CH4_PPT - ACCRUAL ACCOUNTING CONCEPTS 4-1 Financial...

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College Accounting, Chapters 1-27
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Chapter 5 / Exercise 1
College Accounting, Chapters 1-27
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Unformatted text preview: ACCRUAL ACCOUNTING CONCEPTS 4-1 Financial Accounting, Seventh Edition 4 Learning Learning Objectives Objectives After studying this chapter, you should be able to: 4-2 1. Explain the revenue recognition principle and the expense recognition principle. 2. Differentiate between the cash basis and the accrual basis of accounting. 3. Explain why adjusting entries are needed, and identify the major types of adjusting entries. 4. Prepare adjusting entries for deferrals. 5. Prepare adjusting entries for accruals. 6. Describe the nature and purpose of the adjusted trial balance. 7. Explain the purpose of closing entries. 8. Describe the required steps in the accounting cycle. Timing Timing Issues Issues Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption). Jan. 4-3 Feb. Mar. Apr. ..... Generally a month, a quarter, or a year. Fiscal year vs. calendar year Dec. LO 1 Explain the revenue recognition principle and the expense recognition principle. Timing Timing Issues Issues Review Question What is the periodicity assumption? a. Companies should recognize revenue in the accounting period in which it is earned. b. Companies should match expenses with revenues. c. The economic life of a business can be divided into artificial time periods. d. The fiscal year should correspond with the calendar year. 4-4 LO 1 Explain the revenue recognition principle and the expense recognition principle. Timing Timing Issues Issues The Revenue Recognition Principle Companies recognize revenue in the accounting period in which the performance obligation is satisfied. 4-5 LO 1 Explain the revenue recognition principle and the expense recognition principle. Timing Timing Issues 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: 4-6 LO 1 Explain the revenue recognition principle and the expense recognition principle. Timing Timing Issues Issues Illustration 4-1 (Partial) “Let the expenses follow the revenues.” 4-7 LO 1 Explain the revenue recognition principle and the expense recognition principle. Timing Timing Issues Issues Accrual versus Cash Basis of Accounting Accrual-Basis Accounting ► Transactions recorded in the periods in which the events occur. ► Revenues are recognized when services performed, even if cash was not received. ► Expenses are recognized when incurred, even if cash was not paid. 4-8 LO 2 Differentiate between the cash basis and the accrual basis of accounting. Timing Timing Issues 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). 4-9 LO 2 Differentiate between the cash basis and the accrual basis of accounting. Timing Timing Issues Issues Illustration: Suppose that Fresh Colors paints a large building in 2013. In 2013, 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 2014. Illustration 4-2 (Partial) 2013 4-10 2014 LO 2 Differentiate between the cash basis and the accrual basis of accounting. Timing Timing Issues Issues Review Question Which one of these statements about the accrual basis of accounting is false? 4-11 a. Companies record events that change their financial statements in the period in which events occur, even if cash was not exchanged. b. Companies recognize revenue in the period in which the performance obligation is satisfied. c. This basis is in accord with generally accepted accounting principles. d. Companies record revenue only when they receive cash, and record expense only when they pay out cash. LO 2 Differentiate between the cash basis and the accrual basis of accounting. The The Basics Basics of of Adjusting Adjusting Entries Entries Adjusting entries 4-12 ensure that the revenue recognition and expense recognition principles are followed. are required every time a company prepares financial statements. includes one income statement account and one balance sheet account. never include cash. LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries The The Basics Basics of of Adjusting Adjusting Entries Entries Review Question Adjusting entries are made to ensure that: 4-13 a. expenses are recognized in the period in which they are incurred. b. revenues are recognized in the period in which the performance obligation is satisfied. c. balance sheet and income statement accounts have correct balances at the end of an accounting period. d. All of the above. LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Types Types of of Adjusting Adjusting Entries Entries Illustration 4-3 Categories 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 before service are performed. Accruals: 4-14 1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Types Types of of Adjusting Adjusting Entries Entries Trial Balance – Each account is analyzed to determine whether it is complete and upto-date. Illustration 4-4 4-15 LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Adjusting Adjusting Entries Entries for for Deferrals Deferrals Deferrals are either: Prepaid expenses OR 4-16 Unearned revenues. