4-1 accrual accounting concepts 4 fall 2015 accounting, fifth edition
TRANSCRIPT
4-2
Generally we use a month, a quarter, or a year.
Fiscal year vs. calendar year: The business fiscal year might be the same as a calendar year from Jan 1 to Dec 31, or may start at some other date (July 1 to June 30).
Recall: We can divide the economic life of a business into artificial time periods (the Periodicity Assumption).
Jan. Feb. Mar. Apr. Dec.. . . . .
TimingTiming Issues IssuesTimingTiming Issues Issues
4-3
Accrual Basis Accounting
► Transactions are recorded in the periods in which the
events occur. That means:
► Revenues are recognized (meaning they’re recorded)
when earned, even if cash was not immediately
received (cash is received sometime later).
► Expenses are recognized (meaning they’re recorded)
when incurred, even if cash was not immediately paid
(cash is paid out sometime later).
Timing IssuesTiming IssuesTiming IssuesTiming Issues
Accrual versus Cash Basis of Accounting
4-4
Cash Basis Accounting - This method of accounting is
frequently used but is not allowed (prohibited) under
generally accepted accounting principles (GAAP).
►Revenues are recognized only when cash is actually
received.
►Expenses are recognized only when cash is actually
paid.
►The problem: you can influence when you receive or pay
out cash to manipulate the Income Statement
Timing IssuesTiming IssuesTiming IssuesTiming Issues
Accrual versus Cash Basis of Accounting
4-5
Timing IssuesTiming IssuesTiming IssuesTiming Issues
The Revenue Recognition Principle is part of the Accrual Basis of Accounting
Companies recognize revenue
in the accounting period in which
it is earned. Recognized simply
means the activity is recorded in
the journal.
In a service enterprise, revenue
is earned and recognized at the
time the service is performed.
(mow lawn today and record
revenue today, even if you don’t
get paid until next month).
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Timing IssuesTiming IssuesTiming IssuesTiming Issues
Papa Ron’s Lawn Mowing Service mows a lawn (performs
the service) on June 30, but… does not get paid until
July 11. There are 2 J/Es involved here, one on each date:
30
11
Accounts Receivable
June 30 200 July 11 200
Balance 0
Cash
July 11 200
Service Revenue
June 30 200
4-7
Adjusting entries are needed every time a
company wants to prepare their F/S (monthly,
quarterly or yearly) to ensure the revenue and
expense recognition principles are followed.
Adjusting entries Include one I/S account and
one B/S account which makes it possible to
report correct amounts on the I/S and the B/S.
The Basics of The Basics of AdjustingAdjusting Entries EntriesThe Basics of The Basics of AdjustingAdjusting Entries Entries
4-8
Get Paid $300 in May to mow lawns
over the summer
Cash 300 UnE Rev 300
Mow LawnIn June
Earn $100
UnE 100 Rev 100
Adjusting Entries - Deferrals
Mow LawnIn July
Earn $100
UnE 100 Rev 100
Mow LawnIn AugustEarn $100
UnE 100 Rev 100
Lawns are all mowed and the $300 has all
been earnedNo entry needed here!
Pay $800 in May to pre-pay rent (an asset)
For two months
Prepaid Rent 800 Cash 800
Stay in Apt.In June
Expense $400
Rent Exp. 400 Prepaid Rent 400
Stay in Apt.In July
Expense $400
Rent Exp. 400 Prepaid Rent 400
You’ve used up the $800 by staying in
the Apt.No entry needed
here!
1. Cash Out Now - Expense is “deferred” over time1. Cash Out Now - Expense is “deferred” over time
2. Cash In Now - Revenue is “deferred” over time2. Cash In Now - Revenue is “deferred” over time
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You agree to mow lawns over summer but… you don’t get
paid until Sept.
No entries yet!
Mow LawnIn JuneRev 200
A/R 200 Rev 200
Adjusting Entries - Accruals
Mow LawnIn July
Rev $200
A/R 200 Rev 200
Mow LawnIn AugustRev $200
A/R 200 Rev 200
Sept. - Lawns are all mowed and now you
collect $600
Cash 600 A/R 600
Stay at an Apt. for 2 months @ $450 a
month… pay after the 2 month stay
No entries yet!
