ACCT 1501 Session 1, 2015

Week 5 Accrual Accounting Adjustments

Student Handout

Lecturer: Jeffrey Knapp

School of Accounting UNSW

QUAD 3103 j.knapp@unsw.edu.au

Moodle: https://moodle.telt.unsw.edu.au/login/index.php

Business School

ACCT1501 Accounting and Financial Management 1A

Session 1 2015

ACCT 1501 Session 1, 2015 2

WEEK 5: Accrual Accounting Adjustments

1. Lecturer comments Accrual accounting exists to provide timely information about the financial affairs of organisations to users or stakeholders for their economic decision-making. In financial accounting, the focus is on providing useful information to external stakeholders such as shareholders and creditors. The financial affairs of organisations involve financial position, financial performance, changes in equity and cash flows. The balance sheet addresses financial position by showing the economic resources under the organisations control (assets) and its financial and other obligations (liabilities). The balance sheet captures the fundamental equation (A L = OE) and it is the driving force in accrual accounting. The need at regular intervals at the end of each accounting period to determine the assets and liabilities of the enterprise is at the heart of accrual accounting and accrual adjustments. In the business world, analysts and investors tend to focus on financial performance for the accounting period, that is, profit or earnings. The profit is the income less expenses for the period. Income equals revenue plus gains. The income statement shows the revenues for the period less the expenses incurred in generating those revenues this is referred to as the matching principle. Accrual accounting is superior to cash flow information to assess the financial position and financial performance of an enterprise. Cash flow information only records the financial effects of transactions and events on the cash balance. In contrast, accrual accounting records the financial effects of all transactions and events that affect economic resources or obligations of the enterprise. Consider this simple example. Assume a company sold land that had cost $1m in return for new land valued at $5m. This transaction would not be recorded in cash accounting. In accrual accounting we would recognise the new land as an asset in the balance sheet $5m and we would recognise a gain of $4m in the income statement. Keeping track of cash flow is important for business success, but it is not enough. We have to go beyond cash flow to assess economic performance more broadly and to assess non-cash resources and obligations. In accrual accounting, we make estimates, judgements and other accounting choices that make the financial information more subjective than transaction-based cash flow figures. Accrual accounting information therefore tends to be more relevant to users economic decision-making than cash-based information but less reliable. This week, adjusting entries are the key concept. Adjusting entries are the steps required to ensure the accounts represent the assets, liabilities, revenues and expenses once we get to the end of the accounting period. For reasons of convenience, we dont record a wages expense for every hour (or minute, or second, or millisecond). But at the end of the accounting period, we must ensure that any wages owing (liability) is recorded together with the related wages expense for the period. When preparing the financial statements for the accounting period, we want to ensure that all assets, liabilities, revenues and expenses are recognised and measured. To make sure this happen, we have to adjust the accounts. This week we also consider closing entries. Only the account balances for assets, liabilities and equity carry forward from one accounting period to the next. The accounts for revenues and expenses must be closed at the end of the accounting period to determine the profit for the period. An income summary account is used to facilitate this process. The profit for the period is then transferred to the equity account of retained profits.

ACCT 1501 Session 1, 2015 3

Learning objectives At the end of this topic you should be able to: Explain how the timing of revenue and expense recognition differs from cash inflows

and outflows. Prepare journal entries for accrual accounting adjustments. Understand contra accounts and the impact on the financial statements. Understand and perform the closing process.

Required Reading Trotman, Gibbins & Carson Chapter 4:pages 174-177 Trotman, Gibbins & Carson Chapter 5:pages 201-242

(Note from lecturer. Please read all the learning objectives for chapter 5 on page 201 of the textbook. These learning objectives are covered during my 4 week lecturing period.)

2. Tutorial Questions Due in Week 6

Preparation Questions: Students should review the following preparation questions using the solutions available from Moodle.

Discussion Questions DQ 5.2, DQ 5.4, DQ 5.13 Problems P5.4, P5.6, P5.18, P5.20, P5.23 Case 5A

Tutorial Questions: Students should attempt the following tutorial questions before class.

Discussion Questions DQ 5.10, DQ5.19 Problems P5.7, P5.9, P5.13

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ACCT1501

Semester 1, 2015

Week 5Accrual Accounting Adjustments

Jeffrey KnappQuad 3103

Topic 5: Learning Objectives (LO)

At the end of Topic 5, you should be able to:

LO1: Explain how the timing of revenue and expense recognition differs from cash inflows and outflows (the accrual concept)

LO2: Prepare journal entries for accrual accounting adjustments (the adjusting entries)

LO3: Understand contra accounts and the impact on the financial statements

LO4: Understand and perform the closing process

Essential reading for Week 5 Trotman, Gibbins & Carson Chapter 4 pp. 174-177

Trotman, Gibbins & Carson Chapter 5 pp. 201-242

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Recap: Cash and accrual accounting

Accrual accounting records:

Revenues when they are earned, not received.

