Finance T2 block B 2018 summary
Chapter 3: Measuring business income: adjusting the accounts
Revenues are increases in stockholders’ equity resulting from selling goods, rendering service
or performing other business activities. When payment is promised it is recorded as Accounts
Receivable or Notes receivable.
Expenses are decreases in stockholders’ equity resulting from the cost of selling goods or
rendering services and the cost of the activities necessary to carry on a business. Examples
are: salary expense, rent expense, advertising expense, utilities expense and depreciation.
The major assumptions made in measuring business income are continuity, periodicity and accrual
accounting (the matching rule).
Continuity: certain expense and revenue transactions are allocated over several accounting
periods. The continuity assumption states: ‘’unless there is evidence to the contrary, the
accountant assumes that the business is a going concern and will continue to operate
indefinitely’’. The continuity assumption allows the cost of certain assets to be held on the
balance sheet until a future accounting period, where the cost will become an expense.
Periodicity: not all transactions can be easily assigned to specific periods (i.e. purchase of a
building). The assumption: ‘’although the lifetime of a business is uncertain, it is nonetheless
useful to estimate the business’s net income in terms of accounting periods’’.
o to make comparisons easier, the periods are of equal length. A 12-month accounting
period is called a fiscal year, and accounting periods of less are called interim periods.
Accrual accounting: here net income is measured by assigning:
o Revenues to the accounting period in which the goods are sold or the services
performed
o Expenses to the accounting period in which they are used to produce revenue.
Adjusting the accounts is a technique used to accomplish accrual accounting.
Recognizing revenues
Revenue recognition: the process of determining when revenue should be recorded.
Persuasive evidence of an arrangement exists
A product or service has been delivered
The seller’s price to the buyer is fixed or determinable
Collectability is reasonable ensured
Recognizing expenses
, There is an agreement to purchase goods or services
The goods have been delivered or the services rendered
A price has been established or can be determined
The goods or service have been used to produce revenue.
The adjustment process
When transactions span more than once accounting period, accrual accounting requires the use of
adjusting entries. Adjusting entries provide information about past or future cash flows, but never
involve an entry to the Cash account.
Examples:
Type 1: prepayments of rent, insurance and supplies and the deprecation of plant and
equipment.
Type 2: wages and interest that have been incurred but are not recorded during an
accounting period.
Type 3: payments received in advance and deposits made for goods or services to be
delivered or provided in the future.
Type 4: revenue that a company has earned for providing a service, but for which is has not
billed or collected a fee.
Type 1 adjustment: Allocating recorded costs (deferred expenses)
Prepaid expenses: companies customarily pay some expenses, including those for rent,
supplied and insurance, in advance. By the end of an accounting period, a portion or all of the
prepaid services/goods will have been used. The required adjusting entry reduces the asset
and increases the expense. If this would not be adjusted, the net income on the income
statement and SE on the balance sheet will be overstated.
Depreciation of Plant and Equipment: because a long-term asset is a deferral of an expense,
the accountant must allocate the cost of the asset over its estimated useful life.
o Accumulated depreciation accounts are called contra accounts. A contra account is
paired with a related account.
Using the Adjusted Trial Balance to prepare Financial Statements
, Adjusting entries do not affect cash flows in the current period, since they never involve the
Cash account.
Chapter 4: Foundations of financial reporting and the classified balance sheet
, To be useful for decision making, financial report must enable the user to:
Asses cash flow prospects. Ultimate value of a business and its ability to pay dividends,
interest or otherwise provide return to capital providers.
Asses management’s stewardship: capital providers and others need information about the
resources.
Accounting information must fulfil the qualitative characteristics (FASB):
Relevance: information has a direct bearing on a decision.
o Needs have predictive value: helps for future decisions
o Confirmative value: confirms or changes previous evaluations
o Materiality: Information is material if its omission or misstatement could influence
the user’s economic decision. related to both the nature of an item and its size or
misstatement. As a rule, when an item is worth 5% or more of net income,
accountants treat it as material.
o Faithful representation: complete, neutral and free from material error.
o Comparability
o Verifiability
o Timeliness
o Understandability
Classified Balance Sheet
Chapter 3: Measuring business income: adjusting the accounts
Revenues are increases in stockholders’ equity resulting from selling goods, rendering service
or performing other business activities. When payment is promised it is recorded as Accounts
Receivable or Notes receivable.
