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Principles of Accounting, Volume 1: Financial Accounting

4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries

Principles of Accounting, Volume 1: Financial Accounting4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

Analyzing and Recording Transactions was the first of three consecutive chapters covering the steps in the accounting cycle (Figure 4.2).

A large circle labeled, in the center, The Accounting Cycle. The large circle consists of 10 smaller circles with arrows pointing from one smaller circle to the next one. The smaller circles are labeled, in clockwise order: 1 Identify and Analyze Transactions; 2 Record Transactions to Journal; 3 Post Journal Information to Ledger; 4 Prepare Unadjusted Trial Balance; 5 Adjusting Entries; 6 Prepare Adjusted Trial Balance; 7 Prepare Financial Statements; 8 Closing Entries; 9 Prepare Post-Closing Trial Balance; 10 Reversing Entries (optional).
Figure 4.2 The Basic Accounting Cycle. In this chapter, we examine the next three steps in the accounting cycle—5, 6, and 7—which cover adjusting entries (journalize and post), preparing an adjusted trial balance, and preparing the financial statements. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

In Analyzing and Recording Transactions, we discussed the first four steps in the accounting cycle: identify and analyze transactions, record transactions to a journal, post journal information to the general ledger, and prepare an (unadjusted) trial balance. This chapter examines the next three steps in the cycle: record adjusting entries (journalizing and posting), prepare an adjusted trial balance, and prepare the financial statements (Figure 4.3).

Three boxes with arrows pointing from one box to the next, labeled left to right: 5 Adjusting Entries; 6 Prepare Adjusted Trial Balance; 7 Prepare Financial Statements.
Figure 4.3 Steps 5, 6, and 7 in the Accounting Cycle. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

As we progress through these steps, you learn why the trial balance in this phase of the accounting cycle is referred to as an “adjusted” trial balance. We also discuss the purpose of adjusting entries and the accounting concepts supporting their need. One of the first concepts we discuss is accrual accounting.

Accrual Accounting

Public companies reporting their financial positions use either US generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), as allowed under the Securities and Exchange Commission (SEC) regulations. Also, companies, public or private, using US GAAP or IFRS prepare their financial statements using the rules of accrual accounting. Recall from Introduction to Financial Statements that accrual basis accounting prescribes that revenues and expenses must be recorded in the accounting period in which they were earned or incurred, no matter when cash receipts or payments occur. It is because of accrual accounting that we have the revenue recognition principle and the expense recognition principle (also known as the matching principle).

The accrual method is considered to better match revenues and expenses and standardizes reporting information for comparability purposes. Having comparable information is important to external users of information trying to make investment or lending decisions, and to internal users trying to make decisions about company performance, budgeting, and growth strategies.

Some nonpublic companies may choose to use cash basis accounting rather than accrual basis accounting to report financial information. Recall from Introduction to Financial Statements that cash basis accounting is a method of accounting in which transactions are not recorded in the financial statements until there is an exchange of cash. Cash basis accounting sometimes delays or accelerates revenue and expense reporting until cash receipts or outlays occur. With this method, cash flows are used to measure business performance in a given period and can be simpler to track than accrual basis accounting.

There are several other accounting methods or concepts that accountants will sometimes apply. The first is modified accrual accounting, which is commonly used in governmental accounting and merges accrual basis and cash basis accounting. The second is tax basis accounting that is used in establishing the tax effects of transactions in determining the tax liability of an organization.

One fundamental concept to consider related to the accounting cycle—and to accrual accounting in particular—is the idea of the accounting period.

The Accounting Period

As we discussed, accrual accounting requires companies to report revenues and expenses in the accounting period in which they were earned or incurred. An accounting period breaks down company financial information into specific time spans, and can cover a month, a quarter, a half-year, or a full year. Public companies governed by GAAP are required to present quarterly (three-month) accounting period financial statements called 10-Qs. However, most public and private companies keep monthly, quarterly, and yearly (annual) period information. This is useful to users needing up-to-date financial data to make decisions about company investment and growth. When the company keeps yearly information, the year could be based on a fiscal or calendar year. This is explained shortly.