E.g. Expenses when they are incurred, not paid.

E.g. Some items that have no cash flow effect.

E.g.

Remember, cash accounting records revenues and

expenses when

cash is received or paid.

LO1

3 4

Often a timing difference between the significant

economic event (earning revenue/incurring expense) and

related cash flow

provide a more complete picture of economic performance,

particularly in the short term

Does not imply that the payment or receipt of cash are

unimportant events

the lifeblood of business

Accrual accounting LO1

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Revenue expense and recognition

Lets review the differences in how revenue and expense

are recognised under an accrual versus cash system.

LO1

5

Revenue recognition

1. Recognition of revenue (resource inflow) at the same time as cash inflow.

E.g. Sale to customer for cash.

Cash entry:

Dr Cash (+A)

Cr Sales (+R)

Accrual entry:

Dr Cash (+A)

Cr Sales (+R)

Note: both entries are the same.

LO1

6

Revenue recognition

2. Recognition of revenue (resource inflow) prior to cash inflow

E.g. Sale to customer on credit.

Cash entry:

Nothing

Accrual entry:

Dr Accounts receivable (+A)

Cr Sales (+R)

Note : the cash entry understates sales.

LO1

7

Revenue recognition

3. Recognition of revenue (resource inflow) after cash inflow.

E.g. Receipt of subscription fees in advance.

Cash entry:

Dr Cash (+A)

Cr Sales (+R)

Accrual entry:

Dr Cash (+A)

Cr Unearned revenue (+L)

Note : the cash entry overstates sales.

LO1

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Expense recognition

1. Recognition of expense (resource outflow) at the same time as cash outflow.

E.g. Payment of wages.

Cash entry:

Dr Wages expense (+E)

Cr Cash (-A)

Accrual entry:

Dr Wages expense (+E)

Cr Cash (-A)

Note: both entries are the same.

LO1

9

Expense recognition

2. Recognition of expense (resource outflow) prior to cash outflow

E.g. wages owing at year end

Cash entry:

Nothing

Accrual entry:

Dr Wages expense (+E)

Cr Wages payable (+L)

Note: the cash entry understates expenses.

LO1

10

Expense recognition

3. Recognition of expense (resource outflow) after cash outflow

E.g. Payment of insurance for the next 24-month period.

Cash entry:

Dr Insurance Expense (+E)

Cr Cash (-A)

Accrual entry:

Dr Prepaid insurance (+A)

Cr Cash (-A)

Note : the cash entry overstates expenses.

LO1

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Summary: Cash versus accrual profit

The earning of a revenue is not necessarily accompanied

by an inflow of cash in the same period.

The incurrence of an expense is not necessarily

accompanied by an outflow of cash in the same period.

Accrual profit is not the same as cash profit.

LO1

12

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Accrual accounting adjustments

Adjusting entries are entries necessary at the end of the

accounting period to measure all revenues and expenses

of that period.

Types:

1.Deferrals-related

1.1 Revenue adjustment: Unearned revenue

1.2. Expense adjustment: Prepayment

2. Accruals-related

2.1. Revenue adjustment: Accrued revenues

2.2. Expense adjustment: Accrued expenses

3. Valuation-related: Book value adjustments: Contra accounts

LO2

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Accrual accounting adjustments LO2

t

Revenue earned over time

Expense incurred over timet-1 t+1

Cash received before earned

Cash paid before incurred

Cash received after earned

Cash paid after incurred

1.1.Unearned revenue

1.2.Prepayment

2.1.Accrued revenue

2.2. Accrued expense

Deferrals Accruals

...

Year End

Each involves two entries:#1 One for the cash receipt or payment

#2 One for recording the revenue or expense in the proper period (Adjusting entries)

#1 #1#2

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1.1. Unearned revenue

Cash received in advance of earning revenue.

Liability goods or services are owing to others

Examples:

insurance premiums

magazine subscriptions

rent received in advance

Qantas, Telstra

LO2

15 16

...

