Financial Accounting: Tools for Business Decision Making, 3rd Ed. Kimmel, Weygandt, Kieso ELS

Chapter 4

Chapter 4 Accrual Accounting Concepts PowerPoint Slides After studying Chapter 4, you should be able to: Explain the revenue recognition principle and the matching principle. Differentiate between the cash basis and the accrual basis of accounting. Explain why adjusting entries are needed and identify the major types of adjusting entries. Prepare adjusting entries for prepayments. 1

Chapter 4 Accrual Accounting Concepts PowerPoint Slides After studying Chapter 4, you should be able to: Prepare adjusting entries for accruals. Describe the nature and purpose of the adjusted trial balance. Explain the purpose of closing entries. Describe the required steps in the accounting cycle. 2

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.

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

Revenue Recognition Principle... PowerPoint Slides Revenue Recognition Principle... dictates that revenue be recognized in the accounting period in which it is earned. is considered earned when the service has been provided or when the goods are delivered. 3

PowerPoint Slides Matching Principle... requires that expenses be recorded in the same period in which the revenues they helped produce are recorded. 4

Cash Basis Revenue recorded only when cash is received. PowerPoint Slides Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid. 5

PowerPoint Slides Cash Basis in not GAAP GAAP 5

Accrual Basis Accounting PowerPoint Slides Accrual Basis Accounting Adheres to the: Revenue Recognition Principle Matching Principle 5

Accrual Basis Accounting PowerPoint Slides Accrual Basis Accounting Revenue recorded only when earned, not when cash is received Expense recorded only when incurred, not when cash paid 5

Accrual Basis adheres to... PowerPoint Slides Accrual Basis adheres to... Generally Accepted Accounting Principles 5

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

HAPPEN! Adjusting Entries revenue recognition & matching principles PowerPoint Slides Adjusting Entries Adjusting entries make the: revenue recognition & matching principles HAPPEN! 9

Types of Adjusting Entries PowerPoint Slides Types of Adjusting Entries Prepayments: Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. Unearned Revenues: Cash received and recorded as liabilities before revenue is earned. Accruals: Accrued revenues: Revenues earned but not yet received in cash or recorded. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. 10

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

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

Sierra Corporation Trial Balance October 31, 2004 Debit Credit PowerPoint Slides Sierra Corporation Trial Balance October 31, 2004 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 9

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

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

Supplies Expense Oct $1,500 Nov $1,800 Dec $1,410 Jan $1,425 Feb $1,601 Mar $1,435 Apr $1,510 May $1,592 June $1,652 July $1,621 Aug $1,427 Sept $1,555 Supplies expense is based on usage... so different amounts appear each month

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

Insurance Policy 1 Year $ 600 Oct $50 Nov $50 Dec $50 Jan $50 Feb $50 Mar $50 Apr $50 May $50 June $50 July $50 Aug $50 Sept $50

Prepaid Expenses On October 31st, $50 ($600/12 months) of the insurance was used-up or expired. Prepaid Insurance Insurance Expense Cash Oct 1 600 Oct 1 600 50 Oct 31 50 Oct 31 GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month

Depreciation How do you apply the Matching Principle to the cost of a long lived asset ?

Depreciation 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!

Office Equipment Depreciation= $480/year Oct $40 Nov $40 Dec $40 Jan $40 Feb $40 Mar $40 Apr $40 May $40 June $40 July $40 Aug $40 Sept $40

Accumulated Depreciation-Office Equipment Depreciation Expense Office Equipment 5,000 Oct 2 40 Oct 31 40 Oct 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.

Balance Sheet Presentation Office equipment $ 5,000 Less : accumulated depreciation 40 $4,960 Book Value or Carrying Value

Unearned Service Revenue Unearned Revenues Received on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31. Unearned Service Revenue Cash 1,200 Oct 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 Dec 31.

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

Accrual Revenue has been earned, but not collected. Expenses have been incurred, but not yet paid.

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

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

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

Formula for Computing Interest Face Value of Note Interest 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

Accrued Interest Interest Expense Interest Payable Oct 31 50 GENERAL JOURNAL Debit Credit Oct 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month

Accrued Salaries - Salaries Paid for after the Service Has Been Performed.

Accrued Salaries Salaries Expense Salaries 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

Adjusted Trial Balance 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 For the Month Ended October 31, 2004 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2004

Balance as Oct. 31 from Retained Earnings Statement SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 Balance Sheet October 31, 2004

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.

All liability accounts Temporary Permanent All revenues accounts All asset accounts All expense accounts All liability accounts Dividends Stockholders’ equity accounts

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

The Accounting Cycle

Required Steps in the Accounting Cycle PowerPoint Slides Required Steps in the Accounting Cycle Analyze business transactions. Journalize the transactions. Post to ledger accounts. Prepare a trial balance. Journalize and post adjusting entries--prepayments and accruals. Prepare an adjusting trial balance. 20