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” 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: 4-17 insurance rent supplies equipment advertising buildings LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Prepaid Expenses 4-18 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. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Adjusting entries for prepaid expenses Illustration 4-5 4-19 Increases (debits) an expense account and Decreases (credits) an asset account. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” 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 Supplies Expense Supplies ($2,500 – 1,000 = $1,500) 4-20 1,500 1,500 Illustration 4-6 (Partial) LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” 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 Insurance Expense 50 Prepaid Insurance 50 Illustration 4-7 (Partial) 4-21 LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Depreciation 4-22 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. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Oct. 31 Depreciation Expense 40 Accumulated Depreciation-Equipment 40 Illustration 4-8 (Partial) 4-23 LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Statement Presentation Accumulated DepreciationEquipment is a contra asset account. Appears just after the account it offsets (Equipment) on the balance sheet. Illustration 4-9 4-24 LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Prepaid “Prepaid Expenses” Expenses” Summary Illustration 4-10 4-25 LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Unearned “Unearned Revenues” Revenues” Receipt of cash recorded as a liability before services are performed. Cash Receipt BEFORE Revenue Recorded Unearned revenues often occur in regard to: 4-26 rent magazine subscriptions airline tickets customer deposits LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Unearned “Unearned Revenues” Revenues” Unearned Revenues 4-27 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. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Unearned “Unearned Revenues” Revenues” Adjusting entries for unearned revenues Illustration 4-11 4-28 Decrease (a debit) to a liability account and Increase (a credit) to a revenue account. LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Unearned “Unearned Revenues” 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 Unearned Service Revenue Service Revenue 400 400 Illustration 4-12 (Partial) 4-29 LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for “Unearned “Unearned Revenues” Revenues” Summary Illustration 4-13 ACCOUNTING FOR UNEARNED REVENUES Examples Rent, magazine subscriptions, customer deposits for future service 4-30 Reason for Adjustment Accounts Before Adjustment Adjusting Entry Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed Liabilities overstated. Revenues understated. Dr. Liabilities Cr. Revenues LO 4 Prepare adjusting entries for deferrals. Adjusting Adjusting Entries Entries for for Accruals Accruals Made to record: Revenues earned and OR Expenses incurred in the current accounting period that have not been recognized through daily entries. 4-31 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Revenues for services performed but not yet received in cash or recorded. Adjusting entry results in: Revenue Recorded BEFORE Cash Receipt Accrued revenues often occur in regard to: 4-32 rent interest services performed LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Accrued Revenues An adjusting entry serves two purposes: (1) Shows the receivable that exists, and (2) Records the revenues for services performed. 4-33 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Adjusting entries for accrued revenues Illustration 4-14 4-34 Increases (debits) an asset account and Increases (credits) a revenue account. LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Illustration: In October, Sierra Corporation performed guide services for $200 that were not billed to clients before October 31. Oct. 31 Accounts Receivable Service Revenue 200 200 Illustration 4-15 4-35 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Revenues” Revenues” Summary Illustration Illustration 4-16 4-16 ACCOUNTING FOR ACCRUED REVENUES 4-36 Examples Reason for Adjustment Accounts Before Adjustment Adjusting Entry Interest, rent, services performed but not collected Services performed but not yet received in cash or recorded Assets understated. Revenues understated. Dr. Assets Cr. Revenues LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” 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: 4-37 rent taxes interest salaries LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Accrued Expenses An adjusting entry serves two purposes: (1) Records the obligations, and (2) Recognizes the expenses. 