ACCOUNTING 4
ACCRUAL CONCEPTS
4-1
Accounting, Fourth Edition
Study Objectives
1. 2. 3. 4. 5. 6. 7. 8. Explain the revenue recognition principle and the expense recognition principle. Differentiate between the cash basis and the accrual basis of accounting. Explain why adjusting entries are needed, and identify the major types of adjusting entries. Prepare adjusting entries for deferrals. Prepare adjusting entries for accruals. Describe the nature and purpose of the adjusted trial balance. Explain the purpose of closing entries. Describe the required steps in the accounting cycle.
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Timing Issues
Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption).
.....
Jan. Feb. Mar. Apr. Dec.
Generally a month, a quarter, or a year. Fiscal year vs. calendar year
4-3
SO 1 Explain the revenue recognition principle and the expense recognition principle.
Timing Issues
The Revenue Recognition Principle
Companies 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.
SO 1 Explain the revenue recognition principle and the expense recognition principle.
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Timing Issues
Illustration: Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. The journal entries for June and July would be:
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SO 1 Explain the revenue recognition principle and the expense recognition principle.
Timing Issues
Illustration 4-1 (Partial)
"Let the expenses follow the revenues."
SO 1 Explain the revenue recognition principle and the expense recognition principle.
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Timing Issues
Accrual versus Cash Basis of Accounting
Accrual-Basis Accounting
Transactions recorded in the periods in which the
events occur.
Revenues are recognized when earned, even if cash
was not received.
Expenses are recognized when incurred, even if cash
was not paid.
4-7
SO 2 Differentiate between the cash basis and the accrual basis of accounting.
Timing Issues
Accrual versus Cash Basis of Accounting
Cash-Basis Accounting
Revenues are recognized only when cash is received. Expenses are recognized only when cash is paid. Prohibited under generally accepted accounting
principles (GAAP).
4-8
SO 2 Differentiate between the cash basis and the accrual basis of accounting.
Timing Issues
Illustration: Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012.
Illustration 4-2 (Partial)
4-9
SO 2 Differentiate between the cash basis and the accrual basis of accounting.
The Basics of Adjusting Entries
Adjusting entries - needed to ensure that the revenue recognition and expense recognition principles are followed. 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. Includes one income statement account and one balance sheet account.
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SO 3
Explain why adjusting entries are needed, and identify the major types of adjusting entries
Types of Adjusting Entries
Deferrals: 1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned revenues: Cash received and reported as liabilities before revenue is earned.
Illustration 4-3 Categories of adjusting entries
Accruals: 1. Accrued revenues: Revenues earned but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.
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SO 3
Explain why adjusting entries are needed, and identify the major types of adjusting entries
Types of Adjusting Entries
Trial Balance Each account is analyzed to determine whether it is complete and upto-date.
Illustration 4-4
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SO 3
Explain why adjusting entries are needed, and identify the major types of adjusting entries
Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses OR Unearned revenues.
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Cash Payment
BEFORE
Expense Recorded
Prepayments often occur in regard to:
insurance supplies advertising rent equipment buildings
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Prepaid Expenses
Costs that expire either with the passage of time or through use. Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.
4-15
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Illustration: Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset 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. Oct. 31
Illustration 4-6 (Partial)
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Illustration: On October, 4 Sierra Corporation paid $600 for a oneyear 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 the October 31 trial balance. Insurance of $50 ($600 12) expires each month. Oct. 31
Illustration 4-7 (Partial)
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Depreciation
Buildings, equipment, and motor 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. Depreciation does not attempt to report the actual change in the value of the asset.
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Oct. 31
Illustration 4-8 (Partial)
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Statement Presentation
Accumulated Depreciation-Equipment a is contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet.
Illustration 4-9
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Prepaid Expenses"
Summary
Illustration 4-10
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Unearned Revenues"
Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt
BEFORE
Revenue Recorded
Unearned revenues often occur in regard to:
rent airline tickets magazine subscriptions customer deposits
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Unearned Revenues"
Unearned Revenues
Adjusting entry to record the revenue that has been earned and to show the liability that remains. Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Unearned Revenues"
Illustration: Sierra Corporation received $1,200 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. From an evaluation of the service Sierra performed for Knox during October, the company determines that it has earned $400 in October. Oct. 31
Illustration 4-12 (Partial)
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for "Unearned Revenues"
Summary
Illustration 4-13
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SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for Accruals
Made to record:
Revenues earned and OR Expenses incurred in the current accounting period that have not been recognized through daily entries.
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Revenues"
Revenues earned but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded
BEFORE
Cash Receipt
Accrued revenues often occur in regard to:
rent interest services performed
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Revenues"
Accrued Revenues
An adjusting entry serves two purposes: (1) Shows the receivable that exists, and (2) Records the revenues earned.
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Revenues"
Illustration: In October, Sierra Corporation earned $200 for guide services that were not billed to clients before October 31.
Oct. 31
Illustration 4-15
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Revenues"
Summary
Illustration 4-16
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Expenses"
Expenses incurred but not yet paid in cash or recorded. Adjusting entry results in: Expense Recorded
BEFORE
Cash Payment
Accrued expenses often occur in regard to:
rent interest
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taxes salaries
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Expenses"
Accrued Expenses
An adjusting entry serves two purposes: (1) Records the obligations, and (2) Recognizes the expenses.
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SO 5 Prepare adjusting entries for accruals.
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%.
Illustration 4-18
Oct. 31
Illustration 4-19 (Partial)
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued 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 3 days).
Illustration 4-20
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued 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). Oct. 31
Illustration 4-21
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SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for "Accrued Expenses"
Summary
Illustration 4-22
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SO 5 Prepare adjusting entries for accruals.
Summary of Basic Relationships
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SO 5 Prepare adjusting entries for accruals.
The Adjusted Trial Balance
After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance). The adjusted trial balance's purpose is to prove the equality of debit balances and credit balances in the ledger. The adjusted trial balance is the primary basis for the preparation of the financial statements.
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SO 6 Describe the nature and purpose of the adjusted trial balance.
Preparing Financial Statements
Illustration 4-27
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Preparing Financial Statements
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Illustration 4-28
Closing the Books
At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders' equity account--Retained Earnings.
Illustration 4-29
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SO 7 Explain the purpose of closing entries.
Closing the Books
In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.
Illustration 4-30
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SO 7 Explain the purpose of closing entries.
Closing the Books
2012
Illustration 4-31
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Closing the Books
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SO 7 Explain the purpose of closing entries.
Preparing a Post-Closing Trial Balance
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.
All temporary accounts will have zero balances.
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SO 7 Explain the purpose of closing entries.
Summary of the Accounting Cycle
1. Analyze business transactions 9. Prepare a postclosing trial balance Journalize and post closing entries Prepare financial statements Prepare an adjusted trial balance 2.
Illustration 4-33 Required steps in the accounting cycle
Journalize the transactions Post to ledger accounts Prepare a trial balance Journalize and post adjusting entries: Deferrals/Accruals
8.
3.
7.
4.
6.
5.
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SO 8 Describe the required steps in the accounting cycle.