Stay in Apt.In June
Expense is $450
Rent Exp. 450 A/P 450
Stay in Apt.In July
Expense is $450
Rent Exp. 450 A/P 450
You stayed in the Apt, and now you pay $900
A/P 900 Cash 900
4. Expense is “accrued” when incurred – Cash Out Later4. Expense is “accrued” when incurred – Cash Out Later
3. Revenue is “accrued” when earned – Cash In Later3. Revenue is “accrued” when earned – Cash In Later
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Types and Examples of Adjusting EntriesTypes and Examples of Adjusting EntriesTypes and Examples of Adjusting EntriesTypes and Examples of Adjusting Entries
Deferrals: CASH now, revenues & expenses deferred to later
1. Prepaid expenses: You pay the rent for 2 months before you move in; debit the asset “Pre-paid Rent” and credit “Cash”
2. Unearned revenues: You get paid before mowing the lawn; debit “Cash” and credit “Unearned Mowing Revenue”
Accruals: revenues & expenses accrued now, CASH later
3. Accrued revenues: You get paid after you mow the lawn; debit “Accounts Receivable” and credit “Mowing Revenue”
4. Accrued expenses: You pay the rent after 2 months of use; debit “Rent Expense” and credit “Accounts Payable”
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Original Entries Adjusting Entries
1. Pre-paid Rent 800 Rent Expense 400
Cash 800 Pre-paid Rent 400
______________________________________________
2. Cash 300 Unearned Rev 100
Unearned Rev 300 Revenue 100
______________________________________________
3. Accts Rec 600 Cash 600
Revenue 600 Accts Rec 600
______________________________________________
4. Rent Expense 900 Accts Pay 900
Accts Pay 900 Cash 900
______________________________________________________________________________________________
Original Entries 1st - Adjusting Entries 2ndOriginal Entries 1st - Adjusting Entries 2nd
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11. Adjusting Entries for “. Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””11. Adjusting Entries for “. Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
Supplies (usage)
Pre-paid Insurance (time)
Pre-paid Advertising (time)
Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE
Pre-paid Rent (time)
Equipment (long time)
Buildings (long time)
Prepayments often occur in regard to:
These start off as assets! Pay cash and record the
expense initially as an asset, it turns into an expense
either with the passage of time or through use. The
adjusting entry increases (a debit) an expense and a
decreases (a credit) an asset. Note: not all accounts use
the term “pre-paid” in their title.
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Usage Adjustment: Sierra purchased supplies costing $2,500 on
October 5 recording the purchase by increasing (debiting) the asset Supplies
and crediting cash (not shown here). The balance of $2,500 on the October
31 trial balance needs to be adjusted because an inventory count at the close
of business on October 31 reveals that only $1,000 of supplies are still on
hand. This means $1,500 has been used up (2,500 – 1,000 = 1,500)
Supplies (the asset) 1,500
Supplies Expense 1,500Oct. 31
1.1. Adjusting Entries for “ Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””1.1. Adjusting Entries for “ Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
4-14
Over Time Adjustment: October, 1 Sierra pre-paid a $600 expense
for a one-year fire insurance policy with cash. Sierra recorded the payment by
increasing (debiting) the asset Prepaid Insurance. This account shows a
balance of $600 in the October 31 trial balance. However, insurance of $50
($600 ÷ 12) expires each month. So…. on Oct 31, the account needs a $50
adjustment!
Prepaid Insurance (the asset) 50
Insurance Expense 50Oct. 31
1.1. Adjusting Entries for “ Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””1.1. Adjusting Entries for “ Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
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Depreciation of Long-Lived Assets
Buildings, equipment, and vehicles (long-lived assets –
meaning used over years) are initially recorded as
assets, rather than expenses, in the year acquired.
Companies report a portion of the cost of the asset as
an expense (called depreciation expense) during each
period of the asset’s useful life. With each passing year
the total amount of depreciation is kept in an account
called accumulated depreciation.
Note: Depreciation does not attempt to report the actual
change in the market value of the asset.
1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
4-16
Over A Long Time Adjustment: Oct 2 paid $5,000 cash for Equipment.
Assume the depreciation on $5,000 is $40 per month ($480 yearly). Each month
the I/S will have a $40 expense. The B/S will accumulate the monthly expenses
by adding $40 to the Accumulated Depreciation account each month until it
reaches the total of $5,000 (when the equipment is fully depreciated)
Accumulated Depreciation-Equip. (B/S) 40
Depreciation Expense (I/S) 40Oct. 31
1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
4-17
B/S Presentation for Depreciation
Accumulated Depreciation-Equipment is a contra asset account. It
shows up as a credit and thus subtracted from the related asset which
has a debit balance (see example below).
It appears on the B/S just after the account it offsets (Equipment). The
$4,960 (see below) is referred to as the book value of the equipment.