4-38 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Adjusting entries for accrued expenses Illustration 4-17 4-39 Increases (debits) an expense account and Increases (credits) a liability account. LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” 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 Interest Expense 50 Interest Payable 50 Illustration 4-19 (Partial) 4-40 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” 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 4-41 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” 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 Salaries and Wages Expense Salaries and Wages Payable 1,200 1,200 Illustration 4-21 4-42 LO 5 Prepare adjusting entries for accruals. Adjusting Adjusting Entries Entries for for “Accrued “Accrued Expenses” Expenses” Summary Illustration 4-22 4-43 LO 5 Prepare adjusting entries for accruals. Summary Summary of of Basic Basic Relationships Relationships Illustration 4-23 Summary of adjusting entries 4-44 LO 5 Prepare adjusting entries for accruals. The The Adjusted Adjusted Trial Trial Balance 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. 4-45 LO 6 Describe the nature and purpose of the adjusted trial balance. The The Adjusted Adjusted Trial Trial Balance Balance Illustration 4-26 Adjusted trial balance 4-46 LO 6 The The Adjusted Adjusted Trial Trial Balance Balance Review Question Which of the following statements is incorrect concerning the adjusted trial balance? 4-47 a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. b. The adjusted trial balance provides the primary basis for the preparation of financial statements. c. The adjusted trial balance lists the account balances segregated by assets and liabilities. d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. LO 6 Describe the nature and purpose of the adjusted trial balance. Preparing Preparing Financial Financial Statements Statements Financial Financialstatements statementsare areprepared prepareddirectly directlyfrom from the the Adjusted AdjustedTrial Trial Balance. Balance. Income Statement 4-48 Retained Earnings Statement Balance Sheet LO 6 Describe the nature and purpose of the adjusted trial balance. Preparing Preparing Financial Financial Statements Statements Illustration 4-27 4-49 Preparing Preparing Financial Financial Statements Statements 4-50 Illustration 4-28 Closing Closing the the Books 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 4-51 LO 7 Explain the purpose of closing entries. Closing Closing the the Books 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 4-52 LO 7 Explain the purpose of closing entries. Closing Closing the the Books Books 2014 Illustration 4-31 4-53 Closing Closing the the Books Books Illustration 4-32 Posting of closing entries 4-54 LO 7 Explain the purpose of closing entries. Preparing Preparing aa Post-Closing Post-Closing Trial Trial Balance 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. 4-55 LO 7 Explain the purpose of closing entries. Summary Summary of of the the Accounting Accounting Cycle Cycle 1. Analyze business transactions 9. Prepare a post-closing trial balance 2. Journalize the transactions 8. Journalize and post closing entries 3. Post to ledger accounts 7. Prepare financial statements 4. Prepare a trial balance 6. Prepare an adjusted trial balance 4-56 Illustration 4-33 Required steps in the accounting cycle 5. Journalize and post adjusting entries: Deferrals/Accruals LO 8 Describe the required steps in the accounting cycle. Steps Steps in in Preparing Preparing aa Worksheet Worksheet 1. Prepare a Trial Balance on the Worksheet 4-57 Illustration 4A-1 LO 10 Describe the purpose and the basic form of a worksheet. Steps Steps in in Preparing Preparing aa Worksheet Worksheet 1. Prepare a Trial Balance on the Worksheet Illustration 4A-1 Trial balance amounts come directly from ledger accounts. Include all accounts with balances. 4-58 LO 10 Describe the purpose and the basic form of a worksheet. Using Using aa Worksheet Worksheet Illustration 4-24 General journal showing adjusting entries 2012 Adjusting Journal Entries 4-59 LO 10 Steps Steps in in Preparing Preparing aa Worksheet Worksheet 2. Enter the Adjustments in the Adjustments Columns (a) (b) (d) (d) (g) (e) (a) (b) Adjustments Key: (a) Supplies Used. (b) Insurance Expired. (c) Depreciation Expensed. (d) Ser...
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