Accrual Accounting Concepts Principles of Accounting Kimmel • Weygandt • Kieso Accrual Accounting Concepts Chapter 4 Prepared by Carol A. Hartley Providence College Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Study Objectives 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. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Study Objectives 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. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Recall: Time Period Assumption Divides life of business into artificial time periods: monthly, quarterly, yearly Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#1 Revenue Recognition Principle Dictates that revenue be recognized in the accounting period in which it is earned. Considered earned when the service has been provided or when the goods are delivered. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#1 Revenue Recognition Principle Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. #1 Matching Principle Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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#2 Differentiate Between Cash Basis and Accrual Basis of Accounting Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Cash Basis Revenue recorded only when cash is received. Expenses recorded only when cash is paid. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint Slides Cash Basis is not GAAP GAAP Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 5 10

Accrual Basis Accounting PowerPoint Slides Accrual Basis Accounting Follows both . . . Revenue Recognition Principle Matching Principle Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 5 10

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint Slides Accrual Basis is GAAP Revenue recorded only when earned not when cash is received Expense recorded only when incurred not when cash paid Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 5 10

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Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? a. Cost principle. b. Matching principle. c. Periodicity principle. d. Revenue recognition principle. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? a. Cost principle. b. Matching principle. c. Periodicity principle. d. Revenue recognition principle. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review When would revenue be recorded for the following scenario . . . Ad agency is hired for a project in May, does work in June and is paid in July? The answer is June! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review When would expenses be recorded for this companion scenario . . . The Ad agency on this project incurs $1,500 of expenses in May, $3,000 in June, and none in July? The answer is June! Matching says the expenses should follow the revenue. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review When would revenue be recorded for the following scenario . . . Sell plane ticket on September 1 for a flight on October 15? The answer is October – when the service is provided! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review When would expenses be recorded for the following scenario . . . The airline pays pilot salaries on October 7th for the week ended September 30th? The answer is September – the pilots provided labor services for September flights during that month. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Now let’s discuss how accounting makes this happens . . . Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. #3 Explain Why Adjusting Entries are Needed and Identify the Major Types of Adjusting Entries Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Adjusting Entries Trial balance is not up to date. To produce accurate financial statements, we record adjusting entries . . . Revenues are recognized (recorded) when they are earned. Expenses are recognized (recorded) when they are incurred (used up). Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. PowerPoint Slides Adjusting Entries Adjusting entries ensure that Revenue Recognition and Matching Principles are followed! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 9 15

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. (cash paid in advance) Unearned Revenues: Cash received and recorded as liabilities before revenue is earned. (cash received in advance) Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 10 16

Types of Adjusting Entries PowerPoint Slides Types of Adjusting Entries Accruals: Accrued revenues: Revenues earned but not yet received in cash or recorded (someone owes us). Accrued expenses: Expenses incurred but not yet paid in cash or recorded (we owe someone else). Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 10 16

