Review for Quiz 4 PDF

Review for Quiz 4 Format: Part A: Knowledge 10 marks Part B: Application 10 marks Part C: Thinking 10 marks The Adjustment Process v It is critical for F/S to be accurate, current, and consistent from year to year. v Responsibility for F/S rests entirely with the compan...

Review for Quiz 4 Format: Part A: Knowledge 10 marks Part B: Application 10 marks Part C: Thinking 10 marks The Adjustment Process v It is critical for F/S to be accurate, current, and consistent from year to year. v Responsibility for F/S rests entirely with the company’s accountants v Accountants must ensure that: § All accounts are brought up to date § Late transactions are taken into account § Calculations are correct § Accounting principles/standards are followed v So accountants must adjust the accounts § Done through adjusting journal entries § This brings the accounts up to date § Ensures that accounting principles are followed Time Period Concept The time period concept assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year. The accounting time period of one year in length is usually known as a fiscal year. So accounts must be adjusted at the end of each fiscal period. Revenue Recognition Principle The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned not when cash is received. In a service business, revenue is usually considered to be earned at the time the service is performed. Most customers/clients will pay later Some customers/clients pay in advance Matching Principle The practice of expense recognition is referred to as the matching principle. The matching principle dictates that expenses be matched with revenues in the same time period. Accrual Basis of Accounting Adheres to the ○ Revenue recognition principle ○ Matching principle Revenue is recorded when earned, not necessarily when cash is received. Expense is recorded when services or goods are used in the generation of revenue, not necessarily when cash is paid. Adjusting Entries make these principles HAPPEN! Adjusting entries are required each time financial statements are prepared. 5 types of adjusting entries: 1. Supplies 2. Prepaid expenses 3. Unearned revenue 4. Late arriving purchase invoices 5. Depreciation 1. Supplies – you have used supplies but the usage has not been recorded. 2. Prepaid expenses — Expenses pre-paid in cash and originally recorded as assets before they are used. 3. Unearned revenues — Revenues pre-received in cash and originally recorded as liabilities before they are earned. 4. Late arriving purchasing invoices — Expenses incurred but their invoices arrive late and they have not yet been paid. 5. Depreciation — Allocation of the cost of long-term assets to expense over their useful lives. Supplies A business purchases supplies regularly throughout the year. When they purchase supplies, the entry is: DR Supplies CR Bank or A/P At the end of the year, someone counts the supplies and states how much they have left over. Once you know the amount that is left over, you can subtract it from how much you have in the Supplies account to see how much you have used during the year. The ADJUSTING entry will be: DR Supplies Expense CR Supplies Notice that the account “Supplies” is an asset account and the account “Supplies Expense” is an expense account. For example, if the total supplies account is $1000 and at the end of the year, they balance is $300, then the amount of supplies used are $700 ($1000 - $300). So the ADJUSTING entry will be: DR Supplies Expense 700 CR Supplies 700 Prepaid Expenses When you pay for something up front such as rent and insurance, it is considered an asset because you can ask for it back. As you use it up though, you must move it from the assets to expenses. Rent – most businesses pay rent in advance. When they pay the rent in advance: DR Prepaid Rent CR Bank At the end of the year, an ADJUSTING entry must be completed: DR Rent Expense CR Prepaid Rent Similarly, most businesses pay for insurance in advance. When they pay for insurance in advance: DR Prepaid Insurance CR Bank At the end of the year, an ADJUSTING entry must be completed: DR Insurance Expense CR Prepaid Insurance Unearned Revenue Unearned Revenue is the opposite of Prepaid Expenses. It represents the amount of revenue that your customer has paid in advance for you to do the work. It is like a deposit that you have collected before you start the work. So when the customer pays in advance, the entry is: DR Bank CR Unearned Revenue The revenue recognition principle says that you recognize revenue when it is earned, not when cash is received. So in this case, the cash is received but the revenue has not yet been earned. As revenue is earned, you move it from Unearned Revenue to Revenue. Unearned Revenue is a liability account. It is a liability because you have not done the work for the customer and the customer can ask for the money back. When the work is complete, the ADJSUTING entry is; DR Unearned Revenue CR Revenue Think about it from another angle. When you prepay rent, you record it as an asset in your books because you have paid it in advance. On the books of the landlord who has collected the prepaid rent, it is considered Unearned Revenue as it is a liability for them. Type of Account Accounts Before ADJUSTING ENTRY Adjustment Relationship Adjustment Supplies Assets & Assets Overstated DR Supplies Expense Expenses Expenses Understated CR Supplies Prepaid Assets & Assets overstated DR Expense Expenses Expenses Expenses understated CR Prepaid Asset Unearned Liabilities & Liabilities DR Unearned Revenues Revenues overstated Revenue Revenues CR Revenue understated Late Arriving Expenses & Liabilities DR Expense Purchase Assets/Liabiliti Understated Invoices es CR Cash or A/P Expenses Understated Depreciation Expense & Expenses DR Depreciation Contra Asset Understated Expense  Assets Overstated CR A/A Depreciation Depreciation