Chapter 3

Differentiate between accrual and cash-basis accounting 2Copyright (c) 2009 Prentice Hall. All rights reserved.

3 Accrual Basis Revenues are recognized when earned and expenses are recognized when incurred. Cash Basis Revenues are recognized when cash is received and expenses recorded when cash is paid. Not GAAP Copyright (c) 2009 Prentice Hall. All rights reserved. Often TAX

4 Accrual – Revenue recognized when services provided Cash – Revenue recognized when cash is received Copyright (c) 2009 Prentice Hall. All rights reserved.

5 Accrual – Expense recognized when incurred Cash – Expense recognized when cash is paid Copyright (c) 2009 Prentice Hall. All rights reserved.

 You pay 6 months of rent in advance? ◦ Accrual entry? ◦ Cash entry? Copyright (c) 2009 Prentice Hall. All rights reserved.6

Define and apply the accounting period concept, revenue, and matching principles 7Copyright (c) 2009 Prentice Hall. All rights reserved.

 Businesses prepare financial statements for specific periods to evaluate performance  Basic accounting period = one year ◦ Calendar year ◦ Fiscal year (often follows seasonal nature of business)  Interim periods ◦ Financial statements of less than one year  Monthly  Quarterly  Semiannually 8Copyright (c) 2009 Prentice Hall. All rights reserved.

 When to record revenue? ◦ When it is earned  When service is provided or product delivered  This is not necessarily the time when cash is received  Follows legal rules of transaction (Can you sue for it?)  What amount of revenue should be recorded? ◦ Value of item or service transferred to customer ◦ This is based on what they will pay for it 9Copyright (c) 2009 Prentice Hall. All rights reserved.

 Measure all expenses incurred during the accounting period  Match the expenses against the revenues earned during the same period  This is a MAJOR difference between cash and accrual ◦ Accrual matches ◦ Cash may not 10Copyright (c) 2009 Prentice Hall. All rights reserved.

 Requires that accounting information be reported at regular intervals  Accounts are updated at the end of each accounting period ◦ MUST be updated at end of period ◦ May be updated at interval reporting ◦ It is driven by the need to prepare statements 11Copyright (c) 2009 Prentice Hall. All rights reserved.

Explain why adjusting entries are needed 12Copyright (c) 2009 Prentice Hall. All rights reserved.

13 Smart Touch Learning Unadjusted Trial Balance May 31, 2010 Cash4,800 Accounts Receivable2,200 Supplies700 Prepaid Rent3,000 Furniture18,000 Building 48,000 Accounts Payable18,200 Kay Torres, Capital 29,500 Kay Torres, Withdrawals3,200 Service Revenue 7,000 Salary Expense550 Utilities Expense40050,050 Unearned Service Revenue 600 Notes Payable 20,000 Sheena Bright, Capital 33,200 Sheena Bright, Withdrawals1,000 Service Revenue 7,000 Salary Expense900 Utilities Expense400 79,000

 Prepared at end of an accounting period  Assign: ◦ Revenues to the period when earned  These were previously recorded as unearned revenue when the cash was received ◦ Expenses to the period when incurred  These were previously recorded as pre-paid expense when the cash was paid out.  Need to properly measure: ◦ Net Income ◦ Assets & Liabilities 14Copyright (c) 2009 Prentice Hall. All rights reserved.

 Update asset and liability accounts ◦ Assets  Types of entries  Prepaid expenses (record how much expense has been incurred on expenses that were prepaid)  Depreciation of Plant And Equipment (and amortization)  Accrued revenue (record how much revenue has been earned from customers who owe for goods and services received)  You will be doing one of the following  Decreasing the asset (credit)  recording an expense (debit)  Increasing an asset (debit)  recording revenue 15Copyright (c) 2009 Prentice Hall. All rights reserved.

 Update asset and liability accounts ◦ Liabilities  Types of entries  Unearned revenue (When customers prepay, you set up a liability. You now must show how much of this prepayment has been earned)  Accrued expense (Business owes for goods and services received but that haven’t been paid)  You will be doing one of the following  Decreasing the liability (debit)  Recording a revenue (credit)  Increasing a liability (credit)  Recording an expense (debit) 16Copyright (c) 2009 Prentice Hall. All rights reserved.

Never involve cash Either increase revenue or increase an expense “Accrued” means amount must be recorded 17Copyright (c) 2009 Prentice Hall. All rights reserved.

