Accrual Accounting vs. Cash-Basis Accounting

Two alternative methods may be used for calculating a business’s net income: Accrual Basis of Accounting Cash Basis of Accounting

Cash Basis of Accounting Revenues are recorded when cash is received Expenses are recorded when cash is paid No notion of Accounts Receivable (A/R) or

Accounts Payable (A/P) Not a GAAP method

Accrual Accounting vs. Cash-Basis Accounting

Two alternative methods may be used for calculating a business’s net income: Accrual Basis of Accounting Cash Basis of Accounting

Accrual Basis of Accounting Revenues are recorded when they are earned

– i.e., when the service is performed or the goods are delivered

Expenses are recorded when resources are utilized to use revenue – i.e., when used or consumed

GAAP Method

Accrual Accounting Concepts

Revenue Principle – governs that revenue should be recognized when it is earned (i.e., when performance has occurred).

Matching Principle – governs the recognition of expenses (i.e., that expenses should be recognized when they are incurred).

Time-Period Concept (Periodicity) – governs the reporting of accounting information and/or financial statements at regular intervals.

Adjustment Process

The calculation of Net Income (Revenues – Expenses) at the end of a period is critical.

Accountants make certain adjustments at

the end of the period in order to update records and accurately reflect all revenues and expenses.

The adjustment process involves recording all revenues and expenses that have been earned or incurred in the current period.

Rules of Thumb on Adjusting Entries

Each adjusting entry will affect one Revenue or Expense account and one Asset or Liability account.

The key to figuring out the necessary adjusting entries is to: (1) Identify the revenue/expense that needs

to be updated or asset/liability (2) Identify the corresponding account

affected by the transaction. Adjusting entries never affect cash.

Adjusting Entries – Deferrals

Deferrals are when cash has been received or paid in advance of actually recognizing an expense or revenue. Supplies (Asset) = purchased $500 worth of

office supplies. Prepaid Insurance (Asset) = paid $10,000 for a 6-

month insurance premium. Prepaid Rent (Asset) = paid $10,000 for 1 year of

rent. Unearned Revenue (Liability) = received $2,000

to paint two houses in the future.

Deferrals – Initial Journal Entry

Since cash has been received or paid in advance, it may be helpful to think of the original journal entry. This is not required unless the problem specifies it, but can be a helpful first step.

Supplies 500 Cash 500

Prepaid Insurance/Prepaid Rent 10,000 Cash

10,000

Cash 2,000 Unearned Revenue 2,000

Adjustments – Deferrals

Example of the adjustment process for Prepaid Expenses (deferrals) – Prepaid Rent, Prepaid Insurance, and Supplies These are expenses recorded in advance, in an asset

account. Must properly allocate the expenses to the period

during the adjustment process.

Example: On December 1, 2005, Shilling Construction, Inc. pre-pays 12 months of rent expense in the amount of $10,000.

10,000

Prepaid Rent10,000

Cash

Adjustments – Deferrals

What is the adjusting entry on December 31, 2005 to record the proper amount of Rent Expense for the period?

General Journal

Date Accounts and Explanations Debit Credit

12/31 Rent Expense ($10,000/12) 833

Prepaid Rent 833

To record rent expense

Adjustments – Deferrals

Example of the adjustment process for Unearned Revenue, in which Revenues (Cash) are received before they are earned. Unearned Revenue is a liability account.

Example: On December 1, 2005, Georgetown Painters received $2,000 to paint two houses. At the time of receiving the cash, Georgetown planned to perform the work in the future.

2,000

Cash

2,000

Unearned Revenue

Adjustments – Deferrals

As of December 31, 2005, Georgetown had painted 1 of the two houses.

What is the adjusting entry on December 31, 2005 to record the proper amount of revenue for the month?

General Journal

Date Accounts and Explanations Debit Credit

12/31 Unearned Revenue 1,000

Service Revenue ($2,000/2) 1,000

To record rent revenue

Adjustments – Depreciation

Depreciation is the allocation of the cost of a plant asset to expense over the plant’s useful life. Long-lived plant assets (buildings, equipment,

etc.) are not expensed when purchased; rather, such assets are expensed as they are used or consumed.

Depreciation expense is recorded in each accounting period in which the asset is used.

Adjusting Entry – Depreciation Expense

Calculating depreciation expense: Using the straight-line depreciation method, allocate

an equal amount each accounting period in which the asset is expected to benefit (the “useful life”).