#4 Prepare Adjusting Entries for Prepayments – Prepaid Expenses Expenses paid in cash and recorded as assets before they are used or consumed. (paid in advance) Prepaid expenses expire with the passage of time OR they are consumed (used) Time: rent, insurance Consumed: supplies Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Prepaid Expenses Amount equals cost of goods or services used up or expired If not adjusted, expenses would be understated and assets overstated Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#4 Prepare Adjusting Entries for Prepayments – Prepaid Expenses Start with the trial balance to find information to adjust prepayments Let’s use the Sierra Corporation examples in the book . . . Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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Prepaid Expenses - Supplies What is the entry when you purchase supplies? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Supplies GENERAL JOURNAL Debit Credit Oct 5 Supplies 2,500 Cash 2,500 Purchased Advertising Supplies Supplies 2,500 Oct 5 Cash Supplies Expense Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Supplies Oct. 31: Take inventory and it shows $1,000 of supplies still on hand What is the adjusting entry? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Supplies GENERAL JOURNAL Debit Credit Oct 31 Supplies Expense 1,500 Supplies 1,500 To record supplies used Supplies 2,500 Oct 5 Cash Supplies Expense Oct 31 1,500 Oct 31 1,500 Oct 31 1,000 Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Supplies Expense October $1,500 November $1,800 December $1,410 January $1,425 February $1,601 March $1,435 April $1,530 May $1,592 June $1,622 July $1,652 August $1,427 September $1,557 Expense varies each month with usage Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Insurance What is the entry when you purchase the insurance policy? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Insurance GENERAL JOURNAL Debit Credit Oct 4 Prepaid Insurance 600 Cash 600 Purchased one-year fire insurance policy. 600 Oct 4 Cash Insurance Expense Prepaid Insurance Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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Prepaid Expenses - Insurance Oct. 31: You are at the end of the month. How much of the insurance policy has expired? $600 / 12 months = $50 per month What is the adjusting entry? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Prepaid Expenses - Insurance GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 To record expired insurance coverage 600 Oct 4 Cash Insurance Expense Prepaid Insurance Oct 31 50 Oct 31 50 Oct 31 550 Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Insurance Expense October $50 November December January February March April May June July August September Policy Expense is the same each month Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Depreciation What is the entry when you purchase equipment? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Depreciation Office Equipment Depreciation Expense Cash Oct 2 5,000 Oct 2 5,000 GENERAL JOURNAL Debit Credit Oct 2 Office Equipment 5,000 Cash 5,000 To record purchase of office equipment Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Depreciation Following the matching principle, the cost of assets with long lives must be allocated over their useful lives As we use the asset, we recognize a portion of its cost as expense: depreciation Depreciation expense is an estimate It is an allocation of cost, NOT valuation Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Depreciation Expense October $40 November December January February March April May June July August September Let’s say expense is estimated at $480 per year Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Depreciation Office Equipment Depreciation Expense Accumulated Depreciation Oct 2 5,000 Oct 31 40 Oct 31 40 GENERAL JOURNAL Debit Credit Oct 31 Depreciation Expense 40 Accumulated Depreciation 40 To record monthly depreciation of annual $480 estimate Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Adjustment for Depreciation Accumulated Depreciation Depreciation Expense Adjusting Entry Credit Debit Amount equals cost of asset allocated to accounting period CONTRA-ASSET ACCOUNT EXPENSE ACCOUNT Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Balance Sheet Presentation Office equipment $ 5,000 Less: accumulated depreciation 40 $4,960 Accumulated depreciation is a contra asset account, an offset against the fixed asset account. Book Value Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 30

#4 Prepare Adjusting Entries for Prepayments – Unearned Revenues Cash received and recorded as liabilities before revenue is earned. (cash received in advance) Earned when services are provided Rent, magazine subscriptions, customer deposits Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Unearned Revenues Amount equals price of services performed or goods delivered If not adjusted, revenues would be understated and liabilities overstated Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Unearned Revenues What is the entry when you are paid in advance for services? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Unearned Revenues Unearned Revenue Cash Revenue Oct 2 1,200 Oct 2 1,200 Oct 3 10,000 GENERAL JOURNAL Debit Credit Oct 2 Cash 1,200 Unearned Revenue 1,200 To record customer payment received in advance of services Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Unearned Revenues Oct. 31: Some of the work has been performed, $400 has been earned What is the adjusting entry? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Unearned Revenues Unearned Revenue Cash Revenue Oct 2 1,200 Oct 31 400 Oct 2 1,200 Oct 3 10,000 Oct 31 400 Oct 31 800 Oct 31 10,400 GENERAL JOURNAL Debit Credit Oct 31 Unearned Revenue 400 Revenue 400 To record revenue earned Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#5 Prepare Adjusting Entries for Accruals – Accrued Revenues PowerPoint Slides #5 Prepare Adjusting Entries for Accruals – Accrued Revenues Accrued revenues: revenues earned but not yet received in cash or recorded at the statement date Adjusting entry is required to show the receivable that exists at the balance sheet date Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 10 16