Continuing Application

Adjustment Process for Grocery Stores

In every industry, adjustment entries are made at the end of the period to ensure revenue matches expenses. Companies with an online presence need to account for items sold that have not yet been shipped or are in the process of reaching the end user. But what about the grocery industry? At first glance, it might seem that no such adjustment entries are necessary. However, grocery stores have adapted to the current retail environment. For example, your local grocery store might provide catering services for a graduation party. If the contract requires the customer to put down a 50% deposit, and occurs near the end of a period, the grocery store will have unearned revenue until it provides the catering service. Once the party occurs, the grocery store needs to make an adjusting entry to reflect that revenue has been earned.

The Fiscal Year and the Calendar Year

A company may choose its yearly reporting period to be based on a calendar or fiscal year. If a company uses a calendar year, it is reporting financial data from January 1 to December 31 of a specific year. This may be useful for businesses needing to coincide with a traditional yearly tax schedule. It can also be easier to track for some businesses without formal reconciliation practices, and for small businesses.

A fiscal year is a twelve-month reporting cycle that can begin in any month and records financial data for that consecutive twelve-month period. For example, a business may choose its fiscal year to begin on April 1, 2019, and end on March 31, 2020. This can be common practice for corporations and may best reflect the operational flow of revenues and expenses for a particular business. In addition to annual reporting, companies often need or choose to report financial statement information in interim periods.

Interim Periods

An interim period is any reporting period shorter than a full year (fiscal or calendar). This can encompass monthly, quarterly, or half-year statements. The information contained on these statements is timelier than waiting for a yearly accounting period to end. The most common interim period is three months, or a quarter. For companies whose common stock is traded on a major stock exchange, meaning these are publicly traded companies, quarterly statements must be filed with the SEC on a Form 10-Q. The companies must file a Form 10-K for their annual statements. As you’ve learned, the SEC is an independent agency of the federal government that provides oversight of public companies to maintain fair representation of company financial activities for investors to make informed decisions.

In order for information to be useful to the user, it must be timely—that is, the user has to get it quickly enough so it is relevant to decision-making. You may recall from Analyzing and Recording Transactions that this is the basis of the time period assumption in accounting. For example, a potential or existing investor wants timely information by which to measure the performance of the company, and to help decide whether to invest, to stay invested, or to sell their stockholdings and invest elsewhere. This requires companies to organize their information and break it down into shorter periods. Internal and external users can then rely on the information that is both timely and relevant to decision-making.

The accounting period a company chooses to use for financial reporting will impact the types of adjustments they may have to make to certain accounts.

Ethical Considerations

Illegal Cookie Jar Accounting Used to Manage Earnings

From 2000 through the end of 2001, Bristol-Myers Squibb engaged in “Cookie Jar Accounting,” resulting in $150 million in SEC fines. The company manipulated its accounting to create a false indication of income and growth to create the appearance that it was meeting its own targets and Wall Street analysts’ earnings estimates during the years 2000 and 2001. The SEC describes some of what occurred:

Bristol-Myers inflated its results primarily by (1) stuffing its distribution channels with excess inventory near the end of every quarter in amounts sufficient to meet its targets by making pharmaceutical sales to its wholesalers ahead of demand; and (2) improperly recognizing $1.5 billion in revenue from such pharmaceutical sales to its two biggest wholesalers. In connection with the $1.5 billion in revenue, Bristol-Myers covered these wholesalers’ carrying costs and guaranteed them a return on investment until they sold the products. When Bristol-Myers recognized the $1.5 billion in revenue upon shipment, it did so contrary to generally accepted accounting principles.1

In addition to the improper distribution of product to manipulate earnings numbers, which was not enough to meet earnings targets, the company improperly used divestiture reserve funds (a “cookie jar” fund that is funded by the sale of assets such as product lines or divisions) to meet those targets. In this circumstance, earnings management was considered illegal, costing the company millions of dollars in fines.

Footnotes

  • 1 U.S. Securities and Exchange Commission. “Bristol-Myers Squibb Company Agrees to Pay $150 Million to Settle Fraud Charges.” August 4, 2004. https://www.sec.gov/news/press/2004-105.htm
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