MUHASEBE I - Deneme Sınavı - 6

In revenue recognition principle, revenue is recorded when it is earned, not when the cash is
received just the same as the accrual basis accounting.

If cash is received in advance (before revenue is earned), a liability account (called as deferred revenue) will be used as a correspondence to cash account, a liability account called deferred revenue is used as a correspondence to cash account.

At the end of each accounting period, companies present their financial statements in order to communicate with information users. To present the company’s true and fair situation all accounts must be updated because recording some revenue and expense transactions are omitted during the period. That means some accounts must be adjusted, and some adjusting entries must be made.

The two basic categories of adjustments can be divided into four different types as follows:

Deferred expenses are the ones that are firstly paid and reported as an asset but will not be recorded as an expense until a future accounting period.

Value and usefulness of plant assets will decline when the business uses them in its operations. The decline in usefulness of a plant asset is an expense which is called as a  expense. Here the concept of depreciation emerges. Depreciable amount is the cost of an asset minus its residual value, and depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.  In other words, depreciation is a cost allocation process over the plant asset’s useful life.

Some types of services, such as insurance, are normally paid for before they are used. As you learned before, these prepayments are deferrals. Rent, interest, salaries, wages, utilities, etc. are the other examples of accrued expenses over time. Expenses incurred but not yet paid or recorded at the end of the accounting period are accrued expenses. Accrued expenses are the ones that are firstly incurred and not recorded as an expense until a future accounting period. Because of the unnecessity, such kinds of expenses are not required for daily recordings. For that reason, companies do not recognize them until the preparation of financial reports. The amount of such an accrued but unpaid item at the end of the accounting period is both an expense and a liability.

The time-period concept assumes that unlimited economic life of a company will be divided into regular intervals and that financial statements will be prepared for specific periods such as a month, quarter, or year. Each company is set up with the expectation that it will have an unlimited lifetime (remember the going concern assumption). But companies’ related parties (such as government, creditors, investors, management, customers, etc.) wish to have information about the activities and financial position of the company over certain periods. In order to meet these demands and give feedback, the unlimited economic lifetimes are divided into artificial time periods by accountants. The time-period concept (or alternatively periodicity concept) assumes that unlimited economic life of a company will be divided into artificial time periods and that financial statements can be prepared for specific periods such as a month, quarter, or year.

It is important to know when companies should recognize revenue, in other words, when the companies earned the revenue. Revenue recognition principle will guide us. But first of all we will start with the definition of revenue and expense terms. Revenue is the gross inflow of economic benefits during the period arising from the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. Expense is outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

Information users need to know how well the company is performing. Actually, companies will identify and record the company’s financial events on daily basis. To summarize and give information about the company’s ending position at the end of the period, they must prepare their financial statements by using the accounts balances. This process will begin with the trial balance. This trial balance is unadjusted because the accounts are not yet ready to prepare the financial statements. The reasons as follows:
1. Some financial events are not recorded on a day-to-day basis because it is unwise to do so such as consumption of supplies or the earnings of salaries by employees.
2. Some costs are not recorded during the current accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions such as rent expense or insurance expense.
3. Some types of expenses may be unrecorded. For example, an electricity bill may not be received until the next accounting period.

Adjusting entries are important in order to prepare correct and up-to-date financial reports. There are two basic categories of adjusting entries. These are deferrals and accruals. In a deferral adjustment, cash will be paid before an expense is incurred or the cash will be received before the revenue is earned. Accruals adjustments are the opposite of deferrals. An accrual records an expense before the cash is paid, or it records the revenue before the cash is received. The two basic categories of adjustments can be divided into four different types as follows:
1. Deferred (Prepaid) Expenses
2. Deferred (Unearned) Revenues
3. Accrued Expenses
4. Accrued Revenues

Deferred expenses (prepaid expenses) are advance payments of future expenses. Deferred expenses are the ones that are firstly paid and reported as an asset but will not be recorded as an expense until a future accounting period. In other words, cash is paid before the expense is recognized. Rent, interest, insurance, etc. are the examples of prepaid expenses. The amounts of office supplies used up may also be considered as prepaid expenses. As it is not necessary, such kinds of expenses are not required in daily recordings. For that reason, companies do not recognize them until the preparation of their financial reports.

Depreciable amount is the cost of an asset, or other amount substituted for cost, less than its residual value. Depreciation is the systematic allocation of the depreciable amount of an asset over its useful life. Useful life is the estimated lifespan of a plant asset. Accumulated Depreciation is a contra asset account and it will accumulate the depreciation expense during the useful life of depreciable asset.

Some types of services, such as insurance, are normally paid for before they are used. As you learned before, these prepayments are deferrals. Rent, interest, salaries, wages, utilities, etc. are the other examples of accrued expenses over time. Expenses incurred but not yet paid or recorded at the end of the accounting period are accrued expenses. Accrued expenses are the ones that are firstly incurred and not recorded as an expense until a future accounting period.

At the end of the period, we have to get the adjustment data. Data needed for adjusting entries include the following:
a. Office supplies on hand 
b. Companies' equipment
c. Accrued salary expense 
d. Accrued service revenue

At the end of the accounting period, an adjusting entry is completed, and it records revenues to the period in which they are earned and expenses to the period in which they occur. Adjusting entries also update the asset and liability accounts. Adjustments are necessary to properly measureseveral items such as:
1. Net income (loss) on the income statement
2. Assets and liabilities on the balance sheet

Accounting periods may be monthly, quarterly, semiannually or yearly. The correct answer is A.

In cash basis accounting, companies record revenues when they receive the cash and they record expenses when the cash is paid. Cash basis accounting records only cash transactions—cash receipts and cash payments. Basically, it is a simple method. But it prevents businesses from being cautious. Companies adopting cash basis accounting focus only transactions involving cash. Those with no monetary input are not taken into consideration. It is possible to say that cash basis accounting is mostly used by small businesses. The correct answer is A.

Accrual basis accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the transaction will be recorded even if the business did not receive or did not pay any cash. In accrual basis accounting, companies record revenues when they are earned and record expenses when they are incurred. Recording regardless of monetary inflows and outflows forms the basis of accrual basis accounting. So, the profitability of the company applying accrual basis accounting can be measured much better when compared with applying the cash basis accounting.

The correct answer is C.