accrual accounting & adjusting entries chapter 4

Accrual Accounting & Adjusting Entries

Chapter 4

Chapter 4 Highlights

Examine Revenue Recognition and Matching Principles

What is an accrual? What type of accrual entries do we need? Prepare adjusting entries, closing entries

and an adjusted Trial Balance

Revenue Recognition

Accounting rule: revenue must be recorded in the books in the period it is “earned”

For example: If purchase a CD on May 1st but don’t pay for it until June

Record sale in May

Matching Principle

Expenses must be matched to revenue

i.e.. must record all expenses associated with the revenue you are recording

Not following either of this principles will distort results!

Cash Basis of Accounting

Revenue recorded only when cash received

Expense recorded only when cash paid

Accrual Basis of Accounting

Adheres to the Revenue recognition

principle Matching principle

Revenue recorded when earned, not only when cash received

Expense recorded when incurred, not only when cash paid

Adjusting Entries

Required to ensure matching and rev recognition followed

Normally req’d each time statements are prepared

Common Adjusting Entries

Prepaid Expense = item paid for that have not been used or consumed (ie shown as assets)

Example: autopac insurance

Unearned Revenue = cash rec’d and recorded before revenue has been earned

Should appear as a liability

Example: maintenance fees, deposits

Common Adjusting Entries

Accrued Revenue = revenue earned but not yet recorded and/or cash not rec’d yet

Example: Home builder

Accrued Expenses = expenses incurred but not yet billed or paid for

Example: place ad in the newspaper on April 27 not billed until May

On October 5 the company paid $2,500

for advertising supplies.

GENERAL JOURNAL Debit Credit

Oct 5 Advertising Supplies 2,500 Cash 2,500

Purchased advertising supplies

Advertising Supplies2,500Oct 5

Cash2,500Oct 5

Advertising Supplies Expense

Supplies

An inventory on October 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. ($2,500- $1,000) =$ 1,500


Oct 5 Advertising Supplies Expense 1,500 Advertising Supplies 1,500

To record advertising supplies consumed

Advertising Supplies2,500Oct 5

Cash2,500Oct 5


Supplies

1,500Oct 311,500Oct 31

Bal. 1,000

Oct $1,500

Mar $1,435

Apr $1,510

May $1,592

Feb $1,601

Nov $1,800

Dec $1,410

Jan $1,425

June $1,652

July $1,621

Aug $1,427

Sept $1,555

Advertising supplies expense is based on usage... so different amounts appear each month


Prepaid Expenses

On October 4 the company paid $600 for a 1-year

insurance policy. Coverage began October 1.


Oct 4 Prepaid Insurance 600 Cash 600

Purchased one-year policy effective October 1

Prepaid Insurance

600Oct 4

Cash600Oct 4

Insurance Expense

Prepaid ExpensesOn October 31st, $50 ($600/ 12 months)

of the insurance was used-up or expired.


Oct 31 Insurance Expense 50

Prepaid Insurance 50

Record insurance expense for the month

Prepaid Insurance

600Oct 4

Cash600Oct 4

Insurance Expense

50Oct 3150Oct 31

Insurance Policy

1 Year $ 600

Oct $50

Mar $50

Apr $50

May $50

Feb $50

Nov $50

Dec $50

Jan $50

June $50

July $50

Aug $50

Sept $50

21

Amortization

How do you apply the matching principleto the cost of a long-lived asset?

22

Amortization

Allocate the cost of an asset to expense over its useful life

Amortization is an allocation concept, not a valuation concept

We’re not attempting to reflect the

actual change in value of an asset!

Office Equipment

Amortization= $480/year

Oct $40

Mar $40

Apr $40

May $40

Feb $40

Nov $40

Dec $40

Jan $40

June $40

July $40

Aug $40

Sept $40


Oct 31 Amortization Expense 40

Accumulated Amortization-Office Equip 40

To record monthly amortization

Accumulated Amortization is a contra asset account - an offset against the capital asset account

Accumulated Amortization-

Office Equipment40Oct 31

Office Equipment5000Oct 2

Amortization Expense

40Oct 31

25

Office equipment $ 5,000

Less : Accumulated amortization 40

4,960

Balance Sheet Presentation

Net book value

Unearned Revenues

Received on Oct. 2 $1,200 for advertising services expected to be completed by 12/ 31.

Unearned Service RevenueCash

1,200Oct 21,200Oct 2

Service Revenue


Oct 2 Cash 1,200

Unearned Service Revenue 1,200

Collected money for work to be performed by 12/31.

Unearned Revenues

During October $400 of the revenue was earned.

Unearned Service RevenueCash

1,200Oct 2

Service Revenue

1,200Oct 2


Oct 31 Unearned Service Revenue 400

Service Revenue 400

To record revenue earned

Oct. 31 400 Oct. 31 400

Bal. 800

Accrued Revenues

Earned $200 for advertising services to clients in October, but they were not billed until after October 31st.


Oct 31 Accounts Receivable 200

Service Revenue 200

Accounts Receivable

200Oct 31

Service Revenue

200Oct 31

Formula for Calculating Interest

Face Value of Note Interest

Timein Terms of One Year

Annual Interest

Rate

$ 5,000 X 12% 1/12 = $50

Interest expense is the cost a company incurs to use money:Information needed to compute interest expense: face value of note interest rate (always expressed in annual rate) the length of time note is outstanding

Interest Expense Interest Payable

Oct 31 50 Oct 31 50


Oct 31 Interest Expense 50 Interest Payable 50

Accrue interest expense for the month

Accrued Interest Expense

Accrued Salaries Expense(Salaries Paid for after the Service Has Been Performed)

Salaries Expense Salaries Payable

Oct 31 1,200 Oct 31 1,200


Oct 31 Salaries Expense 1,200

Salaries Payable 1,200

Accrue salary expense for the month

Accrued Salaries Expense

Summary of Adjustments

Type of Adjustment Adjusting Entries

Prepd Exp. Dr. ExpCr. Assets

Unearned Rev. Dr. LiabCr. Rev.

Accrued Rev. Dr. AssetsCr. Rev.

Accrued Exp. Dr. Exp.Cr. Liab.

Adjusted Trial Balance

1st need to journalize the adjusting entries

Next post adjusting entries Prepare the “new” adjusted

Trial balance reflecting these changes

Note: all should still balance between Dr & Cr balances

Adjusted Trial Balance

Once adjusted TB has been prepared and reviewed create financial stmts

Note: Top of financial statement(s) should have 3 lines

1st – Organization name 2nd – Type of report 3rd – reporting period and

date

Closing the Books

Involves preparing the books for a new year of activity

I/S related accounts must be closed as they represent the activity for a period only

I.e. not cumulative

Closing the Books

Temporary accounts are closed (i.e. record entry to create a zero balance in that account) at the end of the period

All Rev & Exp are closed out to a summary acct. called “Income Summary” which is then closed out to Retained Earnings

Temporary Accounts

All revenue accounts

All expense accounts

Dividends

Retained Earnings is a permanent account; the others shown hereare temporary

Individual Expenses

Retained Earnings

Income Summary

Individual Revenues

Dividends

1

3

4

2

The Accounting Cycle Review

1.Analyze business transactions

2.Journalize the transactions

3.Post to ledger accounts

4.Prepare a trial balance

5.Journalize and post adjusting entries-prepayments and accruals

The Accounting Cycle Review

6. Prepare an adjusting trial balance

7. Prepare financial statements

8. Journalize and post closing

entries

9. Prepare a post-closing trial

balance

Chapter 4 – The End

accrual accounting & adjusting entries chapter 4

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