1. Accounting
Lecture no 9
Prepared by: Jan Hájek

2. DEFINITIONS Revenues Expenses
Inflows of assets or settlements of liabilities during a period from delivering or producing goods or services.
Expenses
Outflows of assets or incurrence of liabilities during a period from delivering or producing goods or services.
Incurred in an attempt to produce revenues 3 3 3 3

3. Increases owner’s equity. Decreases owner’s equity.
Revenue and Expenses
The price for goods sold
and services rendered during a given accounting period.
Increases owner’s equity.
The costs of goods and services used up in the process of earning revenue.
Decreases owner’s equity.

4. Debits and Credits for Revenue and Expense
Expenses decrease owner’s equity.
Revenues increase owner’s equity.
EQUITIES
Debit for Decrease
Credit for Increase
EXPENSES
Credit for Decrease
Debit for Increase
REVENUES
Debit for Decrease
Credit for Increase

5. REVENUE PRINCIPLE
Revenue should be recognized in the financial statement when . . .
It is earned, and
It is realized or realizable
(Measurable) 7 7 7 7

6. REVENUE PRINCIPLE
Revenue is earned when the earnings process is completed or virtually completed.
Revenue is realized when cash is received.
Revenue is realizable when claims to cash are received that can be converted into a known amount of cash. 8 8 8 8

7. Revenue is typically recognized:
REVENUE PRINCIPLE
Revenue is typically recognized:
At delivery (point of sale)
After delivery
Before delivery
of product or service 9 9 9 9

8. REVENUE RECOGNITION POINTS
before delivery
Recognition
at delivery
Recognition
after delivery
Design and production,
construction in progress,
minerals discovered
Goods completed
and ready for sale,
contract complete
Delivery of
product or
service
Cash collected
for goods or
services
Right of
return expires
Percentage-of
completion method
Production
method
Point
of sale
method
Installment
method
Right of
return
expiration
method
Completed
contract
method
Cost
recovery
method
RELEVANCE
RELIABILITY

9. REVENUE RECOGNITION Point of Sale
Revenue is earned and realized at the point of sale.
The product or service has been delivered to the customer and cash has been received or is receivable.
This method is sometimes called the “sales method,” or “delivery method.” 10 10 10 10

10. REVENUE RECOGNITION After Delivery
Uncertainties about collectibility or future performance by seller.
Sale with right of return.
Product-financing arrangements. 11 11 11 11

11. INSTALLMENT SALES
When we are uncertain about the collectibility of the sales revenue or the ability of the seller to deliver futures services, we should defer revenue recognition.
Two commonly used accounting methods are the . . .
Installment sales method.
Cost recovery method. 15 15 15 15

12. INSTALLMENT SALES Installment Sales Method
Sale and cost of sale recorded as usual.
Compute gross margin rate on the installment sales.
Recognize gross margin as cash is received.
Gross margin not realized is deferred until a future period. 16 16 16 16

13. INSTALLMENT SALES Example
Sam’s Appliances made sales of $200,000 in 20xx that qualified for the installment sales method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx.
Prepare the journal entries to record the installment sales transactions during 20xx. 17 17 17 17

14. INSTALLMENT SALES 18 18 18 18

15. INSTALLMENT SALES 19 19 19 19

16. INSTALLMENT SALES 20 20 20 20

17. INSTALLMENT SALES Example21 21 21 21

18. INSTALLMENT SALES Example22 22 22 22

19. INSTALLMENT SALES Example23 23 23 23

20. INSTALLMENT SALES Example
Cash collection in 20xx $90,000
Gross margin percentage %
Gross profit to recognize $31,500 24 24 24 24

21. INSTALLMENT SALES
Balance Sheet 25 25 25 25

22. INSTALLMENT SALES
Balance Sheet 26 26 26 26

23. UNCERTAINTY IS GREATER!
COST RECOVERY METHOD
Like the installment sales method, cost recovery is used when we are uncertain about the collectibility of the sales revenue or the ability of the seller to complete future performance.
UNCERTAINTY IS GREATER!
No profit is recognized until cost of item sold is fully recovered. 27 27 27 27

24. COST RECOVERY
Sam’s Appliances made sales of $200,000 in 20xx that qualified for the cost recovery method of accounting. The items sold have a cost to Sam’s of $130,000. During 20xx, Sam’s collected cash from installment customers of $90,000. The remaining amount will be collected in 20xx.
Prepare the journal entries to record the installment sales transactions during 20xx. 28 28 28 28

25. COST RECOVERY 29 29 29 29

26. COST RECOVERY 30 30 30 30

27. COST RECOVERY 31 31 31 31

28. COST RECOVERY No profit is recognized in 20xx because the cost of the
item sold ($130,000) has not been recovered in the
form of cash receipts. Once we collect $130,000 in
cash, profit recognition begins. 32 32 32 32