Land is never depreciated. Depreciation expense = Cost of the Asset

Useful Life

Adjusting Entry – Depreciation Expense

Accumulated Depreciation The cumulative total of all depreciation expense

relating to a particular plant asset. It is a “contra asset.” This means it is an “anti-

asset,” meaning it is presented with a companion asset account, but it has a normal balance that is opposite the companion account.

Accumulated Depreciation has a credit balance and increases with a credit.

Book Value Asset – Accumulated Depreciation = Book

Value

Adjustments – Depreciation

Example of the adjustment process for depreciation:On December 1, 2005, Shilling Construction purchases new office furniture on account for $20,000. The furniture is expected to last 5 years.

20,000Furniture Accounts Payable

20,000

Adjustments – Depreciation

Depreciation Expense = Cost of the Asset

Useful Life

Depreciation Expense=$20,000=$4,000/year

5 years

Depreciation Expense=$4,000/yr=$333/month

12 months

Adjustments – Depreciation

What is the adjusting entry on December 31, 2005 to record the proper amount of Depreciation Expense for the period?

General Journal

Date Accounts and Explanations Debit Credit

12/31 Depreciation Expense - Furniture 333

Accumulated Depreciation - Furniture 333

To record depreciation expense for furniture

Adjustments – Depreciation

Book Value (or carrying amount) is the net amount of the plant asset, calculated by netting the cost of the asset minus the related accumulated depreciation. Book value is not the same as fair market

value. Book value represents the amount left to be

allocated to depreciation expense in future periods.

Furniture 20,000$ Less Accumulated Depreciation (333) 19,667$ Book value of plant assets 19,667$

Plant Assets of Shilling Construction at 12/13/05

Adjusting Entry – Accrued Expenses

Accrued Expenses are expenses that have not yet been paid in cash, and have not been recorded at the end of the month. Since cash has not been received or paid prior to recognizing a revenue or expense, this is a type of accrual. Salary Expense – employees work, but have not

yet been paid. Interest Expense – accrue interest on a bank

loan that you borrow, but have not paid the interest back yet.

Interest Revenue – earn interest on a CD, but have not received the cash yet.

Service Revenue – perform ongoing travel services to another corporation.

Adjustments – Accrued Expenses

Example of the adjustment process for Accrued Expenses, which are liabilities that arise from expenses that have not yet been paid.

Example: Shilling Construction pays its employees a monthly salary of $1,900, half on the 15th and half on the last day of the month. If a payday falls on a weekend, Shilling pays the employee on the following Monday.

Note: For these purposes, assume that December 31st, the second payday of the month, falls on a Saturday, and so the second half-month amount of $950 will be paid on Monday, January 2nd. Therefore, an adjustment entry is needed on 12/31 for additional salary expense and salary payable.

Adjustments – Accrued Expenses

Salary Payable 12/31 950

Bal. 950

Bal. 1,90012/31 950

Salary Expense12/15 950

Cash12/15 950

Adjustments – Accrued Revenues

Example of the adjustment process for Accrued Revenues, which are revenues that have been earned but not yet paid in cash.

Example: Towne East hires Air & Sea Travel on April 15th to provide travel services on a monthly basis. Towne East will pay Air & Sea Travel $500 monthly, with the first payment on May 15th.

Adjustments – Accrued Revenues

Adjusting Entry:

General Journal

Date Accounts and Explanations PR Debit Credit

4/15 Accounts Receivable ($500 * 1/2) 250

Service Revenue 250

To accrue service revenue.

Summary of Adjusting Entries

Adjusting entries always affect at least one: One Revenue or Expense account – which

measure net income One Asset or Liability account – which update the

Balance SheetAdjusting entries never involve cash.

Adjusted Trial Balance

The Adjusted Trial Balance is a list of all of the ledger accounts (i.e., all of the T-accounts) with their adjusted balances.

The Adjusted Trial Balance is used to prepare the financial statements.

Trial Balance Adjustments Adjusted Trial Balance

Debit Credit Debit Credit Debit Credit

Refer to Exhibit 3-9, page 123, for format.

Preparation of Financial Statements

Using the Adjusted Trial Balance, the financial statements must be prepared in the following order:

(1) Income Statement Single step – All Revenues, followed by

all Expenses Multi-step – Subtotals (such as COGS and Gross

Profit)(2) Statement of Retained Earnings(3) Balance Sheet

Assets – Current Assets first (in order to liquidity), followed by Long-Term Assets

Liabilities – Current Liabilities, then Long-Term Liabilities

Note: the Statement of Cash Flows does not need to be prepared in a particular order, but it is typically prepared last.