Chapter 1: Adjusting Accounts for Page 84 Financial Statements

Timing and Reporting in Accounting The Accounting Period Periodic reporting is essential for timely decision-making, as it ensures that financial information reaches users at regular intervals, allowing them to evaluate a company's performance. To achieve this, accounting systems follow the time period assumption, which divides an organization’s activities into specific periods, such as months, quarters, or years. Most companies prepare annual financial statements covering a year, while some also prepare interim financial statements for shorter periods (one, three, or six months). • • Fiscal Year: Not all organizations follow the calendar year (ending December 31). A company can adopt any 12-month or 52-week period as its fiscal year. For example, Gap’s fiscal year ends in late January or early February. Natural Business Year: Some companies with seasonal sales patterns, like retailers (e.g., Target and Nordstrom), end their fiscal year when sales are at their lowest, typically after the holiday season. Accrual Basis vs. Cash Basis Accounting Companies may need to adjust their accounts for internal transactions not yet recorded by the end of a period. This is where accrual accounting comes into play. • Accrual Accounting: o Records revenues when goods or services are delivered and expenses when incurred, matching them with related revenues. o Accrual accounting better reflects a company’s performance by aligning revenues and expenses within the appropriate periods, increasing the comparability of financial statements. For example, if FastForward pays $2,400 for 24 months of insurance starting in December 2021, under accrual accounting, $100 is recognized as an expense monthly (for December 2021 through November 2023). This ensures that expenses are matched with the benefits they provide, and any unexpired premium is reported as a Prepaid Insurance asset. • Cash Basis Accounting: o Records revenues when cash is received and expenses when cash is paid, which can misalign income and expense recognition. o For FastForward, under cash basis accounting, the entire $2,400 insurance payment would be recognized as an expense in December 2021, and no expenses would be reported in 2022 or 2023. No prepaid asset is recognized, and expenses do not align with the periods in which insurance coverage is provided. Accrual accounting is generally preferred because it more accurately represents business performance and ensures the proper matching of costs and revenues over time. Recognizing Revenues and Expenses Adjustments are required to ensure the proper reporting of revenues and expenses. Two key principles guide this process: • • Revenue Recognition Principle: Revenue should be recorded when goods or services are provided to customers at the expected amount, ensuring that revenue is recognized in the appropriate period. Expense Recognition (Matching) Principle: Expenses should be recorded in the same period as the revenues they help generate, ensuring proper matching of costs to benefits. Framework for Adjustments Adjustments are necessary for transactions or events that span multiple accounting periods. These adjustments are made using a three-step process: 1. Determine what the current balance is. 2. Calculate what the balance should be. 3. Record an adjusting entry to get from the current to the desired balance. An adjusting entry affects both an income statement account (e.g., revenue or expense) and a balance sheet account (e.g., prepaid insurance or accrued expenses), but never affects the cash account directly. This process ensures that financial statements provide a more accurate view of a company’s financial position and performance.