31 MayPeriod end30 Jun

$100 of services provided

Cr Unearned revenue (L) $1,20031 May Dr Cash (A) $1,200

Cr Revenue (R) $10030 Jun Dr Unearned revenue (L) $100

1.1. Unearned revenue An example

1 Jun

LO2

On 31 May, a company received $1200 for the service to be provided in the future

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1.2. Prepayments

Cash paid in advance of incurring expense

Assets future economic benefit

current or non-current asset?

Examples:

prepaid insurance

prepaid rent

office supplies

LO2

17 18

...

31 May

Period end30 JunCr Cash (A) $1,000

31 May Dr Office supplies (A) $1,000

Cr Office supplies (A) $70030 Jun Dr Office supplies expense (E) $700

1 Jun

1.2 Prepayments Example 1

i.e. $700 had been consumed.

On 31 May, a company purchased office supplies of $1000.

At 30 June, $300 of the office supplies remained

LO2

1.2 Prepayments Example 2

On 1 May 2012, a company pays $1200 for a one-year

rent. Financial year ended date is 30 June 2012.

What journal entries will the company make on 1 May

2012 and 30 June 2012?

LO2

19 20

...

1 MayPeriod end30 Jun

2-month rent has been used up

Cr Cash (A) $1,2001 May Dr Prepaid rent (A) $1,200

Cr Prepaid rent (A) $20030 Jun Dr Rent expense (E) $200

1.2 Prepayments Example 2 LO2

=$1,200/12 2 = $200

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1.2 Prepayments Example 3

Opening balance prepaid rent $3000

Closing balance prepaid rent: $4000

Rent expense: $5000

What was the cash paid for rent during the year?

LO2

c/d $3000

c/d $4000

Rent exp. $5000

Prepaid rent

Cash $6000

(A)

Dr. Rent exp. Cr. Prepaid rent

Dr. Prepaid rentCr. Cash

$3,000+X-5,000=$4,000

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2.1. Accrued revenue

Revenue has been earned but cash will not be received

until the following period.

Receivables, assets

Examples:

commissions earned but not received

interest earned but not received.

Telstra, Sydney water

LO2

22

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2.1 Accrued revenue An example

Orange company deposited $300 000 with a bank at 10

per cent per annum and interest is paid on 1 March

every year and the next payment of interest will be

received on 1 March 2013.

Financial year ended date is 30 June 2012.

What journal entries will the company make on 30 June

2012 and 1 March 2013?

LO2

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...

1 Mar, 2012

$10 000 interest has been earned

2.1 Accrued revenue An example

...

1 Mar, 2013

Cr Interest revenue (R) $10 00030 Jun Dr Interest receivable (A) $10 000

Cr Interest receivable (A) $10 000 1 Mar Dr Cash (A) $30 000

Period end 30 June, 2012

$20 000 interest has been earned(=$300,00010%8/12)

LO2

(=$300,00010%4/12)

Cr Interest revenue (R) $20 000

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2.2. Accrued expense

Expense has been incurred but cash will not be paid until

the following period

Payables, liability

Examples:

wages earned by employees but not paid after end of

financial period

interest payable on outstanding loan.

LO2

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2.2 Accrued expense An example

A firm pays weekly wages of $50 000 each Friday (25 June,

2 July).

Financial year ended date is 30 June, 2012 (Wednesday).

What journal entries will the firm make on 30 June 2012

and 2 July 2012?

LO2

26

27

...

25 June, 2012 Friday

Cr Cash (A) $50 00025 June Dr Wages expense (E) $50 000

2.2 Accrued expense An example

...

2 July, 2012Friday

Cr Wages payable (L) $30 00030 Jun Dr Wages expense (E) $30 000

Cr Cash (A) $50 000

2 July Dr Wages expense (E) $20 000

Period end 30 June, 2012Wednesday

2 days wages incurred3 days wages incurred but not paid

Dr Wages payable (L) $30 000

LO2 3. Contra accounts

A contra account

is paired with and follows its related account

Its normal balance (debit or credit) is the opposite of the

balance of the related account

Examples:

Accounts receivable Allowance for doubtful debts (ADD)

Property, plant and equipment Accumulated depreciation

Intangibles Accumulated amortisation

Inventory Provision for obsolescence.

LO3

28

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3. Contra accounts Why are they useful?

Allow users to ascertain:

Accounts receivable Allowance for doubtful debts (ADD) level of doubtful debts (and changes therein), collection policies and

problems

Property, plant and equipment Accumulated depreciation likely ages of assets and future cash outflows for purchases of new

assets

Intangibles Accumulated amortisation likely life of intangibles

Inventory Provision for obsolescence. levels of slow-moving, out-of-date stock, efficiency of stock

management.

