2DEFINITIONS Revenues Expenses Inflows of assets or settlements of liabilities during a period from delivering or producing goods or services.ExpensesOutflows of assets or incurrence of liabilities during a period from delivering or producing goods or services.Incurred in an attempt to produce revenues3333
3Increases owner’s equity. Decreases owner’s equity. Revenue and ExpensesThe price for goods soldand services rendered during a given accounting period.Increases owner’s equity.The costs of goods and services used up in the process of earning revenue.Decreases owner’s equity.
4Debits and Credits for Revenue and Expense Expenses decrease owner’s equity.Revenues increase owner’s equity.EQUITIESDebit for DecreaseCredit for IncreaseEXPENSESCredit for DecreaseDebit for IncreaseREVENUESDebit for DecreaseCredit for Increase
5REVENUE PRINCIPLERevenue should be recognized in the financial statement when . . .It is earned, andIt is realized or realizable(Measurable)7777
6REVENUE PRINCIPLERevenue is earned when the earnings process is completed or virtually completed.Revenue is realized when cash is received.Revenue is realizable when claims to cash are received that can be converted into a known amount of cash.8888
7Revenue is typically recognized: REVENUE PRINCIPLERevenue is typically recognized:At delivery (point of sale)After deliveryBefore deliveryof product or service9999
8REVENUE RECOGNITION POINTS before deliveryRecognitionat deliveryRecognitionafter deliveryDesign and production,construction in progress,minerals discoveredGoods completedand ready for sale,contract completeDelivery ofproduct orserviceCash collectedfor goods orservicesRight ofreturn expiresPercentage-ofcompletion methodProductionmethodPointof salemethodInstallmentmethodRight ofreturnexpirationmethodCompletedcontractmethodCostrecoverymethodRELEVANCERELIABILITY
9REVENUE RECOGNITION Point of Sale Revenue is earned and realized at the point of sale.The product or service has been delivered to the customer and cash has been received or is receivable.This method is sometimes called the “sales method,” or “delivery method.”10101010
10REVENUE RECOGNITION After Delivery Uncertainties about collectibility or future performance by seller.Sale with right of return.Product-financing arrangements.11111111
11INSTALLMENT SALESWhen we are uncertain about the collectibility of the sales revenue or the ability of the seller to deliver futures services, we should defer revenue recognition.Two commonly used accounting methods are the . . .Installment sales method.Cost recovery method.15151515
12INSTALLMENT SALES Installment Sales Method Sale and cost of sale recorded as usual.Compute gross margin rate on the installment sales.Recognize gross margin as cash is received.Gross margin not realized is deferred until a future period.16161616
13INSTALLMENT SALES Example Sam’s Appliances made sales of $200,000 in 20xx that qualified for the installment sales method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx.Prepare the journal entries to record the installment sales transactions during 20xx.17171717
23UNCERTAINTY IS GREATER! COST RECOVERY METHODLike the installment sales method, cost recovery is used when we are uncertain about the collectibility of the sales revenue or the ability of the seller to complete future performance.UNCERTAINTY IS GREATER!No profit is recognized until cost of item sold is fully recovered.27272727
24COST RECOVERYSam’s Appliances made sales of $200,000 in 20xx that qualified for the cost recovery method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx.Prepare the journal entries to record the installment sales transactions during 20xx.28282828
28COST RECOVERY No profit is recognized in 20xx because the cost of the item sold ($130,000) has not been recovered in theform of cash receipts. Once we collect $130,000 incash, profit recognition begins.32323232
29All gross profit has been deferred until we recover the COST RECOVERYBalance SheetAll gross profit has been deferred until we recover the$130,000 cost of the item sold.33333333
30Equipment Manufacturing RIGHT OF RETURNIn some industries it is common practice that the sales terms allow customers the right to return goods under specified conditions and over long periods of time.Equipment ManufacturingBook Publishing13131313
31Recognize revenue at point of sale if, RIGHT OF RETURNRecognize revenue at point of sale if,Selling price is fixed or determinable.Buyer is obligated to pay the seller and payment is not contingent upon resale of the product.Buyer is obligated even in case of theft or physical destruction.Buyer has economic substance apart from that provided by the seller.Seller has no obligation for future performance.Future returns can be estimated.14141414
32PRODUCT-FINANCING ARRANGEMENTS An agreement in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product.The sponsoring companyRecords a liability when the proceeds are received.No sale is recorded and inventory is not adjusted.Wait for a sale to outside party.12121212
33REVENUE RECOGNITION Before Delivery Accounting for long-term construction contractsCompleted-Contract MethodPercentage-of-Completion Method34343434
