4-1

4-2 Accrual Accounting Concepts Kimmel ● Weygandt ● Kieso Financial Accounting, Eighth Edition 4

4-3 Prepare adjusting entries for deferrals. CHAPTER OUTLINE Explain the accrual basis of accounting and the reasons for adjusting entries. 1 2 LEARNING OBJECTIVES Prepare adjusting entries for accruals. 3 Prepare an adjusted trial balance and closing entries. 4

4-4 LEARNING OBJECTIVE Explain the accrual basis of accounting and the reasons for adjusting entries. 1 LO 1  Generally a month, a quarter, or a year.  Fiscal year vs. calendar year. Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption). Jan.Feb.Mar.Apr.Dec ▼ HELPFUL HINT An accounting time period that is one year long is called a fiscal year.

4-5 Periodicity Assumption Review Question What is the periodicity assumption?  Companies should recognize revenue in the accounting period in which it is earned.  Companies should match expenses with revenues.  The economic life of a business can be divided into artificial time periods.  The fiscal year should correspond with the calendar year. LO 1

4-6 Companies recognize revenue in the accounting period in which the performance obligation is satisfied. REVENUE RECOGNITION PRINCIPLE LO 1

4-7 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: REVENUE RECOGNITION PRINCIPLE LO 1

4-8 “Let the expenses follow the revenues.” ILLUSTRATION 4-1 EXPENSE RECOGNITION PRINCIPLE LO 1

4-9 ILLUSTRATION 4-1 GAAP relationships in revenue and expense recognition EXPENSE RECOGNITION PRINCIPLE LO 1

4-10 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. ACCRUAL VERSUS CASH BASIS LO 1

4-11 Cash-Basis Accounting ► Revenues are recognized only when cash is received. ► Expenses are recognized only when cash is paid. ► Not in accordance with generally accepted accounting principles (GAAP). ACCRUAL VERSUS CASH BASIS LO 1

Illustration: Suppose that Fresh Colors paints a large building in In 2016, 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 ACCRUAL VERSUS CASH BASIS ILLUSTRATION 4-2 Accrual-versus cash-basis accounting LO 1

4-13 Periodicity Assumption Review Question Which one of these statements about the accrual basis of accounting is false?  Companies record events that change their financial statements in the period in which events occur, even if cash was not exchanged.  Companies recognize revenue in the period in which the performance obligation is satisfied.  This basis is in accord with generally accepted accounting principles.  Companies record revenue only when they receive cash, and record expense only when they pay out cash. LO 1

4-14 Adjusting entries  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. THE NEED FOR ADJUSTING ENTRIES LO 1

4-15 Adjusting entries are made to ensure that: 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. Review Question THE NEED FOR ADJUSTING ENTRIES LO 1

4-16 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: 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. TYPES OF ADJUSTING ENTRIES ILLUSTRATION 4-3 Categories of adjusting entries LO 1

4-17 LO 1 Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. TYPES OF ADJUSTING ENTRIES ILLUSTRATION 4-4 Trial balance

4-18 Analyze business transactions Journalize Post Trial Balance Journalize and Post Adjusting Entries Adjusted Trial Balance Financial Statements Closing Entries Post-Closing Trial Balance To defer means to postpone or delay. LO 2 LEARNING OBJECTIVE Prepare adjusting entries for deferrals. 2

4-19 Deferrals are either:  Prepaid expenses OR  Unearned revenues. Deferrals LO 2

4-20 Expenses paid in cash before they are used or consumed.  insurance  supplies  advertising Cash Payment Expense Recorded BEFORE  rent  equipment  buildings Prepayments often occur in regard to: PREPAID EXPENSES LO 2

4-21 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. PREPAID EXPENSES LO 2

4-22 Adjusting entries for prepaid expenses  Increases (debits) an expense account and  Decreases (credits) an asset account. ILLUSTRATION 4-5 Adjusting entries for prepaid expenses PREPAID EXPENSES LO 2

4-23 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. Supplies1,500 Supplies Expense1,500Oct. 31 ILLUSTRATION 4-6 ($2,500 – 1,000 = $1,500) Supplies LO 2

4-24 Illustration: On October 4, Sierra Corporation paid $600 for a one- year 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. Prepaid Insurance50 Insurance Expense50Oct. 31 ILLUSTRATION 4-7 Insurance LO 2

4-25  Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.  Depreciation is the process of allocating the cost of an asset to expense (depreciation) over its useful life.  Depreciation does not attempt to report the actual change in the value of the asset. Depreciation LO 2

4-26 Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Accumulated Depreciation-Equipment40 Depreciation Expense40Oct. 31 ILLUSTRATION 4-8 Depreciation LO 2

4-27 Statement Presentation  Accumulated Depreciation- Equipment is a contra asset account.  Appears just after the account it offsets (Equipment) on the balance sheet. ILLUSTRATION 4-9 Balance sheet presentation of accumulated depreciation Depreciation ▼ HELPFUL HINT All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate. LO 2

4-28 ILLUSTRATION 4-10 Accounting for prepaid expenses PREPAID EXPENSES LO 2

4-29 Receipt of cash recorded as a liability before services are performed.  rent  airline tickets Cash Receipt Revenue Recorded BEFORE  magazine subscriptions  customer deposits Unearned revenues often occur in regard to: UNEARNED REVENUES LO 2

4-30  Adjusting entry is made to record the revenue for services performed during the period 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. UNEARNED REVENUES LO 2

4-31 Adjusting entries for unearned revenues  Decrease (a debit) to a liability account.  Increase (a credit) to a revenue account. ILLUSTRATION 4-11 UNEARNED REVENUES LO 2

