chapter 6 accrual accounting concepts and the accounting cycle

Chapter 6

Accrual Accounting Concepts and the Accounting Cycle

In Chapter 3

You learned how to:

o Prepare Journal Entries

o Prepare an Unadjusted Trial Balance

o And use the Unadjusted Balances to prepare Financial Statements

We made it through Step 3 of the Accounting Cycle

In this chapter we need to complete the cycle…

Did she say WRONG!?

All of the transactions

were recorded correctly

Here are the financial

statements from Chapter 3

The unadjusted trial balance

was in balance…

And so was the balance sheet…

Too Bad the Balances are

wrong!

What’s the Accrual Basis of Accounting!?

Our Cash Balance is Correct!

How can the balances be

wrong…

Every Cash Receipt and

Disbursement was recorded.

So what are we missing?

Financial Statements must

be prepared using the Accrual Basis

of Accounting

The Accrual Basis is required by

GAAP

Not just the Cash Flow…..

And the Matching Principle.

Can you give us a refresher

on those?

The Accrual Basis of Accounting

looks at the economic activity…

Right! Two important Principles

are the Revenue Recognition

Principle

Generally Accepted

Accounting Principles,

right?

Revenue Recognition Principle

Requires that revenues be recorded in the time period when the work is performed.

The Earnings process is complete.Governs the Timing of Revenues

Income Statement

Revenues:Service Revenue 45,000Rental Revenue 0

Total Revenues 45,000

Expenses:Wages Expense 26,300Equipment Rental Expense 1,500Rent Expense 0Advertising expense 2,600Repairs Expense 900

0 0Total Expenses 31,300

Net Income (Loss) 13,700

Revenue

Reco

gnitio

n

Prin

ciple

Matching Principle

Requires that expenses be recorded in the same time period as the revenues they helped generate.

Governs the Timing of Expenses

Income Statement

Revenues:Service Revenue 45,000Rental Revenue 0

Total Revenues 45,000

Expenses:Wages Expense 26,300Equipment Rental Expense 1,500Rent Expense 0Advertising expense 2,600Repairs Expense 900

0 0Total Expenses 31,300

Net Income (Loss) 13,700

Revenue

Reco

gnitio

n

Prin

ciple

Match

ing

Prin

ciple

Year 1 Year 2

Purchased paint, painted building , paid employees

Received payment for work done in year one

Activity

Accrualbasis

Cashbasis

Revenue $80,000

Expense 50,000

Net Income $30,000

Revenue $ 0

Expense 50,000

Net Loss ( $50,000)

Revenue $80,000

Expense 0

Net Income $80,000

Revenue $ 0

Expense 0

Net Income $ 0

Illustration 4-2

Here’s an example of adhering to the matching principle…..

The unadjusted balance in the Supplies account may not be accurate.

Just because we purchased $500 of supplies……

Doesn’t mean we still have them.

500

0 0 0 0

Supplies

Unless we used none of the supplies

the balance in Supplies is

TOO HIGH!

And the Balance in Supplies Expense

500 0

0 0 0 0

Supplies Supplies Expense

is TOO LOW!

What Happened?

The Journal Entry Process (at the time of Purchase)

Was not simultaneous with the Economic Activity (Usage of the supplies)

It would be silly to prepare a journal entry every time we used the stapler?!

In order for the financial statements to be correct….

500

0 0 0 0

Supplies

The Economic Activity needs to be recorded

This is done by recording an Adjusting Entry

Recording Supplies

Expense of $350

in the time period when we

actually used the supplies is

an

Example of the Matching

Principle

500350 350

150 0 350 0

Supplies Supplies Expense

It’s all about Timing!

Timing of the journal entry

Versus Timing of the economic activity

Sometimes the cash flow precedes the economic activity

Insurance Premium paid

Use SuppliesPurchase Supplies

Policy Term

Customer Pays In Advance We Perform Services

Purchase Equipment We Use Equipment

Cash Flow has already been recorded

The Economic Activity has not yet been recorded.

Each of these prepayments

Insurance Premium paid

Use SuppliesPurchase Supplies

Policy Term

Customer Pays In Advance We Perform Services

Purchase Equipment We Use Equipment

Cash Flow has already been recorded


Requires an adjusting

entry called a DEFERRAL

Sometimes the economic activity precedes the Cash Flow

Employees are paid.Employees Work

We Perform Services We Bill The Customer

Journal Entry for Cash flow will be recorded next period


Each of these unpaid items….