Journalize and post adjusting entries 18Copyright (c) 2009 Prentice Hall. All rights reserved.

19 Prepaid expenses Depreciation Accrued expenses Accrued revenues Unearned revenues Copyright (c) 2009 Prentice Hall. All rights reserved.

 Advance payments of expenses  Examples: ◦ Rent ◦ Insurance ◦ Supplies  Recorded as an asset  Adjusting entry records amount used as an expense 20Copyright (c) 2009 Prentice Hall. All rights reserved.

21 Adjustments – Prepaid/Unearned an Accrued Expenses Current Period End of the current Period/future Period Cash Paid Expense Recorded Expenses Prepaid

22 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT 5/1 3,000 Prepaid rent Copyright (c) 2009 Prentice Hall. All rights reserved. May 1 Prepaid Rent 3,000 Cash 3,000 Prepaid rent for 3 months

23 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Rent expense1,000 Prepaid rent1,000 To record rent expired in May 5/1 3,000 Prepaid rent 5/31 1,000 Rent expense 5/31 1,000 Bal 2,000 Copyright (c) 2009 Prentice Hall. All rights reserved.

24 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT 5/2 500 Supplies Copyright (c) 2009 Prentice Hall. All rights reserved. May 2 Suplies 500 Cash 500

25 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT 5/ Supplies Copyright (c) 2009 Prentice Hall. All rights reserved. May 15 Suplies 200 Cash 200

26 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Supplies expense100 Supplies100 To record supplies used in May 5/ Supplies 5/ Supplies expense 5/ Bal 600 Copyright (c) 2009 Prentice Hall. All rights reserved.

 Plant assets ◦ Long-lived tangible assets used in business operations  Examples: ◦ Land, buildings, equipment, and furniture  Depreciation ◦ Allocation of a plant asset’s cost to expense over its useful life ◦ Land is not depreciated 27Copyright (c) 2009 Prentice Hall. All rights reserved.

28  Depreciation spreads the COST of an asset, (its book value) over the life of the asset (the time it will be used to generate revenue).  It is NOT adjusting the asset to market value

29 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May 3 Furniture18,000 Cash18,000 Purchased furniture 5/3 18,000 Furniture

30 Depreciation - process of allocating the cost of a plant asset to expense over its expected useful life Straight-Line Depreciation Expense = Asset Cost Useful Life

31 Accumulated depreciation accounts are called contra asset accounts because they are deducted from the related asset accounts on the balance sheet. Hint! Consider it like a tick on the back of a dog!

32 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May 31 Depreciation Expense, Furniture300 Accumulated Depreciation, Furniture300 To record depreciation for Sep. Accumulated depreciation is a contra asset account Accumulated depreciation is a contra asset account Income Statement Account Balance Sheet Account

33 5/ Accumulated Depreciation, Furniture 5/ Depreciation Expense, Furniture Bal 300 Bal. 18,000 Furniture Bal 300

34  Reported on balance sheet  Cost minus accumulated depreciation

35 Smart Touch Learning Balance Sheet May 31, 20XX Assets Cash $XXXX. Furniture$ 18,000 Less: Accumulated Depreciation (300) 17,700 Total Assets $XXXX Book Value

36 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May 31 Depreciation Expense, Building200 Accumulated Depreciation, Building200 To record depreciation for Sep. Accumulated depreciation is a contra asset account Accumulated depreciation is a contra asset account Income Statement Account Balance Sheet Account

37 5/ Accumulated Depreciation, Building 5/ Depreciation Expense, Building Bal 200 Bal. 48,000 Building Bal 200

38  Expenses incurred before payment is made ◦ Results in a liability  Opposite of a prepaid expense  Examples: ◦ Salaries ◦ Interest Copyright (c) 2009 Prentice Hall. All rights reserved.

39 Adjustments – Deferrals and Accruals Current Period Future Period Cash Received Revenue Recorded Unearned Cash Received Current Period Future Period Expense Recorded Cash Paid Expense Recorded Expenses Cash Paid Accruals Revenue Recorded Cash Received Revenues Prepaid Accruals

40 Adjustments – Accrued Expense Salary Payable Salary Expense Smart Touch received employee services for the second half of the month of May amounting to $900, to be paid on June 1. Record accrued wages of $900 5/ Expenses Liabilities

41 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Salary expense900 Salary Payable900 To record salaries accrued in May Copyright (c) 2009 Prentice Hall. All rights reserved.

