTING
The revenue recognition and matching principles are used under the accrual basis of accounting.
Under cash-basis accounting, revenue is recorded only when cash is received, and expenses are recorded only when paid.
Generally accepted accounting principles require accrual basis accounting because the cash basis often causes misleading financial statements.
ALTERNATIVE TREATMENT
Some businesses use an alternative treatment for prepaids and unearned revenues.
Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account.
Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account.
This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.
October 31, an inventory count reveals that $1,000 of $2,50

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