Employees are paid.Employees Work

We Perform Services We Bill The Customer

Journal Entry for Cash flow will be recorded next period


Requires an adjusting

entry called an ACCRUAL

The purpose of every adjusting entry:

Is to ensure that all Assets and Liabilities

And the resulting Revenues and Expenses

Are Properly Valued

Prior to the Preparation of Financial Statements.

Okay, so the unadjusted

balances are incorrect…..

But are the Balances on the Unadjusted Trial

Balance Too High

Or

Too Low?Let me

Summarize the Adjusting Entry

Process

Let’s look at the example found on page 181 in your text….

Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Unearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$

321,200$ 321,200$

Unadjusted Trial Balance

These Assets and Liabilities

are Already Recorded on the Unadjusted Trial

Balance These balances were accurate

as of the date of the cash receipt or payment, but

No longer accurately reflect the economic

activity. They will need to be

adjusted.

Items that were Prepaid and Previously Recorded

Each of these unadjusted balances is TOO HIGH!

$3,000

Unearned Revenue

$12,000

Supplies

$1,500

Prepaid Insurance

$48,000

Book Value Equipment

And needs to be reduced to its proper balance

$3,000

Unearned Revenue

$12,000

Supplies

$1,500

Prepaid Insurance

$48,000


$3,000

$2,500

Unearned Revenue

$12,000

$8,000

Supplies

$1,500

$1,000

Prepaid Insurance

$48,000

$36,000


Unearned Revenues

500$

500$

$3,000 Unadjusted $80,000$500 AJE $500

$2,500 Adjusted $80,500

Unearned Revenue Service Revenue

Unearned Revenue

Service Revenue

Required Adjusting Entry

This adjusting entry recognizes the amount of revenue earned in the current period, and reduces

the liability, Unearned Revenues, by $500

Supplies

4,000$

4,000$

Unadjusted $12,000$4,000 AJE $4,000

$4,000 Adjusted $8,000


Supplies

Supplies Expense

Supplies

Supplies Expense

This adjusting entry recognizes the amount of supplies used in the current period, and reduces

the asset, Supplies, by $4,000.

Prepaid Insurance

500$

500$

Unadjusted $1,500$500 AJE $500

$500 Adjusted $1,000

Prepaid Insurance

Insurance Expense

Prepaid Insurance


Insurance Expense

This adjusting entry recognizes the amount of insurance coverage used in the current period, and

reduces the asset, Prepaid Insurance by $500.

Each of the preceding examples

Affected current accounts:Supplies

Prepaid Insurance

Unearned Revenues

The Adjusting EntryReduced the Account Directly

Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Unearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$

321,200$ 321,200$


Equipment is a Depreciable

Asset

There are two general ledger

accounts related to

Equipment.

Now Let’s Look at the Long-Term Accounts

Equipment and Accumulated

Depreciation

The Equipment will be used for several years to help generate revenues

Year 1 2 3 4 5

Revenues: 20% 20% 20% 20% 20%

Expense: 20% 20% 20% 20% 20%

The Matching Principle requires that we match the expense against the revenue

The Process of allocating the cost of a long-term asset over time….

Year 1 2 3 4 5

Revenues: 20% 20% 20% 20% 20%

Expense: 20% 20% 20% 20% 20%

The Matching Principle requires that we match the expense against the revenue

Is Called DEPRECIATION!

60,000

60,000

Equipment

12,000

Accumulated Depreciation

Its purpose is to reduce Equipment

Accumulated Depreciation is a Contra-Asset Account

Assets are reduced

with credits

60,000

60,000

Equipment

12,000


We still own $60,000 of equipment

In a manner that preserves the historical cost information

60,000

Equipment

12,00012,000

24,000


Depreciation Expense $12,000Accumulated Depreciation

$12,000

12,000

12,000

Depreciation Exp

When Long-Term Assets are used, the adjusting entry decreases the book value of the Equipment indirectly

This must be the

second year

Balance Sheet Presentation:

Equipment $60,000Less: Accumulated Depreciation ($24,000)Book Value – Equipment $36,000

This provides better information…

The Equipment cost $60,000



Of Which $24,000 has been charged against Prior Revenues:



The Remaining $36,000 Cost will be charged against Future Revenues:

Summary of Deferrals

Cash Flow preceded the Economic Activity Balance is already recorded on the

unadjusted trial balance The recorded balance is TOO HIGH And must be reduced to its proper balance

Most Accounts are reduced directlyDepreciable Assets are reduced indirectly using a contra-account.

