1 Financial Accounting: Tools for Business Decision Making Kimmel, Weygandt, Kieso, Trenholm KIMMEL
2 Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: 1.Explain the revenue recognition principle and the matching 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 prepayments.
3 Chapter 4 Accrual Accounting Concepts After studying Chapter 4, you should be able to: 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.
4 Time Period Assumption +Divides the economic life of a business into artificial time periods +Interim period (month, quarter) +Year (fiscal, calendar) +WHY? +To provide immediate feedback on how the business is doing
5 Revenue Recognition Principle +Dictates that revenue be recognized in the accounting period in which it is earned +Revenue is considered earned when the service has been provided or when the goods are delivered
6 Matching Principle +Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded
8 Cash Basis +Revenue recorded only when cash received +Expense recorded only when cash paid NOT GAAP
9 Accrual Basis Accounting +Adheres to the +Revenue recognition principle +Matching principle +Revenue recorded when earned, not only when cash received +Expense recorded when incurred, not only when cash paid GAAP
10 Adjusting Entries +Adjusting entries make the revenue recognition and matching principles HAPPEN!
12 +Cash or other asset has been spent but the item acquired has not been used or consumed (prepaid expenses) +Cash has been collected before revenue is earned (unearned revenues) Prepayments
You can start with the trial balance to find information to adjust prepayments
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 Shares 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $28,700 $28,700 Illustration 4-4
On October 5 the company paid $2,500 for advertising supplies. GENERAL JOURNAL Debit Credit Oct 5 Advertising Supplies 2,500 Cash 2,500 Purchased advertising supplies Advertising Supplies 2,500Oct 5 Cash 2,500Oct 5 Advertising Supplies Expense Supplies
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 5 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 To record advertising supplies consumed Advertising Supplies 2,500 Oct 5 Cash 2,500Oct 5 Advertising Supplies Expense Supplies 1,500Oct 311,500Oct 31 Bal. 1,000
Oct $1,500 Mar $1,435 Apr $1,510 May $1,592 Feb $1,601 Nov $1,800 Dec $1,410 Jan $1,425 June $1,652 July $1,621 Aug $1,427 Sept $1,555 Advertising supplies expense is based on usage... so different amounts appear each month Advertising Supplies Expense
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
Prepaid Expenses On October 31st, $50 ($600/12 months) 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
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
21 Amortization + How do you apply the matching principle to the cost of a long- lived asset?
22 Amortization +Allocate the cost of an asset to expense over its useful life +Amortization is an allocation concept, not a valuation concept We’re not attempting to reflect the actual change in value of an asset!
Office Equipment Amortization= $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 $40
GENERAL JOURNAL Debit Credit Oct 31 Amortization Expense 40 Accumulated Amortization-Office Equip 40 To record monthly amortization Accumulated Amortization is a contra asset account - an offset against the capital asset account Accumulated Amortization- Office Equipment 40Oct 31 Office Equipment 5000Oct 2 Amortization Expense 40 Oct 31
25 Office equipment$ 5,000 Less : Accumulated amortization 40 4,960 Balance Sheet Presentation Net book value
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.
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 Bal. 800
28 Accruals +Revenue has been earned, but not collected (accrued revenues) +Expenses were incurred, but not yet paid (accrued expenses) No entry recorded yet!
29 Accrued Revenues +Revenues earned but not yet received in cash or recorded at the end of period
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
31 Accrued Expenses +Expenses incurred but not yet paid or recorded at the end of period
Formula for Calculating Interest Face Value of NoteInterest Time in Terms 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
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 Expense
Accrued Salaries Expense (Salaries Paid for after the Service Has Been Performed)
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 Expense
36 Adjusted Trial Balance +Adjusted trial balance proves 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
39 Closing the Books +Closing entries +Transfer the temporary account balances to update the retained earnings account +Reduce the balances in the temporary accounts to zero to prepare for the next period’s postings
Temporary Permanent All revenues accountsAll asset accounts All expense accountsAll liability accounts Dividends Shareholders’ equity accounts Illustration 4-23
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
43 Required Steps in the Accounting Cycle 1.Analyse business transactions 2.Journalize the transactions 3.Post to ledger accounts 4.Prepare a trial balance 5.Journalize and post adjusting entries-prepayments and accruals
44 Required Steps in the Accounting Cycle 6.Prepare an adjusting trial balance 7.Prepare financial statements 8.Journalize and post closing entries 9.Prepare a post-closing trial balance
45 Decision Checkpoints +At what point should the company record revenue? +At what point should the company record expenses?