Book value is not the same as its market value (what it would sell for
on the current open market). Look at slide 32 to see how this would
appear on the Balance Sheet.
1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””1. 1. Adjusting Entries for “Adjusting Entries for “Prepaid ExpensesPrepaid Expenses””
Book Value =
4-18
22. Adjusting Entries for “. Adjusting Entries for “Unearned RevenuesUnearned Revenues””22. Adjusting Entries for “. Adjusting Entries for “Unearned RevenuesUnearned Revenues””
rent
airline tickets
mowing lawns
Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE
magazine subscriptions
customer deposits
shoveling snow
Unearned revenues often occur in regard to:
These start off as liabilities (obligations). The original receipt of
cash (debit) is recorded along with a liability (credit) because the
revenue has not been earned yet. The adjusting entry records
any revenue that has been earned and shows any liability that
might remain. The adjusting entry shows a decrease (a debit) to
a liability and an increase (a credit) to a revenue.
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2. 2. Adjusting Entries for “Adjusting Entries for “Unearned RevenuesUnearned Revenues””2. 2. Adjusting Entries for “Adjusting Entries for “Unearned RevenuesUnearned Revenues””
Illustration: Sierra Corporation received $1,200 cash in advance on
October 2 from R. Knox for guide services for multi-day trips expected
to be completed by December 31. Unearned Service Revenue shows
a balance of $1,200 in the October 31 trial balance. For services
performed for Knox during October, Sierra determines that it has
earned $400 (of the $1,200) in October.
Service Revenue 400
Unearned Service Revenue 400Oct. 31
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3. 3. Adjusting Entries for “Adjusting Entries for “Accrued RevenuesAccrued Revenues””3. 3. Adjusting Entries for “Adjusting Entries for “Accrued RevenuesAccrued Revenues””
rent
interest
services performed (mowing lawns, shoveling snow)
BEFORE
Accrued revenues often occur in regard to:
Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded
These start off with receivables! The revenues have
been earned and need to be recorded, but the cash
hasn’t been received yet. This adjusting entry results
in a debit to accounts receivable and a credit to
some type of revenue.
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Illustration: In October, Sierra earned $200 for performing guide
services but was not immediately paid. Sierra sent out bills for these
services but the bill wasn’t mailed out until the first week of
November. An adjusting entry is needed at the end of Oct. to record
the revenue and the receivable.
Service Revenue 200
Accounts Receivable 200Oct. 31
3. 3. Adjusting Entries for “Adjusting Entries for “Accrued RevenuesAccrued Revenues””3. 3. Adjusting Entries for “Adjusting Entries for “Accrued RevenuesAccrued Revenues””
What if someone owed you Interest Receivable XXX Interest that you’ve earned? Interest Revenue XXX
4-22
4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””
BEFORE
Accrued expenses often occur in regard to:
Cash PaymentCash PaymentExpense RecordedExpense Recorded
taxes
salaries
rent
interest
These start off with payables! These expenses have
been incurred and need to be recorded, but the cash
hasn’t been paid yet. The adjusting entry results in a
debit to an expense and a credit to a liability (e.g.,
accounts payable).
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4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””
Illustration: Sierra signed a 3 month note payable of $5,000 on Oct.1. The note requires Sierra to pay interest at an annual rate of 12%. First we multiply $5,000 by 12%. Then multiply by the fraction of the year being calculated (if 1 month multiply by 1/12,; if 2 months use 2/12; and so on)
Interest Payable 50
Interest Expense 50Oct. 31
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4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””
Illustration: Sierra Corporation last paid salaries on October 26; the
next payment of salaries will not occur until November 9 (every two
weeks). The employees earn $400 a day ($2,000 for a 5 day work
week. This means accrued salaries at October 31 are $1,200 ($400 ×
3 days). See the next slide for the adjusting journal entry.
4-25
4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””4. 4. Adjusting Entries for “Adjusting Entries for “Accrued ExpensesAccrued Expenses””
Illustration: Sierra Corporation last paid salaries on October 26;
the next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 x 3 days).
Salaries Payable 1,200
Salaries Expense 1,200Oct. 31
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The Trial Balance “Before” Adjustments(this is from Chapter 3)
The Trial Balance “Before” Adjustments(this is from Chapter 3)
4-27
Summary of all the Summary of all the AdjustingAdjusting Journal Entries Journal EntriesSummary of all the Summary of all the AdjustingAdjusting Journal Entries Journal Entries
4-28
After all adjusting entries are journalized and posted the
company prepares another trial balance from the ledger
accounts: The “Adjusted” Trial Balance.