29. All gross profit has been deferred until we recover the
COST RECOVERY
Balance Sheet
All gross profit has been deferred until we recover the
$130,000 cost of the item sold. 33 33 33 33

30. Equipment Manufacturing
RIGHT OF RETURN
In some industries it is common practice that the sales terms allow customers the right to return goods under specified conditions and over long periods of time.
Equipment Manufacturing
Book Publishing 13 13 13 13

31. Recognize revenue at point of sale if,
RIGHT OF RETURN
Recognize revenue at point of sale if,
Selling price is fixed or determinable.
Buyer is obligated to pay the seller and payment is not contingent upon resale of the product.
Buyer is obligated even in case of theft or physical destruction.
Buyer has economic substance apart from that provided by the seller.
Seller has no obligation for future performance.
Future returns can be estimated. 14 14 14 14

32. PRODUCT-FINANCING ARRANGEMENTS
An agreement in which a sponsoring company sells a product to another company and in a related transaction agrees to repurchase the product.
The sponsoring company
Records a liability when the proceeds are received.
No sale is recorded and inventory is not adjusted.
Wait for a sale to outside party. 12 12 12 12

33. REVENUE RECOGNITION Before Delivery
Accounting for long-term construction contracts
Completed-Contract Method
Percentage-of-Completion Method 34 34 34 34

34. REVENUE RECOGNITION Before Delivery
Percentage-of-completion method is appropriate when . . .
Contract specifies the amount of consideration to be exchanged and the terms of settlement.
Buyer is expected to satisfy the obligation.
Contractor can perform according to the terms of the contract. 35 35 35 35

35. MEASURING PROGRESS TOWARD COMPLETION
Input Measures
Effort devoted to project compared to total effort expected (cost incurred to date compared to total estimated costs)
Output Measures
Results to date compared to total results 36 36 36 36

36. MEASURING PROGRESS TOWARD COMPLETION
Cost-to-Cost Method
Total costs incurred to date
Percent complete =
Most recent estimate of total
costs of the project 37 37 37 37

37. MEASURING PROGRESS TOWARD COMPLETION
Cost-to-Cost Method
Current Period Revenue
Total Revenue from Contract
× Percent Complete
Total Revenue to Recognize
- Revenue Recognized in Prior Periods
= Revenue Recognized in Current Period 38 38 38 38

38. LONG-TERM CONTRACTS Example
During 20xx, West, Inc. enters into a contract with Putnam County to build a bridge over Cane River. The project will take 3 years to complete and has a fixed price of $4,500,000. West’s engineers estimate the total cost of the bridge to be $3,000,000. At the end of 20xx, the information on the next page was gathered by West’s accountant. 39 39 39 39

39. LONG-TERM CONTRACTS Example
West uses the percentage-of-completion
method to account for all long-term
construction projects.
Prepare the necessary 20xx journal entries
for this project. 40 40 40 40

40. LONG-TERM CONTRACTS Example41 41 41 41

41. LONG-TERM CONTRACTS Example42 42 42 42

42. LONG-TERM CONTRACTS Example43 43 43 43

43. LONG-TERM CONTRACTS Example44 44 44 44

44. LONG-TERM CONTRACTS Example
If West uses the Completed-Contract method, no
revenue is recognized during 19X6. All
revenue and profit is recognized at the
end of the contract when delivery of the bridge to
Putnam County is made. 45 45 45 45

45. REVENUE RECOGNITION Before Delivery
Completion of Production
Accretion Basis
Discovery Basis 46 46 46 46

46. REVENUE RECOGNITION Service Sales
Specific Performance Method
Proportional Performance Method
Completed Performance Method
Collection 47 47 47 47

47. SPECIFIC PERFORMANCE
Used to account for revenue that is earned by performing a single act.
Franchise revenue (SFAS No. 45)
Bob’s
Burgers 48 48 48 48

48. PROPORTIONAL PERFORMANCE
Used to recognize service revenue that is earned by more than a single act and when the service is rendered in more than one accounting period.
Similar performance acts - equal amount for each act
Dissimilar performance acts - in proportion to direct costs of each act
Similar acts with a fixed period for performance 49 49 49 49

49. COMPLETED PERFORMANCE
Used when revenue is earned by performing a series of acts, and the last act is so important that revenue is only considered earned if it is performed. 50 50 50 50

50. COLLECTION
Used to account for service revenue when the uncertainty of collection is very high.
Revenue recognized when cash is received. 51 51 51 51

51. EXPENSE RECOGNITION
Expenses are outflows of assets or incurrences of liabilities during a period from delivery or producing goods or rendering services. 52 52 52 52

52. MATCHING
Once revenues are determined, the expenses incurred in generating the revenue should be recognized.
As revenues are earned, certain assets are consumed and services are used. 53 53 53 53

53. Expenses What is expenses? What impact do expenses have on equity?
The costs associated with producing revenue.
What impact do expenses have on equity?
Expenses represent a decrease in equity resulting from the cost of producing revenue.
Examples????

