Chapter 4 1 Chapter 4 Accrual Accounting Concepts

Chapter 4 1

Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: z Explain the revenue recognition principle and the matching principle. z Differentiate between the cash basis and the accrual basis of accounting. z Explain why adjusting entries are needed and identify the major types of adjusting entries. z Prepare adjusting entries for prepayments. 2

Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: z Prepare adjusting entries for accruals. z Describe the nature and purpose of the adjusted trial balance. z Explain the purpose of closing entries. z Describe the required steps in the accounting cycle. 3

Time Period Assumption. . . Divides the economic life of a business into artificial time periods WHY? to provide immediate feedback on how the business is doing. 4

Time Period Assumption. . . Generally a month, a quarter, or a year. An accounting time period that is one year long is called fiscal year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year. 5

Revenue Recognition Principle. . . zdictates that revenue be recognized in the accounting period in which it is earned. zis considered earned ywhen the service has been provided or y when the goods are delivered. 6

Matching Principle. . . requires that expenses be recorded in the same period in which the revenues they helped produce are recorded. (or in the period to which they relate) 7

Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid. 8

Cash Basis in not GAAP AP GA 9

Accrual Basis Accounting Adheres to the: • Revenue Recognition Principle • Matching Principle 10

Accrual Basis Accounting • Revenue recorded only when earned, not when cash is received • Expense recorded only when incurred, not when cash paid 11

Accrual Basis adheres to. . . • Generally • Accepted • Accounting • Principles 12

Year 1 Year 2 Activity Purchased paint, painted building , paid employees Accrual basis Cash basis Received payment for work done in year one Revenue $80, 000 Revenue Expense 50, 000 Expense $ 0 0 Net Income $30, 000 Net Income $ Revenue $ 0 Revenue $80, 000 Expense 50, 000 Expense 0 Net Loss ( $50, 000) Net Income 0 $80, 000 13

Adjusting Entries Adjusting entries make the: z revenue recognition & z matching principles HAPPEN! 14

Types of Adjusting Entries y. Prepayments: x. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. x. Unearned Revenues: Cash received and recorded as liabilities before revenue is earned. y. Accruals: x. Accrued revenues: Revenues earned but not yet received in cash or recorded. x. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. 15

Prepayments • Cash or other asset has been spent but the item acquired has not been used or consumed • Cash has been collected before revenue is earned 16

You can start with the trial balance to find information to adjust prepayments. 17

Sierra Corporation Trial Balance October 31, 2004 Cash Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Dividends Service Revenue Salaries Expense Rent Expense Debit Credit $15, 200 2, 500 600 5, 000 $ 5, 000 2, 500 1, 200 10, 000 500 10, 000 4, 000 900 $28, 700 18

Illustration 4 -6 Supplies On October 5 the company paid $2, 500 for advertising supplies. Cash Oct 5 2, 500 Supplies Oct 5 2, 500 GENERAL JOURNAL Oct 5 Supplies Expense Supplies Cash Debit Credit 2, 500 Purchased advertising supplies 19

Supplies Illustration 4 -6 An inventory on October 31 reveals that $1, 000 of supplies remain on hand; therefore $1, 500 of supplies have been used. ($2, 500 - $1, 000) =$ 1, 500 Cash Supplies Oct 5 2, 500 Oct 31 1, 500 GENERAL JOURNAL Oct 5 Supplies Expense Supplies To record advertising supplies consumed Supplies Expense Oct 31 1, 500 Debit Credit 1, 500 20

Supplies Expense Oct $1, 500 Nov $1, 800 Dec $1, 410 Jan $1, 425 Feb $1, 601 Mar $1, 435 Apr $1, 510 May $1, 592 June $1, 652 July $1, 621 Aug $1, 427 Sept $1, 555 Supplies expense is based on usage. . . so different amounts appear each month 21

Prepaid Expenses On October 1 the company paid $600 for a 1 -year insurance policy. Coverage began October 1. Cash Oct 1 Insurance Expense Prepaid Insurance 600 Oct 1 600 GENERAL JOURNAL Debit Oct 1 600 Prepaid Insurance Cash Credit 600 Purchased one-year policy effective October 1 22

Insurance Policy Oct $50 Nov $50 Dec $50 Jan $50 Feb $50 Mar $50 Apr $50 May $50 June $50 July $50 Aug $50 Sept $50 1 Year $ 600 23