The adjusted trial balance’s purpose is to prove the
equality of debit balances and credit balances in the
ledger and is the primary basis for preparing the
Financial Statements!
The The AdjustedAdjusted Trial Balance Trial BalanceThe The AdjustedAdjusted Trial Balance Trial Balance
4-29
The The Adjusted Trial BalanceTrial BalanceThe The Adjusted Trial BalanceTrial Balance
SO 6SO 6
4-30
F/S are prepared directly from the
Adjusted Trial Balance - in this Order!
F/S are prepared directly from the
Adjusted Trial Balance - in this Order!
Balance Sheet
A = L & E
Income Statement
Rev - Exp
Retained Earnings
Statement
Any Div?
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
4-31
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
4-32
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
4-33
At the end of the accounting period, companies transfer the temporary
account balances to the permanent stockholders’ equity account -
Retained Earnings. At the beginning of the next period these balances
start over with zero balances. Closing entries should not be confused
with adjusting entries.
Closing the BooksClosing the BooksClosing the BooksClosing the Books
Common StockRetained Earnings
These 3 all get transferred to Retained Earnings
4-34
1. Service Revenue 10,600
Retained Earnings 10,600 Sierra’s
_________________________________ Retained Earnings
Beg Bal 0
2. Retained Earnings 7,740 10,600
Salaries Expense 5,200 7,740
Supplies Expense 1,500 500
Rent Expense 900 _______________
Insurance Expense 50 $ 2,360
Interest Expense 50
Depreciation Expense 40 Example: look at slide 25!
_________________________________ The Sal/Exp is credited to
transfer the balance to R/E
3. Retained Earnings 500 Sal/Exp is now 0 and starts
Dividends 500 over in the next period
Sierra’s Closing EntriesSierra’s Closing Entries
4-35
The purpose of the post-closing trial balance is to prove the equality of
the permanent account balances that the company carries forward into
the next accounting period. But remember the adjusted trial balance is
the the primary basis for the F/S preparation
Preparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial Balance
All temporary accounts will have zero balances.
These 3 have been reduced to Zero by being closed out
to Retained Earnings!
Common StockRetained Earnings
4-36
Summary of the Accounting Cycle of the Accounting CycleSummary of the Accounting Cycle of the Accounting Cycle
1. Analyze business transactions1. Analyze business transactions
2. Journalize the transactions
2. Journalize the transactions
6. Prepare an adjusted trial balance
6. Prepare an adjusted trial balance
7. Prepare financial statements
7. Prepare financial statements
8. Journalize and post closing entries
8. Journalize and post closing entries
9. Prepare a post-closing trial balance
9. Prepare a post-closing trial balance
4. Prepare a trial balance4. Prepare a trial balance
3. Post to ledger accounts3. Post to ledger accounts
5. Journalize and post adjusting entries:Deferrals/Accruals
5. Journalize and post adjusting entries:Deferrals/Accruals
4-37
Once again, the Debit Credit Summary
Chapter 3-26
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
RevenueRevenue
Chapter 3-27
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
ExpenseExpense
Chapter 3-23
AssetsAssets
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Chapter 3-24
LiabilitiesLiabilities
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Chapter 3-25
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
StockholdersStockholders’’ EquityEquity
Chapter 3-25
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Common StockCommon Stock
Chapter 3-23
DividendsDividends
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
= +
Assets, Expenses & Dividends all go up with DebitsLiabilities, Owners Equity (Common Stock & Retained Earnings)
& Revenues all go up with Credits
Chapter 3-25
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Retained EarningsRetained Earnings
DEAD = Debits increase Expenses, Assets, and Dividends
CLEaR = Credits increase Liabilities, Equity (Common Stock
& Retained Earnings) and Revenues
4-38
Simple Summary For A Sole Proprietor
Chapter 3-26
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
RevenueRevenue
Chapter 3-27
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
ExpenseExpense
Chapter 3-23
AssetsAssets
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Chapter 3-24
LiabilitiesLiabilities
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
Chapter 3-25
Debit / Dr. Credit / Cr.
Normal BalanceNormal Balance
StockholdersStockholders’’ EquityEquity
= +
Assets & Expenses go up with DebitsLiabilities, Owners Equity & Revenues all go up with Credits
DEAD = Debits increase Expenses & Assets
CLEaR = Credits increase Liabilities, Equity and Revenues
Owner’s Equity