Now Let’s look at Accruals

Accruals are required for transactions if The economic activity has occurred But is unrecorded Because the cash flow will not be recorded

until the next period.

Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Salaries Payable -$ Interest PayableUnearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$

321,200$ 321,200$


These Assets and Liabilities

are Not Recorded on the Unadjusted Trial

Balance Because there has not been

any cash flow as of year end.

They are Unpaid and

Unrecorded.

But Since the Economic

Activity has already

occurred, these balances will

also need to be adjusted

Items that are Unpaid and Unrecorded

0

Interest Payable

Each of these unadjusted balances is TOO LOW

0

Salaries Payable

0

750

Salaries Payable

And needs to be increased to its proper balance.

0

2,520

Interest Payable

To Accrue Salaries

750$

750$

$37,500 Unadjusted

$750 AJE $750

$38,250 Adjusted $750

Salaries Payable

Salaries Expense

Salaries Payable


Salaries Expense

This adjusting entry recognizes the amount owed to the employees at year-end and increases the

liability, Salaries Payable by $750.

To Accrue Interest

2,520$

2,520$

Unadjusted

$2,520 AJE $2,520

$2,520 Adjusted $2,520

Interest Payable

Interest Expense

Interest Payable


Interest Expense

This adjusting entry recognizes the amount of interest incurred in the current period, and

increases the liability, Interest Payable, by $2,520.

Other Common Accruals

Accounts Receivable – Services have been performed, but customer has not yet been billed

Accrued Interest on Notes Receivable

Summary of Accruals

Economic Activity has Preceded the Cash Flow

Balance is NOT recorded on the unadjusted trial balance

The recorded balance is TOO LOW And must be increased to its proper balance

Journal Entries for Accruals

$ Amount Earned

$ Amount Earned

Receivable

Revenue


If a liability is previously unrecorded:

If an asset is previously unrecorded:

$ Amount Incurred

$ Amount Incurred

Expense

Payable

For each item under consideration, ask if the Item has been Previously Recorded

Yes No

There is a balance that is TOO

HIGH!

There is a balance that is TOO LOW!

Ask if the Item has been Previously Recorded

Yes, Prepare

a Deferral

No, Prepare

an Accrual

Find the Account that is

Overstated and Reduce it to its proper balance

Find the Account that is

Understated and Increase it to its

proper balance

The Dollar Amount of the Adjusting Entry will Be:

For a

DeferralFor an

Accrual

The Journal Entry is for the Amount to be Deducted

from the account

The Journal Entry is for the Amount to be

Added to the Account

Every Adjusting Entry affects both the Income Statement and Balance Sheet

Unearned Fees


Accrued Salaries


Supplies Used


Insurance Expired


Depreciation


Accrued Interest

Why do we need Closing Entries?

They are consistent with

GAAP

Here are the financial

statements using the Adjusted

Balances

Now is the Accounting

Cycle Complete?

Not Yet. It’s time for Closing

Entries

Purpose of Closing Entries

To achieve zero balances in all of the temporary equity accounts:

Revenues

Expenses

Dividends

Transfer the temporary equity amounts to Retained Earnings, which is a permanent equity account

Closing Entries Parallel the Transfer of Temporary Equity Amounts to the Statement of Retained Earnings

Revenues and Expenses are

closed to Retained Earnings

Dividends are also closed to Retained

Earnings

67,000

67,000

Retained Earnings

Closing the Income Statement to Retained Earnings….

67,0008,230

75,230

Retained Earnings

Closing Dividends Account to Retained Earnings

Beg BalNet Loss Net Income

DividendsEnd Bal

Retained Earnings

67,0005,000 8,230

70,230

Retained Earnings

Cash 125,200$ Accounts Receivable 20,000$ Supplies 8,000$ Interest ReceivablePrepaid Insurance 1,000$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 24,000$ Other AssetsAccounts Payable 10,000$ Salaries Payable 750$ Interest Payable 2,520$ Unearned Revenue 2,500$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Retained Earnings 70,230$ DividendsService RevenueSalaries ExpenseMiscellaneous Operating Expense

259,200$ 259,200$

Post-ClosingTrial BalanceThe Balance

Sheet Accounts are Permanent

Accounts. Their balances are Not Closed

Revenues, Expenses and Dividends are

Temporary Equity Accounts. Their

balances are zero after closing

After Closing Entries are posted, only the Balance Sheet Accounts have balances

Congratulations! You’ve completed the Accounting Cycle

End – Chapter 6

chapter 6 accrual accounting concepts and the accounting cycle

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