CHAPTER 3 Adjusting the Accounts

School: University of Maryland, College Park - Course: ACCOUNTING ACCT 220 7 - Subject: Accounting

CHAPTER3 Adjusting the Accounts Chapter Preview InChapter 1, you learned a neat little formula: Net income = Revenues − Expenses. InChapter 2, you learned some rules for recording revenue and expense transactions. Guess what? Things are not really that nice and neat. In fact, it is often difficult for companies to determine in what time period they should report some revenues and expenses. In other words, in measuring net income, timing is everything. Feature Story Keeping Track of Groupons Who doesn't like buying things at a discount? That's why it's not surprising that three years after it started as a company,Groupon, Inc.was estimated to be worth $16 billion. This translates into an average increase in value of almost $15 million per day. Now consider that Groupon had previously been estimated to be worth even more than that. What happened? Well, accounting regulators and investors began to question the way that Groupon had accounted for some of its transactions. Groupon sells coupons ("groupons"), so how hard can it be to account for that? It turns out that accounting for coupons is not as easy as you might think. First, consider what happens when Groupon makes a sale. Suppose it sells a groupon for $30 for Highrise Hamburgers. When it receives the $30 from the customer, it must turn over half of that amount ($15) to Highrise Hamburgers. So should Groupon record revenue for the full $30 or just $15? Until recently, Groupon recorded the full $30. But, in response to an SEC ruling on the issue, Groupon now records revenue of $15 instead. This caused Groupon to restate its previous financial statements. This restatement reduced annual revenue by $312.9 million. A second issue is a matter of timing. When should Groupon record this $15 revenue? Should it record the revenue when it sells the groupon, or must it wait until the customer uses the groupon at Highrise Hamburgers? The accounting becomes even more complicated when you consider the company's loyalty programs. Groupon offers free or discounted groupons to its subscribers for doing things such as referring new customers or participating in promotions. These groupons are to be used for future purchases, yet the company must record the expense at the time the customer receives the groupon. Finally, Groupon, like all other companies, relies on many estimates in its financial reporting. For example, Groupon reports that "estimates are utilized for, but not limited to, stock-based compensation, income taxes, valuation of acquired goodwill and intangible assets, customer refunds, contingent liabilities and the depreciable lives of fixed assets." It notes that "actual results could differ materially from those estimates." So, next time you use a coupon, think about what that means for the company's accountants! Chapter Outline LEARNING OBJECTIVESREVIEWPRACTICE LO 1Explain the accrual basis of accounting and the reasons for adjusting entries.Fiscal and calendar years Accrual- vs. cash-basis accounting Recognizing revenues and expenses Need for adjusting entries Types of adjusting entries DO IT! 1Timing Concepts LO 2Prepare adjusting entries for deferrals.Prepaid expenses Unearned revenuesDO IT! 2Adjusting Entries for Deferrals

LEARNING OBJECTIVESREVIEWPRACTICE LO 3Prepare adjusting entries for accruals.Accrued revenues Accrued expenses Summary of basic relationships DO IT! 3Adjusting Entries for Accruals LO 4Describe the nature and purpose of an adjusted trial balance.Preparing the adjusted trial balance Preparing financial statements DO IT! 4Trial Balance Go to theReview and Practice section at the end of the chapter for a review of key concepts and practice applications with solutions. Visit WileyPLUS for additional tutorials and practice opportunities. Accrual-Basis Accounting and Adjusting Entries LEARNING OBJECTIVE 1 Explain the accrual basis of accounting and the reasons for adjusting entries. If we could wait to prepare financial statements until a company ended its operations, no adjustments would be needed. At that point, we could easily determine its final balance sheet and the amount of lifetime income it earned. However, most companies need feedback about how well they are performing during a period of time. For example, management usually wants monthly financial statements. The Internal Revenue Service requires all businesses to file annual tax returns. Therefore,accountants divide the economic life of a business into artificial time periods. This convenient assumption, as shown inIllustration 3.1, is referred to as thetime period assumption(seeAlternative Terminology).