42 Adjustments – Accrued Expense Salary Payable Salary Expense Smart Touch received employee services for the second half of the month of May amounting to $900, to be paid on June 1. Record accrued wages of $ / Expenses Liabilities A5 5/ ,800

43 Adjustments – Accrued Expenses Adjustments – Accrued Expenses Cash Notes Payable 20,000 On May 1, Smart Touch borrowed $20,000 from a bank signing a one year note payable. 20,000

44 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Interest expense100 Interest Payable100 To record interest accrued in May Copyright (c) 2009 Prentice Hall. All rights reserved.

45 Adjustments – Accrued Expense Interest Payable Interest Expense Smart Touch recorded interest accrued of $ / Bal. 100 Expenses Liabilities A5

46  Revenue earned before cash is received  Results in a receivable GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT Dec31Accounts receivable$$$$ Service revenue$$$$ To record accrued revenues Copyright (c) 2009 Prentice Hall. All rights reserved.

47 Adjustments – Deferrals and Accruals Current Period Future Period Current Period Future Period Expense Recorded Cash Paid Expense Recorded Expenses Cash Paid Accruals Revenue Recorded Cash Received Revenues Prepaid Accruals

48 Adjustments – Accrued Revenue Accounts Receivable Services Revenue As of May 31, Smart Touch provided a ½ month of services. Cash to be received on 6/15. Record services earned of $400. 7,000 Bal. Revenues Assets Bal.....2,200

49  Revenue earned before cash is received  Results in a receivable GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Accounts receivable400 Service revenue400 To record accrued revenues Copyright (c) 2009 Prentice Hall. All rights reserved.

50 Adjustments – Accrued Revenue Accounts Receivable Services Revenue As May 31 Smart Touch provided a ½ month of services. Cash to be received on 6/15. Record services earned of $400. 5/ ,600 7,000 bal. Revenues Assets A /31 7,400 bal. Bal.....2,200

51  Cash is collected before revenue is earned ◦ Results in a liability as the company owes a product or service or they will have to give the money back  Also called deferred revenue BEFORE Copyright (c) 2009 Prentice Hall. All rights reserved.

52 Adjustments – Deferrals and Accruals Current Period Future Period Cash Received Revenue Recorded Unearned Cash Received Current Period Future Period Expense Recorded Cash Paid Expense Recorded Expenses Cash Paid Accruals Revenue Recorded Cash Received Revenues Prepaid Accruals

53 Adjustments – Deferred Revenue Cash Unearned Service Revenue Service Revenue 600 On May 21, Smart Touch received cash of $600 in advance for e-learning services to be performed over the next 30 days. Adjustment A3 – Record services earned for Sept. 600 Revenues Liabilities Example S1 – Sale initially recorded as a liability. 7,

54 GENERAL JOURNAL DATEDESCRIPTION REF DEBITCREDIT May31Unearned Service Revenue200 Services Revenue200 To record revenue earned in May Copyright (c) 2009 Prentice Hall. All rights reserved.

55 Adjustments – Deferred Revenue Cash Unearned Service Revenue 5/ Service Revenue 600 On May 21, Smart Touch received cash of $600 in advance for e-learning services to be performed over the next 30 days. Adjustment A3 – Record services earned for May 10/30 X600= $ Revenues Liabilities Example S1 – Sale initially recorded as a liability. 7, ,600

 To properly measure net income on the income statement ◦ Each adjusting entry affects a revenue or an expense  To update the balance sheet ◦ Each adjusting entry affects an asset or a liability 56Copyright (c) 2009 Prentice Hall. All rights reserved.

Category of Adjusting EntryDebitCredit Prepaid expenseExpenseAsset DepreciationExpenseContra asset Accrued expenseExpenseLiability Accrued revenueAssetRevenue Unearned revenueLiabilityRevenue 57Copyright (c) 2009 Prentice Hall. All rights reserved.

Explain the purpose of and prepare an adjusted trial balance

 Prepared after adjusting entries are posted  Useful step in preparing financial statements  Often appears on a work sheet ◦ Tool accountants use at end of period  It is now often done by computers and run with closing entries (which we will get to later) 59Copyright (c) 2009 Prentice Hall. All rights reserved.