54. EXPENSES Recognition Methods
Direct
Period
Allocated 54 54 54 54

55. Expenses A company pays wages of $250. Before using expense accounts:
Dr. Owner’s Equity $250
Cr. Cash $250
Using expense accounts:
Dr. Wages Expense $250
Cr. Cash $250

56. GAINS AND LOSSES
Gains and losses result from peripheral or incidental transactions, events, or circumstances.
Most gains and losses are recognized when the transaction is completed.
Estimated losses are recognized before realization if they are probable and can be reasonably estimated. 55 55 55 55

57. TIME PERIOD ASSUMPTION
The time period (or periodicity) assumption assumes that the economic life of a business can be divided into artificial time periods — generally a month, a quarter, or a year.
Periods of less than one year are called interim periods.
The accounting time period of one year in length is usually known as a fiscal year. 1

58. REVENUE RECOGNITION PRINCIPLE
The revenue recognition principle states that revenue should be recognized in the accounting period in which it is earned.
In a service business, revenue is usually considered to be earned at the time the service is performed.
In a merchandising business, revenue is usually earned at the time the goods are delivered. 2

59. THE MATCHING PRINCIPLE
The practice of expense recognition is referred to as the matching principle.
The matching principle dictates that efforts (expenses) be matched with accomplishments (revenues).
Revenues
earned
this month
are offset
against....
expenses
incurred in
earning the
revenue 3

60. ACCRUAL BASIS OF ACCOUNTING
Adheres to the
Revenue recognition principle
Matching principle
Revenue recorded when earned, not only when cash received.
Expense recorded when services or goods are used or consumed in the generation of revenue, not only when cash paid.
GAAP

61. CASH BASIS OF ACCOUNTING
PowerPoint Slides
CASH BASIS OF ACCOUNTING
NOT GAAP
Revenue recorded only when cash received.
Expense recorded only when cash paid. 5

62. HAPPEN! ADJUSTING ENTRIES
Adjusting entries make the revenue recognition and matching principles
HAPPEN!

63. TRIAL BALANCE
The Trial Balance is analysed to determine the need for adjusting entries.

64. ADJUSTING ENTRIES
Adjusting entries are required each time financial statements are prepared.
Adjusting entries can be classified as
1. prepayments (prepaid expenses or unearned revenues),
2. accruals (accrued revenues or accrued expenses), or
3. estimates (amortization). 5

65. TYPES OF ADJUSTING ENTRIES
Prepayments
1. Prepaid Expenses — Expenses paid in cash and recorded as assets before they are used or consumed.
2. Unearned Revenues — Revenues received in cash and recorded as liabilities before they are earned.

66. TYPES OF ADJUSTING ENTRIES
Accruals
1. Accrued Revenues — Revenues earned but not yet received in cash or recorded.
2. Accrued Expenses — Expenses incurred but not yet paid in cash or recorded.

67. TYPES OF ADJUSTING ENTRIES
Estimates
1. Amortization — Allocation of the cost of capital assets to expense over their useful lives.

68. PREPAYMENTS
Prepayments are either prepaid expenses or unearned revenues.
Adjusting entries for prepayments are required to record the portion of the prepayment that represents
1. the expense incurred or,
2. the revenue earned in the current accounting period.

69. PREPAID EXPENSES
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed.
Prepaid expenses expire with the passage of time or through use and consumption.
An asset-expense account relationship exists with prepaid expenses. 6

70. PREPAID EXPENSES
Prior to adjustment, assets are overstated and expenses are understated.
The adjusting entry results in a debit to an expense account and a credit to an asset account.
Examples of prepaid expenses include supplies, rent, insurance, and property tax. 7

71. UNEARNED REVENUES
Unearned revenues are revenues received and recorded as liabilities before they are earned.
Unearned revenues are subsequently earned by performing a service or providing a good to a customer.
A liability-revenue account relationship exists with unearned revenues. 10

72. UNEARNED REVENUES
Prior to adjustment, liabilities are overstated and revenues are understated.
The adjusting entry results in a debit to a liability account and a credit to a revenue account.
Examples of unearned revenues include rent, magazine subscriptions, airplane tickets, and tuition.