34REVENUE RECOGNITION Before Delivery Percentage-of-completion method is appropriate when . . .Contract specifies the amount of consideration to be exchanged and the terms of settlement.Buyer is expected to satisfy the obligation.Contractor can perform according to the terms of the contract.35353535
35MEASURING PROGRESS TOWARD COMPLETION Input MeasuresEffort devoted to project compared to total effort expected (cost incurred to date compared to total estimated costs)Output MeasuresResults to date compared to total results36363636
36MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost MethodTotal costs incurred to datePercent complete =Most recent estimate of totalcosts of the project37373737
37MEASURING PROGRESS TOWARD COMPLETION Cost-to-Cost MethodCurrent Period RevenueTotal Revenue from Contract× Percent CompleteTotal Revenue to Recognize- Revenue Recognized in Prior Periods= Revenue Recognized in Current Period38383838
38LONG-TERM CONTRACTS Example During 20xx, West, Inc. enters into a contract with Putnam County to build a bridge over Cane River. The project will take 3 years to complete and has a fixed price of $4,500,000. West’s engineers estimate the total cost of the bridge to be $3,000,000. At the end of 20xx, the information on the next page was gathered by West’s accountant.39393939
39LONG-TERM CONTRACTS Example West uses the percentage-of-completionmethod to account for all long-termconstruction projects.Prepare the necessary 20xx journal entriesfor this project.40404040
44LONG-TERM CONTRACTS Example If West uses the Completed-Contract method, norevenue is recognized during 19X6. Allrevenue and profit is recognized at theend of the contract when delivery of the bridge toPutnam County is made.45454545
45REVENUE RECOGNITION Before Delivery Completion of ProductionAccretion BasisDiscovery Basis46464646
46REVENUE RECOGNITION Service Sales Specific Performance MethodProportional Performance MethodCompleted Performance MethodCollection47474747
47SPECIFIC PERFORMANCEUsed to account for revenue that is earned by performing a single act.Franchise revenue (SFAS No. 45)Bob’sBurgers48484848
48PROPORTIONAL PERFORMANCE Used to recognize service revenue that is earned by more than a single act and when the service is rendered in more than one accounting period.Similar performance acts - equal amount for each actDissimilar performance acts - in proportion to direct costs of each actSimilar acts with a fixed period for performance49494949
49COMPLETED PERFORMANCE Used when revenue is earned by performing a series of acts, and the last act is so important that revenue is only considered earned if it is performed.50505050
50COLLECTIONUsed to account for service revenue when the uncertainty of collection is very high.Revenue recognized when cash is received.51515151
51EXPENSE RECOGNITIONExpenses are outflows of assets or incurrences of liabilities during a period from delivery or producing goods or rendering services.52525252
52MATCHINGOnce revenues are determined, the expenses incurred in generating the revenue should be recognized.As revenues are earned, certain assets are consumed and services are used.53535353
53Expenses What is expenses? What impact do expenses have on equity? The costs associated with producing revenue.What impact do expenses have on equity?Expenses represent a decrease in equity resulting from the cost of producing revenue.Examples????
55Expenses A company pays wages of $250. Before using expense accounts: Dr. Owner’s Equity $250Cr. Cash $250Using expense accounts:Dr. Wages Expense $250Cr. Cash $250
56GAINS AND LOSSESGains and losses result from peripheral or incidental transactions, events, or circumstances.Most gains and losses are recognized when the transaction is completed.Estimated losses are recognized before realization if they are probable and can be reasonably estimated.55555555
57TIME PERIOD ASSUMPTION The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year.Periods of less than one year are called interim periods.The accounting time period of one year in length is usually known as a fiscal year.1
58REVENUE RECOGNITION PRINCIPLE The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned.In a service business, revenue is usually considered to be earned at the time the service is performed.In a merchandising business, revenue is usually earned at the time the goods are delivered.2
59THE MATCHING PRINCIPLE The practice of expense recognition is referred to as the matching principle.The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).Revenuesearnedthis monthare offsetagainst....expensesincurred inearning therevenue3
60ACCRUAL BASIS OF ACCOUNTING Adheres to theRevenue recognition principleMatching principleRevenue recorded when earned, not only when cash received.Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid.GAAP
61CASH BASIS OF ACCOUNTING PowerPoint SlidesCASH BASIS OF ACCOUNTINGNOT GAAPRevenue recorded only when cash received.Expense recorded only when cash paid.5
62HAPPEN! ADJUSTING ENTRIES Adjusting entries make the revenue recognition and matching principlesHAPPEN!