60 Smart Touch Learning Adjusted Trial Balance May 31, 2020 Debit Credit Cash 4,800 Accounts Receivable 2,600 Supplies 600 Prepaid Rent 2,000 Furniture 18,000 Building 48,000 Accum. Deprec. Furniture 300 Accum. Depreciation:Building 200 Accounts Payable 18,200 Salary Payable 900 Interest Payable 100 Unearned Service Revenue 400 Notes Payable 20,000 Sheena Bright, Capital 33,200 Sheena Bright, Withdrawals 1,000 Service Revenue 7,600 Rent expense 1,000 Salary expense 1,800 Supplies expense 100 Deprec. Expense: Furniture 300 Depreciation Expense: Build. 200 Interest Expense 100 Utilities Expense 400 _ ____ 80,900 80,900

Prepare the financial statements from the adjusted trial balance

Reports revenue and expenses Determines net income Income statement Shows why Capital changed during the period Computes ending Capital Statement of owner’s equity Reports assets, liabilities, and owner’s equity Needs ending Capital to balance Balance sheet 62Copyright (c) 2009 Prentice Hall. All rights reserved.

63 Smart Touch Learning Adjusted Trial Balance May 31, 2020 Debit Credit Cash 4,800 Accounts Receivable 2,600 Supplies 600 Prepaid Rent 2,000 Furniture 18,000 Building 48,000 Accum. Deprec. Furniture 300 Accum. Depreciation:Building 200 Accounts Payable 18,200 Salary Payable 900 Interest Payable 100 Unearned Service Revenue 400 Notes Payable 20,000 Sheena Bright, Capital 33,200 Sheena Bright, Withdrawals 1,000 Service Revenue 7,600 Rent expense 1,000 Salary expense 1,800 Supplies expense 100 Deprec. Expense: Furniture 300 Depreciation Expense: Build. 200 Interest Expense 100 Utilities Expense 400 _ ____ 80,900 80,900

Smart Touch Learning Income Statement Month Ended May 31, 2010 Service Revenue $7,600 Expenses: Salary expense$1,800 Rent Expense 1,000 Utilities Expense 400 Deprec. Expense-Furniture300 Deprec. Expense-Building 200 Interest Expense 100 Supplies Expense 100 Total expenses 3,900 Net income $3,700

Financial Statements Sheena Bright, capital, May 1, 2010$ 33,200 Net income 3,700 $36,900 Less withdrawals(1,000) Sheena Bright, Capital May 31, 2010$35,900 Smart Touch Learning Statement of Owners Equity Month Ended May 31, 2010

66 Assets Cash$4,800 Accounts Receivable2,600 Supplies600 Prepaid rent2,000 Furniture $18,000 Less: Accum Dep ,700 Building 48,000 Accumulated depreciation-20047,800 Total Assets $75,500 Liabilities Accounts Payable$18,200 Salary Payable900 Interest Payable 100 Unearned Serv. Revenue 400 Notes Payable 20,000 Total Liabilities$39,600 Owner’s Equity Sheens Bright, Capital35,900 Total Liabilities & Owner’s Equity $75,500 Smart Touch Learning Balance Sheet May 31, 2020

Any Company Worksheet December 31, 2010 Adjusted Trial Balance Account TitleDr.Cr. Cash Supplies Equipment Accum. depr. - Equip. Accounts payable Interest payable Note payable Josie Smith, Capital Josie Smith, W/D Service revenue Rent expense Supplies expense Depreciation expense Interest expense Totals 67 5, ,000 1,000 4, , ,300 2, ,000 6,000 12,000 28,300 Balance sheet Income statement

68Copyright (c) 2009 Prentice Hall. All rights reserved.

69Copyright (c) 2009 Prentice Hall. All rights reserved.

Any Company Worksheet December 31, 2010 Trial Balance Adjustments Adjusted Trial Balance Account TitleDr.Cr.Dr.Cr.Dr.Cr. Cash 5,400 Supplies 700 a Equipment 17,000 Accum. depr. - Equip. 1,000 b. 1,000 2,000 Accounts payable 200 Interest payable c Note payable 9,000 Josie Smith, Capital 6,000 Josie Smith, W/D1,000 Service revenue 12,000 Rent expense 4,000 Supplies expense a Depreciation expense b. 1,000 1,000 Interest expense 100 c Totals 27,200 1,600 28,300 70