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Revenues Amount equals price of services performed If not adjusted, revenues would be understated and assets understated Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Revenues What is the adjusting entry for $200 of services performed but not billed before October 31? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Revenues Accounts Receivable Service Revenue Oct 31 200 Oct 3 10,000 Oct 31 400 Oct 31 200 Oct 31 10,600 GENERAL JOURNAL Debit Credit Oct 31 Accounts Receivable 200 Service Revenue 200 To record revenue earned but not billed Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#5 Prepare Adjusting Entries for Accruals – Accrued Expenses PowerPoint Slides #5 Prepare Adjusting Entries for Accruals – Accrued Expenses Accrued expenses: expenses incurred but not yet paid in cash or recorded at the statement date Adjusting entry is required to show the payable that exists at the balance sheet date Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. 10 16

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Expenses Amount equals cost of expense incurred If not adjusted, expenses would be understated and liabilities understated Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Where is the interest expense for this note? Interest expense has not been recorded yet for this period, so we need an adjustment! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Accrued Expenses - Interest Oct. 31: Signed $5,000 note on Oct. 1st with annual interest rate of 12% Use formula to calculate interest: What is the adjusting entry? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Interest Interest Expense Interest Payable Oct 31 50 Oct 31 50 GENERAL JOURNAL Debit Credit Oct 31 Interest Expense 50 Interest Payable 50 To record interest on notes payable Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Accrued Expenses - Salaries Oct. 31: Employees are paid every two weeks. There are 3 days of October that will not be paid until November. Wages are $2,000 for 5 days What is the adjusting entry? Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrued Salaries Salaries Expense Salaries Payable Bal. 4,000 Oct 31 1,200 Oct 31 1,200 Oct 31 5,200 GENERAL JOURNAL Debit Credit Oct 31 Salaries Expense 1,200 Salaries Payable 1,200 To record accrued salaries ( $400 a day times 3 days ) Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Summary of Adjusting Entries Note that each adjusting entry affects at least one balance sheet account and at least one income statement account! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#6 Describe the nature and purpose of the Adjusted Trial Balance Prepared after adjusting entries journalized and posted Shows balances of all accounts See the adjusting journal entry changes on next slide. . . Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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Adjusted Trial Balance Purpose is to prove the equality of total debit balances and total credit balances after the adjusting entries have been made. Financial statements are prepared from the adjusted trial balance Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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#7 Explain the Purpose of Closing Entries Closing entries transfer the temporary accounting balances to the permanent stockholders’ equity account – Retained Earnings. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Close Temporary Accounts Only Zero balance after closing entries! Do not close! Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Closing Entries At the start of the next period, temporary account balances are zero so you can accumulate data separately from data in prior periods. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

#8 Describe the required steps in the Accounting Cycle Steps are performed in sequence and are repeated in each accounting period . . . Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which is not a temporary account? a. Salaries expense. b. Service revenue. c. Accounts receivable. d. Dividends. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which is not a temporary account? a. Salaries expense. b. Service revenue c. Accounts receivable. d. Dividends. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which account will have a zero balance after closing entries? a. Service Revenue. b. Advertising Supplies. c. Prepaid Insurance. d. Accumulated Depreciation. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which account will have a zero balance after closing entries? a. Service Revenue. b. Advertising Supplies. c. Prepaid Insurance. d. Accumulated Depreciation. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which types of accounts will appear in the post-closing trial balance? a. Permanent accounts. b. Temporary accounts. c. Accounts shown in income statement. d. None of the above. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Let’s Review Which types of accounts will appear in the post-closing trial balance? a. Permanent accounts. b. Temporary accounts. c. Accounts shown in income statement. d. None of the above. Copyright © 2005 John Wiley & Sons, Inc. All rights reserved.

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