LO3

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3. Contra account Depreciation LO3

Allocation of the cost of a noncurrent asset to expense

over the life of an asset

To recognise the consumption of the assets economic

value.

Accumulated depreciation (a contra asset account, B/S)

shows all depreciation charged against an asset to date.

Depreciation expense (I/S) shows only this years

depreciation allocation.

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3. Contra account An example

Asset costs $100 000 with a life of 5 years and no estimated

salvage value. Straight line depreciation each year:

Dr Depreciation expense $20 000

Cr Accumulated depreciation $20 000

After 3 years, book value is:

Asset $100 000

Accumulated depreciation ($60 000)

Book value $40 000

LO3

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Comprehensive class example

The following information relating to adjusting

entries is available at the end of June 2013

Transactions 9-13.

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LO2,3&4

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Comprehensive class example

Transaction 9:

A physical count showed supplies costing $180 on hand

at 30 June 2013.

Dr Cr

Supplies Expense E3 370

Supplies A4 370

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Supplies A4 Opening Balance 210 Accounts Payable 340

$550

Opening Balance 180

Closing Balance 180$550

Supplies expense ?

LO2 Comprehensive class example

Transaction 10:

Accrued interest on the bank loan is $240.

Dr Cr

Interest Expense E6 240

Interest Payable L2 240

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LO2

Comprehensive class example

Transaction 11:

Insurance costing $820 expired during the year.

Dr Cr

Insurance Expense E4 820

Prepaid Insurance A3 820

Remember, in Transaction 6. insurance on vehicle, paid in

advance was $840

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LO2 Comprehensive class example

Transaction 12:

Depreciation on the vehicle is $5 350.

Dr Cr

Depreciation Expense MV E2 5,350

Accumulated Depreciation MV A5.1 5,350

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LO2&3

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Comprehensive class example

Transaction 13:

The June telephone account for $180 has not been paid or

recorded.

Dr Cr

Telephone Expense E5 180

Telephone Expense Payable L4 180

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LO2

38

Comprehensive class example

Closing entries for revenue accounts

Dr Cr

Piano Tuning Fees (-R) 28,600

Piano Repair Fees (-R) 24,380

P&L Summary 52,980

Piano tuning fees R1

Cash $23 940A/R $4 660Bal. $28 660

Piano repair fees R2

Cash $16 800A/R $7 580Bal. $24 380

LO4

Before closing,

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Comprehensive class example

Closing entries for expense accounts

Dr Cr

P&L Summary 12,300

Petrol and Oil (-E) 2,680

Depreciation Expense (-E) 5,350

Supplies Expense (-E) 370

Insurance Expense (-E) 820

Telephone Expense (-E) 2,420

Interest Expense (-E) 660

Petrol and oil expense E1

Cash $2 680Bal. $2 680

LO4

Before closing,

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Comprehensive class example

Closing entries for P&L summary account

Dr Cr

P&L Summary 40,680

Retained Profits (+SE) 40,680

Profit & Loss SummaryClosing ent (1) 52,980Closing ent (2) 12,300

Retained Profits 40,680

LO4

Retained Profits

P&L Summary 40,680b/d 554

c/d 41,234

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Revision Question 1

Which of the following would be recorded as an asset?

A. prepayments

B. accrued expenses

C. unearned revenue

D. all would be recorded as assets

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Revision Question 2

On 15 September 2012, a surveyor received an advance

of $7000 from a client for future services. The work was

completed to the clients satisfaction on 10 October

2012. The surveyor uses accrual accounting.

What is the journal entry made by the surveyor on 15

September 2012?

A. Dr Cash 7000 Cr Unearned Revenue 7000

B. Dr Unearned Revenue 7000 Cr Cash 7000

C. Dr Cash 7000 Cr Surveying Revenue 7000

D. Dr Customer Deposits 7000 Cr Unearned Revenue 7000

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Revision Question 3

On 15 September 2012, a surveyor received an advance

of $7000 from a client for future services. The work was

completed to the clients satisfaction on 10 October

2012. The surveyor uses accrual accounting.

What is the journal entry made by the surveyor on 10

October 2012?

A. Dr Cash 7000 Cr Unearned Revenue 7000

B. Dr Accrued Revenue 7000 Cr Surveying Revenue 7000

C. Dr Unearned Revenue 7000 Cr Surveying Revenue 7000

D. Dr Surveying Revenue 7000 Cr Unearned Revenue 7000

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Next Lecture

Accrual adjustments continued (bad debts)

Internal control and cash