is the process of allocating the cost of a long-term asset to expense, over its useful life in a rational and systematic manner. Depreciation attempts to match the cost of a long-term asset to the revenue it generates in each period. Depreciation is an estimate rather than a factual amount of the cost of long-term asset for that period. DR Depreciation Expense – Name of Asset CR Accumulated Depreciation – Name of Asset Balance Sheet Presentation Office equipment $5,000 Less: Accumulated depreciation 83 Net book value $4,917 NBV = Cost of an Asset – AA v Cost of Long Term Asset: the amount paid for the asset. v Useful Life: an estimate of expected life of the asset in number of years. v Salvage Value: estimate of the asset’s value at the end of its useful life. v Use straight line method to calculate depreciation expense for the year. Depreciation: An Example Purchased furniture for $10,000. Useful life is 4 years. Salvage value is $0.  DR Furniture 10,000 CR Cash 10,000 Depreciation calculation using the straight-line method: ($10,000 - $0) / 4 years = $2,500 per year DR Depreciation Expense, Furniture 2,500 CR A/A, Furniture 2,500 Closing Entries v B/S accounts are permanent and I/S accounts are temporary v All temporary accounts must be closed v Updates the owner’s capital account in the ledger by transferring net income (loss) and owner’s drawings to owner’s capital. v Closing the temporary accounts (revenue, expense, drawings) for next year’s transactions by reducing their current balances to ‘0’. Closing Entries STEPS 1. DR revenue account for its balance, and CR the owner’s capital account for total revenue DR Revenue CR Owner’s Capital 1. DR owner’s capital account for total expenses, & CR each expense account for its balance DR Owner’s Capital CR Expense Accounts 3. DR owner’s capital for the balance in the owner’s drawings account & CR owner’s drawings for the same amount.  DR Owner’s Capital CR Owner’s Drawings DR & CR the opposite to close each temporary account. Part A: Knowledge 1. What does the revenue recognition principle state? 2. What does the matching principle state? 3. Why are adjusting entries necessary? 4. What happens if you do not prepare the adjusting entries? 5. What does the accumulated Depreciation account represent? 6. Which accounts are closed and not closed at the end of the year? Part B: Application The 10 Application Questions will be based on DR and CR rules for various transactions. Following are questions for your review: 1. At the beginning of Year 1, the Supplies account had a debit balance of $1800. During the year, the business purchased $800 of supplies. An inventory count of supplies at the end of the year revealed that $750 of supplies remained. The adjusting entry as a result of this information is: a. DR Supplies Expense $1050, CR Supplies $1050 b. DR Supplies Expense $1850, CR Supplies $1850 c. DR Supplies Expense $2600, CR Supplies $2600 d. DR Supplies Expense $3350, CR Accumulated Depreciation $3350 2. A business purchased a 2-year insurance policy for $2400 in cash on Jan 1, 2020. The journal entry to record this transaction is: a. DR Prepaid Insurance $2400, CR Bank $2400 b. DR Insurance Expense $2400, CR Bank $2400 c. DR Insurance Expense $1200, CR Prepaid Insurance $1200 d. DR Prepaid Insurance $1200, CR Insurance Expense $1200 3. In continuing from the previous question, what is the adjusting entry that the business would record on Dec 31, 2020, at the end of the year? a. DR Prepaid Insurance $2400, CR Bank $2400 b. DR Insurance Expense $2400, CR Bank $2400 c. DR Insurance Expense $1200, CR Prepaid Insurance $1200 d. DR Prepaid Insurance $1200, CR Insurance Expense $1200 4. A customer has provided $10,000 cash on Dec 1 to ABC Company for work that ABC Company has not started yet. The journal entry that ABC would complete to reflect this is as follows: a. DR Unearned Revenue, CR Revenue b. DR Bank, CR Unearned Revenue c. DR Unearned Revenue, CR Bank d. DR Bank, CR Revenue 5. In continuing from the previous question, ABC Company has completed 50% of the work for that customer by Dec 31. So the adjusting entry that ABC Company would record is as follows: a. DR Unearned Revenue, CR Revenue b. DR Bank, CR Unearned Revenue c. DR Unearned Revenue, CR Bank d. DR Bank, CR Revenue 6. New office furniture is purchased for $8 000 on January 1 of Year 1. The business expects to replace the furniture in 8 years, and the salvage value is 0. If the straight-line method is used, what will be the journal entry to record the depreciation expense at the end of Year 1? a. DR depreciation expense, CR accumulated depreciation – furniture b. DR accumulated depreciation – furniture, CR depreciation c. DR furniture, CR Bank d. DR depreciation expense, CR furniture Part C: Thinking A scenario will be provided. Example Scenario: ABC Company has a net income of $10,000 and a cash balance of $100,000. Explain to them why this is so? Use, explain, and highlight the following terms in your answer: assets, expenses, matching principle, adjusting entries, net income. In answering the question, you must ensure that all these terms are used and explained according to the question. Explain what would happen to net income? ABC Company’s net income of $10,000 and cash balance of $100,000 differ due to timing differences and the application of accounting principles. The cash balance reflects available liquid assets, while net income represents profit after deducting expenses from revenues for the period. Using the matching principle, expenses are recorded in the same period as the revenue they generate, even if not yet paid, which explains why net income can be lower than cash. Adjusting entries account for unpaid expenses or accrued revenues, ensuring accurate reporting. In this case, the higher cash balance likely results from unpaid expenses or credit sales not immediately impacting cash flow.