4-32 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. Service Revenue400 Unearned Service Revenue400Oct. 31 ILLUSTRATION 4-12 UNEARNED REVENUES LO 2

4-33 ILLUSTRATION 4-13 Accounting for unearned revenues Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed. ACCOUNTING FOR UNEARNED REVENUES Examples Reason for Adjustment Accounts Before Adjustment Adjusting Entry Rent, magazine subscriptions, customer deposits for future service. Liabilities overstated. Revenues understated. Dr. Liabilities Cr. Revenues UNEARNED REVENUES LO 2

4-34 Analyze business transactions Journalize Post Trial Balance Journalize and Post Adjusting Entries Adjusted Trial Balance Financial Statements Closing Entries Post-Closing Trial Balance Increase both a balance sheet and an income statement account. LO 3 LEARNING OBJECTIVE Prepare adjusting entries for accruals. 3

4-35 Made to record:  Revenues for services performed and OR  Expenses incurred in the current accounting period that have not been recognized through daily entries. Adjusting Entries for Accruals LO 3

4-36 Revenues for services performed but not yet received in cash or recorded.  rent  interest  services performed BEFORE Accrued revenues often occur in regard to: Cash Receipt Revenue Recorded Adjusting entry results in: ACCRUED REVENUES LO 3

4-37 Accrued Revenues An adjusting entry serves two purposes: 1.Shows the receivable that exists, and 2.Records the revenues for services performed. ACCRUED REVENUES LO 3

4-38 Adjusting entries for accrued revenues  Increases (debits) an asset account.  Increases (credits) a revenue account. ILLUSTRATION 4-14 ACCRUED REVENUES LO 3

4-39 Illustration: In October, Sierra Corporation performed guide services for $200 that were not billed to clients before October 31. Service Revenue200 Accounts Receivable200Oct. 31 ILLUSTRATION 4-15 ACCRUED REVENUES LO 3

4-40 ILLUSTRATION 4-16 Accounting for accrued revenues Services performed but not yet received in cash or recorded. ACCOUNTING FOR ACCRUED REVENUES Examples Reason for Adjustment Accounts Before Adjustment Adjusting Entry Interest, rent, services performed but not collected. Assets understated. Revenues understated. Dr. Assets Cr. Revenues ACCRUED REVENUES LO 3

4-41 Expenses incurred but not yet paid in cash or recorded. BEFORE Accrued expenses often occur in regard to: Cash Payment Expense Recorded  utilities  salaries Adjusting entry results in:  Interest  taxes ACCRUED EXPENSES LO 3

4-42 An adjusting entry serves two purposes: 1.Records the obligations, and 2.Recognizes the expenses. ACCRUED EXPENSES LO 3

4-43 Adjusting entries for accrued expenses  Increases (debits) an expense account.  Increases (credits) a liability account. ILLUSTRATION 4-17 ACCRUED EXPENSES LO 3

4-44 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%. Interest Payable50 Interest Expense50Oct. 31 ILLUSTRATION 4-19 ILLUSTRATION 4-18 Formula for computing interest Accrued Interest $5,000 x 12% x 1/12 = $50 LO 3

4-45 ILLUSTRATION 4-20 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). Accrued Salaries LO 3

4-46 Salaries and Wages Payable1,200 Salaries and Wages Expense1,200Oct. 31 ILLUSTRATION 4-21 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). Accrued Salaries LO 3

4-47 ILLUSTRATION 4-22 Accounting for accrued expenses ACCRUED EXPENSES LO 3

4-48 ILLUSTRATION 4-23 Summary of adjusting entries SUMMARY OF BASIC RELATIONSHIPS LO 3

4-49 Analyze business transactions Journalize Post Trial Balance Adjusting Entries Adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance LO 4 LEARNING OBJECTIVE Prepare an adjusted trial balance and closing entries. 4

4-50 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. PREPARE ADJUSTED TRIAL BALANCE LO 4

4-51 LO 4 ILLUSTRATION 4-26 Adjusted trial balance

4-52 PREPARE ADJUSTED TRIAL BALANCE Which of the following statements is incorrect concerning the adjusted trial balance?  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.  The adjusted trial balance provides the primary basis for the preparation of financial statements.  The adjusted trial balance lists the account balances segregated by assets and liabilities.  The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. Review Question LO 4

4-53 Financial statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Retained Earnings Statement PREPARING FINANCIAL STATEMENTS LO 4

4-54 ILLUSTRATION 4-27 Preparation of the income statement and retained earnings statement from the adjusted trial balance 4-68

4-55 ILLUSTRATION 4-28 Preparation of the balance sheet from the adjusted trial balance LO 4

4-56 At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings. ILLUSTRATION 4-29 Temporary versus permanent accounts CLOSING THE BOOKS LO 4

4-57 In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. ILLUSTRATION 4-30 The closing process Preparing Closing Entries LO 4

4-58 LO 4 ILLUSTRATION 4-31

4-59 Illustration 4-32 Posting of closing entries Preparing Closing Entries LO 4

4-60 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. Preparing a Post-Closing Trail Balance LO 4

Analyze business transactions 2. Journalize the transactions 6. Prepare an adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare a post-closing trial balance 4. Prepare a trial balance 3. Post to ledger accounts 5.Journalize and post adjusting entries: Deferrals/Accruals 5.Journalize and post adjusting entries: Deferrals/Accruals ILLUSTRATION 4-33 Required steps in the accounting cycle SUMMARY OF THE ACCOUNTING CYCLE LO 4