63TRIAL BALANCEThe Trial Balance is analysed to determine the need for adjusting entries.
64ADJUSTING ENTRIESAdjusting entries are required each time financial statements are prepared.Adjusting entries can be classified as1. prepayments (prepaid expenses or unearned revenues),2. accruals (accrued revenues or accrued expenses), or3. estimates (amortization).5
65TYPES OF ADJUSTING ENTRIES Prepayments1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed.2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned.
66TYPES OF ADJUSTING ENTRIES Accruals1. 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.
67TYPES OF ADJUSTING ENTRIES Estimates1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.
68PREPAYMENTSPrepayments are either prepaid expenses or unearned revenues.Adjusting entries for prepayments are required to record the portion of the prepayment that represents1. the expense incurred or,2. the revenue earned in the current accounting period.
69PREPAID EXPENSESPrepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed.Prepaid expenses expire with the passage of time or through use and consumption.An asset-expense account relationship exists with prepaid expenses.6
70PREPAID EXPENSESPrior to adjustment, assets are overstated and expenses are understated.The adjusting entry results in a debit to an expense account and a credit to an asset account.Examples of prepaid expenses include supplies, rent, insurance, and property tax.7
71UNEARNED REVENUESUnearned revenues are revenues received and recorded as liabilities before they are earned.Unearned revenues are subsequently earned by performing a service or providing a good to a customer.A liability-revenue account relationship exists with unearned revenues.10
72UNEARNED REVENUESPrior to adjustment, liabilities are overstated and revenues are understated.The adjusting entry results in a debit to a liability account and a credit to a revenue account.Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition.
74ACCRUALS A different type of adjusting entry is accruals. Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period.The adjusting entry for accruals will increase both a balance sheet and an income statement account.
75ACCRUED REVENUESAccrued revenues may accumulate with the passing of time or through services performed but not billed or collected.An asset-revenue account relationship exists with accrued revenues.Prior to adjustment, assets and revenues are understated.The adjusting entry requires a debit to an asset account and a credit to a revenue account.Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.
76ACCRUED EXPENSESAccrued expenses are expenses incurred but not yet paid.A liability-expense account relationship exists.Prior to adjustment, liabilities and expenses are understated.The adjusting entry results in a debit to an expense account and a credit to a liability account.Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.
77FORMULA TO CALCULATE INTEREST Face Value of NoteAnnual Interest RateTime(in Terms of One Year)Interestxx=$5,000 x % x /12 = $25
79AMORTIZATIONAmortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner.Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.
80AMORTIZATIONAmortization is an estimate rather than a factual measurement of the cost that has expired.We’re not attempting to reflect theactual change in value of an asset!
81Accumulated Amortization In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited.The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset.xxx xxxAmortization ExpenseAccumulated Amortization
82Balance Sheet Presentation AMORTIZATIONBalance Sheet PresentationOffice equipment $5,000Less: Accumulated amortizationNet book value $4,917
83SUMMARY OF ADJUSTING ENTRIES 1.Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets2.Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues3.Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understated Cr. Revenues4.Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities5.Amortization Expense and Expenses understated Dr. Amort. Exp contra asset Assets overstated Cr. Accum AmortizationAccountAccounts beforeAdjustingType ofAdjustmentRelationshipAdjustmentEntry
84ADJUSTED TRIAL BALANCE An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted.It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period.It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made.Financial statements can be prepared directly from the adjusted trial balance.
85TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED
86PREPARING FINANCIAL STATEMENTS Financial statements can be prepared directly from an adjusted trial balance.1. The income statement is prepared from the revenue and expense accounts.2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement.3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.
87PREPARATION OF THE INCOME STATEMENT AND THE STATEMENT OF OWNER’S EQUITY FROM THE ADJUSTED TRIAL BALANCE
88PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE From Statement of Owner’s Equity
89STEPS IN THE ACCOUNTING CYCLE 1. Analyse transactions2. Journalize the transactions9. Coming next chapter3. Post to ledger accounts8. Coming next chapter4. Prepare a trial balance7. Prepare financial statements5. Journalize and post adjusting entries6. Prepare adjusted trial balance