Chapter 4 Lecture Notes 1.

Items represented on the financial statements are measured in dollars and recorded at their original or historical cost. 2. Under accrual basis accounting, revenue is reported when it is earned (revenue recognition principle), and any related expenses are reported in the same time period (matching principle). 3. Under cash basis of accounting, revenue is reported when cash is received, and expenses are reported when cash is paid out. 4. The Revenue Recognition Principle states that revenues are to be recognized in the Income Statement when they are realized and earned. That typically happens at the point of sale when the product is delivered to the customer or the service is completed. 5. The Expense Recognition Principle requires that expenses be recognized in different ways, depending on the nature of the cost. Ideally, expenses should be matched with revenues. Using the matching principle costs necessary to generate revenues are recognized in the same period as the revenues. Examples include utility expenses, salary expenses, commission expenses, and cost of goods sold expenses. 6. Certain types of costs are associated with long-terms assets, such as buildings and equipment. These costs benefit many periods and it is not possible to match them directly with a specific sale of a product. Instead, they are matched with the periods during which they will provide benefits. An example is depreciation expense. 7. If the accrual basis of accounting is being used then it is necessary to adjus the account balances at the end of the accounting period. Accounts are adjusted by making adjusting entries. There are 4 types of adjusting entries. 8. Deferred expenses (or prepaid expenses) occur when cash is paid out BEFORE the expense is incurred. Examples are supplies, prepaid insurance, prepaid rent, and purchase of long-term assets (property, plant, and equipment) that are depreciated. When the cash is initially paid out these items are recorded as assets. When the assets are used, they become expenses and an adjustment is needed to reclassify them. 9. Deferred revenues (or unearned revenues) occur when cash is received BEFORE the revenue is earned. These items are initially recorded as a liability and when the revenue is earned an adjustment is needed to reclassify them as revenue.

10. Accrued liabilities (or accrued expenses) occur when cash is paid AFTER the expense is actually incurred.. At the time that the expense is incurred a liability must be recorded. 11. Accrued assets (or accrued revenues) occur when revenue is earned BEFORE cash is received and the transaction has not been recorded in the accounting records. An adjustment is needed to record the revenue and the asset. 12. Each of the 4 adjustments will affect both the Income Statement and the Balance Sheet because each adjusting entry involves at least one income statement account (revenue or expense) and at least one balance sheet account (asset or liability). The Cash account is never included in the adjustment process. 13. When an account is closed, the balance becomes zero. If you work and receive a W-2, the amount on the W-2 is for a certain year. The amounts do not add from year to year. Instead, your revenue account starts at zero each year. However, your bank account and debts do not become zero at the end of the year. Therefore, revenue accounts, expense accounts, and dividends paid are temporary accounts (or nominal accounts) that are closed or converted to zero at the end of the year. The Balance Sheet accounts (assets, liabilities, capital stock, and retained earnings) are permanent accounts (or real accounts) that do not close. 14. The four closing entries are: a. Close revenue accounts to Income Summary b. Close expense accounts to Income Summary c. Close Income Summary to Retained Earnings d. Close Dividends to Retained Earnings 15. The steps in the accounting cycle are as follows: 1) Collect and analyze information, 2) Journalize transactions, 3) Post transactions to ledger, 4) Prepare trial balance, 5) Record and post adjusting entries, 6) Prepare financial statements, and 7) Close the accounts.