Prepaid Expenses On October 31 st, $50 ($600/12 months) of the insurance was used-up or expired. Prepaid Insurance Cash Oct 1 600 Oct 31 50 GENERAL JOURNAL Oct 31 Insurance Expense Prepaid Insurance Expense Oct 31 Debit 50 Credit 50 50 Record insurance expense for the month 24

Depreciation How do you apply the Matching Principle to the cost of a long lived asset ? 25

Depreciation Allocate the cost of an asset to expense over its useful life Depreciation is an ALLOCATION CONCEPT- not a VALUATION CONCEPT. We’re not attempting to reflect the actual change in value of an asset! 26

Office Equipment Oct $40 Nov $40 Dec $40 Jan $40 Feb $40 Mar $40 Apr $40 May $40 June $40 July $40 Aug $40 Sept $40 Depreciation= $480/year 27

Office Equipment Accumulated Depreciation. Office Equipment Oct 2 5, 000 Oct 31 40 GENERAL JOURNAL Oct 31 Depreciation Expense Oct 31 40 Debit Credit 40 Accumulated Depreciation-Office Equip 40 To record monthly depreciation Accumulated depreciation is a contra asset account - an offset against the fixed asset account. 28

Balance Sheet Presentation Office equipment Less : accumulated depreciation $ 5, 000 40 $4, 960 Book Value or Carrying Value 29

Unearned Revenues Received on Oct. 2 $1, 200 for advertising services expected to be completed by Dec 31. Unearned Service Revenue Cash Oct 2 1, 200 GENERAL JOURNAL Debit Oct 2 1, 200 Cash Unearned Service Revenue Collected money for work to be performed by Dec 31. Credit 1, 200 30

Unearned Revenues During October $400 of the revenue was earned. Unearned Service Revenue Cash Oct 2 1, 200 Oct. 31 400 Oct 2 GENERAL JOURNAL Oct 31 Unearned Service Revenue Oct. 31 400 1, 200 Debit Credit 400 To record revenue earned 31

Accrual • Revenue has been earned, but not collected. • Expenses have been incurred, but not yet paid. 32

Accrued Revenues earned but not yet received in cash or recorded at the statement date 33

Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31 st. Accounts Receivable Oct 31 200 GENERAL JOURNAL Oct 31 Accounts Receivable Service Revenue Oct 31 Debit 200 Credit 200 34

Accrued Expenses incurred but not yet paid or recorded at the statement date. 35

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 Formula for Computing Interest Face Value of Note $ 5, 000 X Annual Interest Rate 12% Time in term of One Year 1/12 Interest = $50 36

Accrued Interest Expense Oct 31 50 Interest Payable GENERAL JOURNAL Oct 31 Interest Expense Interest Payable Oct 31 50 Debit Credit 50 50 Accrue interest expense for the month 37

Accrued Salaries - Salaries Paid for after the Service Has Been Performed. 38

Accrued Salaries Expense Oct 31 1, 200 Salaries Payable Oct 31 1, 200 GENERAL JOURNAL Debit Oct 31 Salaries Expense 1, 200 Salaries Payable Credit 1, 200 Accrue salary expense for the month 39

Adjusted Trial Balance The adjusted trial balance is used to prove the equity of total debit balances and total credit balances after the adjusting entries have been made. Financial statements can be easily prepared from the adjusted trial balance. 40

SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2004 41

SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Balance Sheet October 31, 2004 Balance as Oct. 31 from Retained Earnings Statement 42

Closing the Books Closing entries transfer the temporary account balances to the retained earnings account in stockholders’ equity. . . and reduce the balances in the temporary accounts to zero. 43

Temporary Permanent All revenues accounts All asset accounts All expense accounts All liability accounts Dividends Stockholders’ equity accounts 44

Individual Revenues Individual Expenses 2 Income Summary 3 Retained Earnings 1 Retained Earnings is a permanent account; the others shown here are temporary 4 Dividends 45

The Accounting Cycle 46

Required Steps in the Accounting Cycle z. Analyze business transactions. z. Journalize the transactions. z. Post to ledger accounts. z. Prepare a trial balance. z. Journalize and post adjusting entries-prepayments and accruals. z. Prepare an adjusting trial balance. 47