Chapter 6 Accrual Accounting Concepts and the Accounting Cycle

In Chapter 3 You learned how to: o Prepare Journal Entries o Prepare an Unadjusted Trial Balance o And use the Unadjusted Balances to prepare Financial Statements

We made it through Step 3 of the Accounting Cycle

In this chapter we need to complete the cycle…

Did she say WRONG!? All of the transactions were recorded correctly Here are the financial statements from Chapter 3 The unadjusted trial balance was in balance… And so was the balance sheet… Too Bad the Balances are wrong!

What’s the Accrual Basis of Accounting!? Our Cash Balance is Correct! How can the balances be wrong… Every Cash Receipt and Disbursement was recorded. So what are we missing? Financial Statements must be prepared using the Accrual Basis of Accounting

The Accrual Basis is required by GAAP Not just the Cash Flow….. And the Matching Principle. Can you give us a refresher on those? The Accrual Basis of Accounting looks at the economic activity… Right! Two important Principles are the Revenue Recognition Principle Generally Accepted Accounting Principles, right?

Revenue Recognition Principle Requires that revenues be recorded in the time period when the work is performed. The Earnings process is complete. Governs the Timing of Revenues

Income Statement Revenue Recognition Principle

Matching Principle Requires that expenses be recorded in the same time period as the revenues they helped generate. Governs the Timing of Expenses

Income Statement Revenue Recognition Principle Matching Principle

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

Here’s an example of adhering to the matching principle….. The unadjusted balance in the Supplies account may not be accurate. Just because we purchased $500 of supplies……

Doesn’t mean we still have them. Unless we used none of the supplies the balance in Supplies is TOO HIGH!

And the Balance in Supplies Expense is TOO LOW!

What Happened?  The Journal Entry Process (at the time of Purchase)  Was not simultaneous with the Economic Activity (Usage of the supplies)  It would be silly to prepare a journal entry every time we used the stapler?!

In order for the financial statements to be correct…. The Economic Activity needs to be recorded This is done by recording an Adjusting Entry Recording Supplies Expense of $350 in the time period when we actually used the supplies is an Example of the Matching Principle

It’s all about Timing! Timing of the journal entry Versus Timing of the economic activity

Sometimes the cash flow precedes the economic activity Insurance Premium paid Use Supplies Purchase Supplies Policy Term Customer Pays In Advance We Perform Services Purchase Equipment We Use Equipment Cash Flow has already been recorded The Economic Activity has not yet been recorded.

Each of these prepayments Insurance Premium paid Use Supplies Purchase Supplies Policy Term Customer Pays In Advance We Perform Services Purchase Equipment We Use Equipment Cash Flow has already been recorded The Economic Activity has not yet been recorded. Requires an adjusting entry called a DEFERRAL

Sometimes the economic activity precedes the Cash Flow Employees are paid. Employees Work We Perform Services We Bill The Customer Journal Entry for Cash flow will be recorded next period The Economic Activity has not yet been recorded.

Each of these unpaid items…. Employees are paid. Employees Work We Perform Services We Bill The Customer Journal Entry for Cash flow will be recorded next period The Economic Activity has not yet been recorded. Requires an adjusting entry called an ACCRUAL

The purpose of every adjusting entry: Is to ensure that all Assets and Liabilities And the resulting Revenues and Expenses Are Properly Valued Prior to the Preparation of Financial Statements.

Okay, so the unadjusted balances are incorrect….. But are the Balances on the Unadjusted Trial Balance Too High Or Too Low? Let me Summarize the Adjusting Entry Process Let’s look at the example found on page 181 in your text….

These Assets and Liabilities are Already Recorded on the Unadjusted Trial Balance These balances were accurate as of the date of the cash receipt or payment, but No longer accurately reflect the economic activity. They will need to be adjusted. Items that were Prepaid and Previously Recorded

Each of these unadjusted balances is TOO HIGH!

And needs to be reduced to its proper balance

Unearned Revenues This adjusting entry recognizes the amount of revenue earned in the current period, and reduces the liability, Unearned Revenues, by $500

Supplies This adjusting entry recognizes the amount of supplies used in the current period, and reduces the asset, Supplies, by $4,000.

Prepaid Insurance This adjusting entry recognizes the amount of insurance coverage used in the current period, and reduces the asset, Prepaid Insurance by $500.

Each of the preceding examples Affected current accounts: Supplies Prepaid Insurance Unearned Revenues The Adjusting Entry Reduced the Account Directly

Equipment is a Depreciable Asset There are two general ledger accounts related to Equipment. Now Let’s Look at the Long-Term Accounts Equipment and Accumulated Depreciation

The Equipment will be used for several years to help generate revenues Year Revenues: 20% 20% 20% 20% 20% Expense: 20% 20% 20% 20% 20% The Matching Principle requires that we match the expense against the revenue

The Process of allocating the cost of a long-term asset over time…. Year Revenues: 20% 20% 20% 20% 20% Expense: 20% 20% 20% 20% 20% The Matching Principle requires that we match the expense against the revenue Is Called DEPRECIATION!