73. ADJUSTING ENTRIES FOR PREPAYMENTS
Prepaid Expenses
Asset
Unadjusted Balance
Credit Adjusting Entry (-)
Expense
Debit Adjusting Entry (+)
Unearned Revenues
Liability
Unadjusted Balance
Debit Adjusting Entry (-)
Revenue
Credit Adjusting Entry (+)

74. ACCRUALS A different type of adjusting entry is accruals.
Adjusting entries for accruals are required to record revenues earned and expenses incurred in the current period.
The adjusting entry for accruals will increase both a balance sheet and an income statement account.

75. ACCRUED REVENUES
Accrued revenues may accumulate with the passing of time or through services performed but not billed or collected.
An asset-revenue account relationship exists with accrued revenues.
Prior to adjustment, assets and revenues are understated.
The adjusting entry requires a debit to an asset account and a credit to a revenue account.
Examples of accrued revenues include accounts receivable, rent receivable, and interest receivable.

76. ACCRUED EXPENSES
Accrued expenses are expenses incurred but not yet paid.
A liability-expense account relationship exists.
Prior to adjustment, liabilities and expenses are understated.
The adjusting entry results in a debit to an expense account and a credit to a liability account.
Examples of accrued expenses include accounts payable, rent payable, salaries payable, and interest payable.

77. FORMULA TO CALCULATE INTEREST
Face Value of Note
Annual Interest Rate
Time
(in Terms of One Year)
Interest x x =
$5,000 x % x /12 = $25

78. ADJUSTING ENTRIES FOR ACCRUALS
Asset
Debit Adjusting Entry (+)
Accrued Revenues
Revenue
Credit Adjusting Entry (+)
Accrued Expenses
Expense
Liability

79. AMORTIZATION
Amortization is the process of allocating the cost of certain capital assets to expense over their useful life in a rational and systematic manner.
Amortization attempts to match the cost of a long-term, capital asset to the revenue it generates each period.

80. AMORTIZATION
Amortization is an estimate rather than a factual measurement of the cost that has expired.
We’re not attempting to reflect the
actual change in value of an asset!

81. Accumulated Amortization
In recording amortization, Amortization Expense is debited and a contra asset account, Accumulated Amortization, is credited.
The difference between the cost of the asset and its related accumulated amortization is referred to as the net book value of the asset.
xxx xxx
Amortization Expense
Accumulated Amortization

82. Balance Sheet Presentation
AMORTIZATION
Balance Sheet Presentation
Office equipment $5,000
Less: Accumulated amortization
Net book value $4,917

83. SUMMARY OF ADJUSTING ENTRIES
1.Prepaid Assets and Assets overstated Dr. Expenses expenses expenses Expenses understated Cr. Assets
2.Unearned Liabilities and Liabilities overstated Dr. Liabilities revenues revenues Revenues understated Cr. Revenues
3.Accrued Assets and Assets understated Dr. Assets revenues revenues Revenues understated Cr. Revenues
4.Accrued Expenses and Expenses understated Dr. Expenses expenses liabilities Liabilities understated Cr. Liabilities
5.Amortization Expense and Expenses understated Dr. Amort. Exp contra asset Assets overstated Cr. Accum Amortization
Account
Accounts before
Adjusting
Type of
Adjustment
Relationship
Adjustment
Entry

84. ADJUSTED TRIAL BALANCE
An Adjusted Trial Balance is prepared after all adjusting entries have been journalized and posted.
It shows the balances of all accounts at the end of the accounting period and the effects of all financial events that have occurred during the period.
It proves the equality of the total debit and credit balances in the ledger after all adjustments have been made.
Financial statements can be prepared directly from the adjusted trial balance.

85. TRIAL BALANCE AND ADJUSTED TRIAL BALANCE COMPARED

86. PREPARING FINANCIAL STATEMENTS
Financial statements can be prepared directly from an adjusted trial balance.
1. The income statement is prepared from the revenue and expense accounts.
2. The statement of owner’s equity is derived from the owner’s capital and drawings accounts and the net income (or net loss) shown in the income statement.
3. The balance sheet is then prepared from the asset and liability accounts and the ending owner’s capital balance as reported in the statement of owner’s equity.

87. PREPARATION OF THE INCOME STATEMENT AND THE STATEMENT OF OWNER’S EQUITY FROM THE ADJUSTED TRIAL BALANCE

88. PREPARATION OF THE BALANCE SHEET FROM THE ADJUSTED TRIAL BALANCE
From Statement of Owner’s Equity

89. STEPS IN THE ACCOUNTING CYCLE
1. Analyse transactions
2. Journalize the transactions
9. Coming next chapter
3. Post to ledger accounts
8. Coming next chapter
4. Prepare a trial balance
7. Prepare financial statements
5. Journalize and post adjusting entries
6. Prepare adjusted trial balance