University of Texas ACC 310 Introduction to Unit 6

Introduction to Unit 6 I just spent a long day at work, but I don't FEEL any richer This man may not feel any richer because he is looking at the world through cash accounting eyes, and he has not been paid yet. As we'll learn in this unit, if he were looking at the world through accrual accounting eyes, he would feel richer because he would count as part of his wealth the money he has earned today even though he has not received it yet. The Accounting Cycle (Unit 6) This unit addresses steps 5 and 6 of the Accounting Cycle, which focus on adjusting entries. As the next video explains, adjusting entries are made at the end of the period, after all transactions have been accounted for, to account for changes in assets and liabilities that are not due to a transaction. These changes usually result from the passage of time. It is necessary to account for these changes, in addition to the transactions for the period, to ensure that the financial statements are completely accurate and reflect all economic activity of the period. Unit 6: Video and Learning Objectives Unit 6 underscores the difference between accrual and cash accounting, a key concept in the course. In accrual accounting, adjusting entries is an important tool that allows for a more accurate measurement of wealth. Learning Objectives  Explain the time period assumption.  Explain the accrual basis of accounting.  Explain the reasons for adjusting entries and identify the major types of adjusting entries.  Prepare adjusting entries for deferrals.  Prepare adjusting entries for accruals.  Describe the nature and purpose of an adjusted trial balance. Video: Comparing Accrual and Cash Accounting Reading: Timing Issues Time Period Assumptions If we could wait to prepare financial statements until a company ended its operations, no adjustments would be needed. At that point, we could easily determine its final balance sheet and the amount of lifetime income it earned. However, most companies need immediate feedback about how well they are doing. For example, management usually wants monthly financial statements. The Internal Revenue Service requires all businesses to file annual tax returns. Therefore, accountants divide the economic life of a business into artificial time periods. This convenient assumption is referred to as the time period assumption. Many business transactions affect more than one of these arbitrary time periods. For example, the airplanes purchased by Southwest Airlines five years ago are still in use today. We must determine the relevance of each business transaction to specific accounting periods. (How much of the cost of an airplane contributed to operations this year?) Fiscal and Calendar Years Both small and large companies prepare financial statements periodically in order to assess their financial condition and results of operations. Accounting time periods are generally a month, a quarter, or a year. Monthly and quarterly time periods are called interim periods. Most large companies must prepare both quarterly and annual financial statements. The time period assumption is also called the periodicity assumption. An accounting time period that is one year in length is a fiscal year. A fiscal year usually begins with the first day of a month and ends 12 months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting period. Some do not. Companies whose fiscal year differs from the calendar year include Delta Air Lines, June 30, and Walt Disney Productions, September 30. Sometimes a company's year-end will vary from year to year. For example, PepsiCo's fiscal year ends on the Friday closest to December 31, which was December 31 in 2011 and December 29 in 2012. Accrual versus Cash-Basis Accounting Under the accrual basis, companies record transactions that change a company's financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when they perform services (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid). An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue for a company that has performed services but for which it has not received the cash. As a result, it does not match expenses with revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Individuals and some small companies do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting. Recognizing Revenues and Expenses It can be difficult to determine when to report revenues and expenses. The revenue recognition principle and the expense recognition principle help in this task. Revenue Recognition Principle When a company agrees to perform a service or sell a product to a customer, it has a performance obligation. When the company meets this performance obligation, it recognizes revenue. The revenue recognition principle therefore requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. To illustrate, assume that Dave's Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Dave's should record revenue in June when it performed the service (satisfied the performance obligation) rather than in July when it received the cash. At June 30, Dave's would report a receivable on its balance sheet an