Chapter 3 - Minimum Take-Aways 1. Chapter 3 adds to your vocabulary and continues to use terms from prior chapters. I am going to use different wording at times since no regulatory authority mandates exact terminology. Choice of terminology varies in the real world. Published financial statements use a variety of words or phrases to mean the same thing. This makes it important to understand concepts and not just memorize wording used in one source. 2. GAAP utilizes the accounting period concept and the matching principle to make sure that revenue and expenses related to the same economic activity are reported in the same accounting period. Specifically, when expenses are incurred to earn revenue, then the expenses incurred to earn that revenue should be deducted in the same period that the revenue is reported. 3. The revenue recognition concept may be very complex in a real business situation. The basic rule is that revenue is recognized when the revenue has been "earned." 4. The revenue recognition rules are designed to ensure that the economics of a transaction determine the accounting treatment not the contract details. The common example cited was cell phones. One company gave the phone to the customer and charged a higher monthly rate for a two-year plan. Another company charged for the phone and then charged a cheaper monthly rate for a two-year plan. Customers of both companies received a phone and two years of service. 5. Cash basis - my recommendation - use for tax purposes only. As a practicing CPA, I advised my clients to keep their records on the accrual basis so they would know what they owed others and what others owed them. Many small businesses keep accrual basis records that are adjusted to the cash basis for tax purposes. 6. Adjusting entries is the term used for entries made at the end of the accounting period to assure that the financial statements comply with GAAP. The adjusting entries at the end of the period are journalized just like any other entry.
7. The following types of adjusting entries are addressed in the chapter: a. Prepaid expenses (asset) - the amount prepaid will be recognized as an expense in the future. Insurance premiums are a common example. b. Accrued revenues (asset) - revenue has been earned but not yet billed and recorded in accounts receivable. Accounting firms may bill for an audit when it is completed but they are earning revenue each month as they provide the auditing services. c. Unearned revenues (liability) - the receipt of a pre-payment for a good or service to be delivered to the customer in the future. When the good is delivered or the service performed, the revenue is earned and recognized on the income statement. d. Accrued expenses (liability) - expenses that have been incurred but not yet paid. The business owes for goods received or services provided when they are received or provided not when an invoice is received. 8. Fixed assets (may be called