Its purpose is to reduce Equipment Accumulated Depreciation is a Contra-Asset Account Assets are reduced with credits

We still own $60,000 of equipment In a manner that preserves the historical cost information

Depreciation Expense $12,000 Accumulated Depreciation $12,000 When Long-Term Assets are used, the adjusting entry decreases the book value of the Equipment indirectly This must be the second year

Balance Sheet Presentation: Equipment $60,000 Less: Accumulated Depreciation ($24,000) Book Value – Equipment $36,000 This provides better information… The Equipment cost $60,000

Balance Sheet Presentation: Equipment $60,000 Less: Accumulated Depreciation ($24,000) Book Value – Equipment $36,000 Of Which $24,000 has been charged against Prior Revenues:

Balance Sheet Presentation: Equipment $60,000 Less: Accumulated Depreciation ($24,000) Book Value – Equipment $36,000 The Remaining $36,000 Cost will be charged against Future Revenues:

Summary of Deferrals Cash Flow preceded the Economic Activity Balance is already recorded on the unadjusted trial balance The recorded balance is TOO HIGH And must be reduced to its proper balance Most Accounts are reduced directly Depreciable Assets are reduced indirectly using a contra-account.

Now Let’s look at Accruals Accruals are required for transactions if The economic activity has occurred But is unrecorded Because the cash flow will not be recorded until the next period.

These Assets and Liabilities are Not Recorded on the Unadjusted Trial Balance Because there has not been any cash flow as of year end. They are Unpaid and Unrecorded. But Since the Economic Activity has already occurred, these balances will also need to be adjusted Items that are Unpaid and Unrecorded

Each of these unadjusted balances is TOO LOW

And needs to be increased to its proper balance.

To Accrue Salaries This adjusting entry recognizes the amount owed to the employees at year-end and increases the liability, Salaries Payable by $750.

To Accrue Interest This adjusting entry recognizes the amount of interest incurred in the current period, and increases the liability, Interest Payable, by $2,520.

Other Common Accruals Accounts Receivable – Services have been performed, but customer has not yet been billed Accrued Interest on Notes Receivable

Summary of Accruals Economic Activity has Preceded the Cash Flow Balance is NOT recorded on the unadjusted trial balance The recorded balance is TOO LOW And must be increased to its proper balance

Journal Entries for Accruals If a liability is previously unrecorded: If an asset is previously unrecorded:

For each item under consideration, ask if the Item has been Previously Recorded Yes No There is a balance that is TOO HIGH! There is a balance that is TOO LOW!

Ask if the Item has been Previously Recorded Yes, Prepare a Deferral No, Prepare an Accrual Find the Account that is Overstated and Reduce it to its proper balance Find the Account that is Understated and Increase it to its proper balance

The Dollar Amount of the Adjusting Entry will Be: For a Deferral For an Accrual The Journal Entry is for the Amount to be Deducted from the account The Journal Entry is for the Amount to be Added to the Account

Every Adjusting Entry affects both the Income Statement and Balance Sheet Unearned Fees

Every Adjusting Entry affects both the Income Statement and Balance Sheet Accrued Salaries

Every Adjusting Entry affects both the Income Statement and Balance Sheet Supplies Used

Every Adjusting Entry affects both the Income Statement and Balance Sheet Insurance Expired

Every Adjusting Entry affects both the Income Statement and Balance Sheet Depreciation

Every Adjusting Entry affects both the Income Statement and Balance Sheet Accrued Interest

Why do we need Closing Entries? They are consistent with GAAP Here are the financial statements using the Adjusted Balances Now is the Accounting Cycle Complete? Not Yet. It’s time for Closing Entries

Purpose of Closing Entries To achieve zero balances in all of the temporary equity accounts: Revenues Expenses Dividends Transfer the temporary equity amounts to Retained Earnings, which is a permanent equity account

Closing Entries Parallel the Transfer of Temporary Equity Amounts to the Statement of Retained Earnings Revenues and Expenses are closed to Retained Earnings Dividends are also closed to Retained Earnings

Closing the Income Statement to Retained Earnings….

Closing Dividends Account to Retained Earnings

The Balance Sheet Accounts are Permanent Accounts. Their balances are Not Closed Revenues, Expenses and Dividends are Temporary Equity Accounts. Their balances are zero after closing After Closing Entries are posted, only the Balance Sheet Accounts have balances

Congratulations! You’ve completed the Accounting Cycle

End – Chapter 6