Expenses are decreases in stockholders’ equity resulting from the cost of selling goods or
rendering services and the cost of the activities necessary to carry on a business. Examples
are: salary expense, rent expense, advertising expense, utilities expense and depreciation.
The major assumptions made in measuring business income are continuity, periodicity and accrual
accounting (the matching rule).
Continuity: certain expense and revenue transactions are allocated over several accounting
periods. The continuity assumption states: ‘’unless there is evidence to the contrary, the
accountant assumes that the business is a going concern and will continue to operate
indefinitely’’. The continuity assumption allows the cost of certain assets to be held on the
balance sheet until a future accounting period, where the cost will become an expense.
Periodicity: not all transactions can be easily assigned to specific periods (i.e. purchase of a
building). The assumption: ‘’although the lifetime of a business is uncertain, it is nonetheless
useful to estimate the business’s net income in terms of accounting periods’’.
o to make comparisons easier, the periods are of equal length. A 12-month accounting
period is called a fiscal year, and accounting periods of less are called interim periods.
Accrual accounting: here net income is measured by assigning:
o Revenues to the accounting period in which the goods are sold or the services
performed
o Expenses to the accounting period in which they are used to produce revenue.
Adjusting the accounts is a technique used to accomplish accrual accounting.
Recognizing revenues
Revenue recognition: the process of determining when revenue should be recorded.
Persuasive evidence of an arrangement exists
A product or service has been delivered
The seller’s price to the buyer is fixed or determinable
Collectability is reasonable ensured
Recognizing expenses
, There is an agreement to purchase goods or services
The goods have been delivered or the services rendered
A price has been established or can be determined
The goods or service have been used to produce revenue.
The adjustment process
When transactions span more than once accounting period, accrual accounting requires the use of
adjusting entries. Adjusting entries provide information about past or future cash flows, but never
involve an entry to the Cash account.
Examples:
Type 1: prepayments of rent, insurance and supplies and the deprecation of plant and
equipment.
Type 2: wages and interest that have been incurred but are not recorded during an
accounting period.
Type 3: payments received in advance and deposits made for goods or services to be
delivered or provided in the future.
Type 4: revenue that a company has earned for providing a service, but for which is has not
billed or collected a fee.
Type 1 adjustment: Allocating recorded costs (deferred expenses)
Prepaid expenses: companies customarily pay some expenses, including those for rent,
supplied and insurance, in advance. By the end of an accounting period, a portion or all of the
prepaid services/goods will have been used. The required adjusting entry reduces the asset
and increases the expense. If this would not be adjusted, the net income on the income
statement and SE on the balance sheet will be overstated.
Depreciation of Plant and Equipment: because a long-term asset is a deferral of an expense,
the accountant must allocate the cost of the asset over its estimated useful life.
o Accumulated depreciation accounts are called contra accounts. A contra account is
paired with a related account.
Using the Adjusted Trial Balance to prepare Financial Statements
, Adjusting entries do not affect cash flows in the current period, since they never involve the
Cash account.
Chapter 4: Foundations of financial reporting and the classified balance sheet
, To be useful for decision making, financial report must enable the user to:
Asses cash flow prospects. Ultimate value of a business and its ability to pay dividends,
interest or otherwise provide return to capital providers.
Asses management’s stewardship: capital providers and others need information about the
resources.
Accounting information must fulfil the qualitative characteristics (FASB):
Relevance: information has a direct bearing on a decision.
o Needs have predictive value: helps for future decisions
o Confirmative value: confirms or changes previous evaluations
o Materiality: Information is material if its omission or misstatement could influence
the user’s economic decision. related to both the nature of an item and its size or
misstatement. As a rule, when an item is worth 5% or more of net income,
accountants treat it as material.
o Faithful representation: complete, neutral and free from material error.
o Comparability
o Verifiability
o Timeliness
o Understandability
Classified Balance Sheet
