accrual accounting concepts

Chapter 4-1

Accrual Accounting Concepts

Accounting, Third Edition

Chapter 4-2

Generally a month, a quarter, or a year.Fiscal year vs. calendar year

Timing IssuesTiming Issues

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

Jan. Feb. Mar. Apr. Dec.. . . . .

Chapter 4-3

Timing IssuesTiming Issues

Revenue Recognition PrincipleCompanies recognize revenue in the accounting period in which it is earned.In a service enterprise, revenue is considered to be earned at the time the service is performed.

Chapter 4-4

Timing IssuesTiming Issues

“Let the expenses follow the revenues.”

Chapter 4-5

Timing IssuesTiming Issues

Chapter 4-6

Accrual-Basis AccountingTransactions recorded in the periods in which the events occurRevenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred, rather than when paid.

Timing IssuesTiming Issues

Accrual- vs. Cash-Basis Accounting

Chapter 4-7

Cash-Basis AccountingRevenues are recognized when cash is received.Expenses are recognized when cash is paid. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

Timing IssuesTiming Issues

Accrual- vs. Cash-Basis Accounting

Chapter 4-8

Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement.

A company must make adjusting entries every time it prepares financial statements.

Every adjusting entry will include one income statement account and one balance sheet account.

The Basics of Adjusting EntriesThe Basics of Adjusting Entries

Chapter 4-9

Types of Adjusting EntriesTypes of Adjusting Entries

1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed.

Deferrals3. Accrued Revenues.

Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

2. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned.

Accruals

Illustration 4-3Categories of adjusting entries

Chapter 4-10

Trial BalanceTrial Balance – Each account is analyzed to determine whether it is complete and up-to-date.

Types of Adjusting EntriesTypes of Adjusting Entries

Illustration 4-4

Chapter 4-11

Deferrals are either: Prepaid expenses

OR

Unearned revenues.

Adjusting Entries for DeferralsAdjusting Entries for Deferrals

Chapter 4-12

Payment of cash, that is recorded as an asset because Payment of cash, that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

insuranceinsurancesuppliessuppliesadvertisingadvertising

Cash Payment Expense RecordedBEFORE

rentrentmaintenance on maintenance on equipmentequipmentfixed assets fixed assets (depreciation)(depreciation)

Prepayments often occur in regard to:Prepayments often occur in regard to:

Chapter 4-13

Prepaid ExpensesCosts that expire either with the passage of time or through use.

Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Chapter 4-14

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Adjusting entries for prepaid expenses

Increases (debits) an expense account and Decreases (credits) an asset account.

Illustration 4-5

Chapter 4-15

Illustration: Sierra Corporation purchased advertising suppliescosting $2,500 on October 5. Sierra recorded the payment by increasing (debiting) the asset Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand.

Advertising supplies 1,500Advertising supplies expense

1,500Oct. 31

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Illustration 4-6

($2,500 – 1,000 = $1,500)

Chapter 4-16

Illustration: On October 4 Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in theOctober 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Prepaid insurance 50Insurance expense 50Oct. 31

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Illustration 4-7

Chapter 4-17

DepreciationBuildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle).

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Chapter 4-18

Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.

Accumulated depreciation

40Depreciation expense 40Oct. 31

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Illustration 4-8

Chapter 4-19

Depreciation (Statement Presentation)Accumulated Depreciation is a contra asset account.Appears just after the account it offsets (Equipment) on the balance sheet.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Illustration 4-9

Chapter 4-20

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

Summary Illustration 4-10

Chapter 4-21

Receipt of cash that is recorded as a liability Receipt of cash that is recorded as a liability because the revenue has not been earned.because the revenue has not been earned.

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

Room rentRoom rentairline ticketsairline ticketsschool tuitionschool tuition

Cash Receipt Revenue RecordedBEFORE

magazine subscriptionsmagazine subscriptionscustomer depositscustomer deposits

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:

Chapter 4-22

Unearned RevenuesCompany makes an adjusting entry to record the revenue that has been earned and to show the liability that remains.

The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

Chapter 4-23

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and Increase (a credit) to a revenue account.

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

Illustration 4-11

Chapter 4-24

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balanceof $1,200 in the October 31 trial balance. From an evaluation of the work Sierra performed for Knox during October, the company determines that it has earned $400 in October.

Service revenue 400Unearned service revenue 400Oct. 31

Illustration 4-12

Chapter 4-25

Summary

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

Illustration 4-13

Chapter 4-26

Made to record: Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

Adjusting Entries for AccrualsAdjusting Entries for Accruals

Chapter 4-27

Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

services performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptRevenue Recorded

Adjusting entry results in:Adjusting entry results in:

Chapter 4-28

Accrued RevenuesAn adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

Chapter 4-29

Adjusting entries for accrued revenues

Increases (debits) an asset account and Increases (credits) a revenue account.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

Illustration 4-14

Chapter 4-30

Illustration: In October Sierra Corporation earned $200 for advertising services that were not billed to clients before October 31.

Service Revenue 200Accounts Receivable 200Oct. 31

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

Illustration 4-15

Chapter 4-31

SummaryIllustration 4-16

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

Chapter 4-32

Expenses incurred but not yet paid in cash or Expenses incurred but not yet paid in cash or recorded.recorded.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

rentrentinterestinterest

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentExpense Recorded

taxestaxessalariessalaries

Adjusting entry results in:Adjusting entry results in:

Chapter 4-33

Accrued ExpensesAn adjusting entry serves two purposes:

(1) It records the obligations, and

(2) It recognizes the expenses.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

Chapter 4-34

Adjusting entries for accrued expenses

Increases (debits) an expense account and Increases (credits) a liability account.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

Illustration 4-17

Chapter 4-35

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%.

Interest payable 50Interest expense 50Oct. 31

Illustration 4-19

Illustration 4-18

Chapter 4-36

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.

SummaryIllustration 4-22

Chapter 4-37

Summary of Basic RelationshipsSummary of Basic Relationships

Chapter 4-38

After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance).

Its purpose is to prove the equality of debit balances and credit balances in the ledger.

The Adjusted Trial BalanceThe Adjusted Trial Balance

Chapter 4-39

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statemen

t

Retained Earnings Statemen

t

Preparing Financial StatementsPreparing Financial Statements

Chapter 4-40

At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings.

Closing the BooksClosing the Books

Illustration 4-29

Chapter 4-41

In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.

Closing the BooksClosing the Books

Illustration 4-30

Chapter 4-42

Closing the BooksClosing the Books

Illustration 4-31

Chapter 4-43

Closing the BooksClosing the Books

SO 7 Explain the SO 7 Explain the purpose of closing purpose of closing

entries.entries.

Chapter 4-44

The purpose of this trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period.

Preparing a Post-Closing Trial BalancePreparing a Post-Closing Trial Balance

All temporary accounts will have zero balances.

SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.

Chapter 4-45

Summary of the Accounting CycleSummary of the Accounting Cycle

1. Analyze business transactions

2. Journalize the transactions

6. Prepare an adjusted trial balance

7. Prepare financial statements

8. Journalize and post closing entries

9. Prepare a post-closing trial balance

4. Prepare a trial balance

3. Post to ledger accounts

5. Journalize and post adjusting entries

Chapter 4-46

Adjusting Entries – Using a Worksheet Adjusting Entries – Using a Worksheet (Appendix)(Appendix)

Illustration 4A-1Form and procedure for a worksheet