2. 1 Financial Accounting: Tools for Business Decision Making, 2nd Ed. Kimmel, Weygandt, Kieso ELS

3. Chapter 4

4. 3 Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: zExplain the revenue recognition principle and the matching principle. zDifferentiate between the cash basis and the accrual basis of accounting. zExplain why adjusting entries are needed and identify the major types of adjusting entries. zPrepare adjusting entries for prepayments.

5. 4 Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: zPrepare adjusting entries for accruals. zDescribe the nature and purpose of the adjusted trial balance. zExplain the purpose of closing entries. zDescribe the required steps in the accounting cycle.

6. 5 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.

7. 6 Time Period Assumption... Generally a month, a quarter, or a year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year. An accounting time period that is one year long is called fiscal year.

8. 7 Revenue Recognition Principle... zdictates that revenue be recognized in the accounting period in which it is earned. zis considered earned when the service has been provided or when the goods are delivered.

9. 8 Matching Principle... requires that expenses be recorded in the same period in which the revenues they helped produce are recorded.

10. 9 Illustration 4-1

11. 10 Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid.

12. 11 Cash Basis in not GAAP GAAP

13. 12 Accrual Basis Accounting Adheres to the: Revenue Recognition Principle Matching Principle

14. 13 Accrual Basis Accounting Revenue recorded only when earned not when cash is received Expense recorded only when incurred not when cash paid

15. 14 Accrual Basis adheres to... Generally Accepted Accounting Principles

16. Year 1 Year 2 Purchased paint, painted building, paid employees Received payment for work done in year one Activity Accrual basis Cash basis Revenue $80,000 Expense 50,000 Net Income $30,000 Revenue $ 0 Expense 50,000 Net Loss ( $50,000) Revenue $80,000 Expense 0 Net Income $80,000 Revenue $ 0 Expense 0 Net Income $ 0 Illustration 4-2

17. 16 Adjusting Entries Adjusting entries make the: z revenue recognition & z matching principles HAPPEN!

18. 17 Types of Adjusting Entries yPrepayments : xPrepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. xUnearned Revenues: Cash received and recorded as liabilities before revenue is earned yAccruals : xAccrued revenues: Revenues earned but not yet received in cash or recorded. xAccrued expenses: Expenses incurred but not yet paid in cash or recorded. Illustration 4-3

19. 18 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

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

21. Sierra Corporation Trial Balance October 31, 2001 Debit Credit Cash $15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $28,700 $28,700 Illustration 4-4

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

23. An inventory on October 31 reveals that $1,000 of supplies remain on hand;therefore $1,500 of supplies had been used. ($2,500- $1,000) =$ 1,500 GENERAL JOURNAL Debit Credit Oct 31 Supplies Expense 1,500 Supplies 1,500 To record advertising supplies consumed Supplies 2,500 Oct 5 Cash 2,500Oct 5 Supplies Expense Supplies 1,500Oct 311,500Oct 31 Illustration 4-6

24. Oct $1500 Mar $1435 Apr $1510 May $1592 Feb $1601 Nov $1800 Dec $1410 Jan $1425 June $1652 July $1621 Aug $1427 Sept $1555 Supplies expense is based on usage... so different amounts appear each month Supplies Expense

25. Prepaid Expenses On October 4 the company paid $600 for a 1-year insurance policy. Coverage began October 1. GENERAL JOURNAL Debit Credit Oct 4 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective October 1 Prepaid Insurance 600Oct 4 Cash 600Oct 4 Insurance Expense Illustration 4-7

26. Insurance Policy 1 Year $ 600 Oct $50 Mar $50 Apr $50 May $50 Feb $50 Nov $50 Dec $50 Jan $50 June $50 July $50 Aug $50 Sept $50 Illustration 4-7

27. Prepaid Expenses On October 31st, $50 ($600/12months) of the insurance was used-up or expired. GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 Record Insurance expense for the month Prepaid Insurance 600Oct 4 Cash 600Oct 4 Insurance Expense 50 Oct 3150 Oct 31 Illustration 4-7

28. 27 How do you apply the Matching Principle to the cost of a long lived asset ? Depreciation Illustration 4-8

29. 28 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! Depreciation

30. Office Equipment Depreciation= $480/year Oct $40 Mar $40 Apr $40 May $40 Feb $40 Nov $40 Dec $40 Jan $40 June $40 July $40 Aug $40 Sept $40 Illustration 4-8

31. GENERAL JOURNAL Debit Credit Oct 31 Depreciation Expense 40 Accumulated Depreciation-Office Equip 40 To record monthly depreciation Accumulated depreciation is a contra asset account - an offset against the fixed asset account. Accumulated Depreciation- Office Equipment 40Oct 31 Office Equipment 5000Oct 2 Depreciation Expense 40 Oct 31 Illustration 4-8

32. 31 Office equipment$ 5,000 Less : accumulated depreciation 40 $4,960 Balance Sheet Presentation Book Value Illustration 4-9

33. Unearned Revenues Received on Oct. 2 $1,200 for advertising services expected to be completed by 12/31. Unearned Service Revenue Cash 1,200Oct 2 1,200Oct 2 Service Revenue GENERAL JOURNAL Debit Credit Oct 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by 12/31. Illustration 4-10

34. Unearned Revenues During October $400 of the revenue was earned. Unearned Service Revenue Cash 1,200Oct 2 Service Revenue 1,200Oct 2 GENERAL JOURNAL Debit Credit Oct 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned Oct. 31 400 Illustration 4-10

35. 34 Accrual Revenue has been earned, but not collected Expenses were incurred, but not yet paid

36. 35 Accrued Revenues Revenues earned but not yet received in cash or recorded at the statement date

37. Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31st. GENERAL JOURNAL Debit Credit Oct 31 Accounts Receivable 200 Service Revenue 200 Accounts Receivable 200Oct 31 Service Revenue 200Oct 31 Illustration 4-12

38. 37 Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date.

39. Formula for Computing Interest Face Value of NoteInterest Time in term of One Year Annual Interest Rate $ 5,000 X 12% 1/12 =$50 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 Illustration 4-13

40. Interest ExpenseInterest Payable Oct 31 50 GENERAL JOURNAL Debit Credit Oct 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month Accrued Interest Illustration 4-14

41. Accrued Salaries - Salaries Paid for after the Service Has Been Performed. Illustration 4-15

42. Salaries ExpenseSalaries Payable Oct 31 1,200 GENERAL JOURNAL Debit Credit Oct 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month Accrued Salaries Illustration 4-15

43. 42 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. Adjusted Trial Balance

44. SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2001 SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2001 Illustration 4-20 SIERRA CORPORATION Income Statement For the Month Ended October 31, 2001

45. 44 Balance as Oct. 31 from Retained Earnings Statement SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2001 SIERRA CORPORATION Balance Sheet October 31, 2001 Illustration 4-21

46. 45 Closing the Books Closing entries transfer the temporary account balances to the stockholders’ equity account... and reduce the balances in the temporary accounts to zero.

47. Temporary Permanent All revenues accountsAll asset accounts All expense accountsAll liability accounts Dividends Stockholders’ equity accounts Illustration 4-22

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

49. 48 The Accounting Cycle

50. 49 Required Steps in the Accounting Cycle zAnalyze business transactions. zJournalize the transactions. zPost to ledger accounts. zPrepare a trial balance. zJournalize and post adjusting entries-- prepayments and accruals. zPrepare an adjusting trial balance.