1. Chapter 12
Skyline College

2. The Accrual Basis of Accounting
system of accounting by which all revenues and expenses are matched and reported on financial statements for the applicable period.
Financial statements usually are prepared using the accrual basis of accounting.
The accrual basis of accounting is different than the cash basis of accounting. In accrual basis accounting, Revenues are recognized when earned, not when paid. Expenses are recorded when they are incurred, not when they are paid.

3. Revenue Recognition
Revenue is recognized when earned, regardless when the cash is received.
Revenue is recognized when the sale is complete.
A sale is complete when title to the goods passes to the customer or when the service is provided.
For sales on account, revenue is recognized when the sale occurs even though the cash is not collected immediately.
In accrual basis accounting, revenue is recognized when earned, not necessarily when the cash is received.

4. The Matching Principle
Expenses are recognized when incurred or used, not necessarily when cash is paid.
Each expense is assigned to the accounting period in which it helped to earn revenue for the business, regardless when paid.
This is often referred to as matching revenues and expenses.
In accrual basis accounting, expenses are recognized when incurred or used, not necessarily when cash is paid.

5. Adjustment for Merchandise Inventory
An asset account for merchandise inventory is maintained in the general ledger.
Inventory
All purchases of merchandise are debited to the Purchases account.
Purchases
The Merchandise Inventory account is an asset that appears on the Balance Sheet. The amount in the account is the beginning balance at the start of the period. However, the journal entry to record the purchase of inventory for cash (assuming a periodic inventory system) is to debit Purchases and credit Cash. At the end of the period, Merchandise Inventory still contains the beginning balance and it must be adjusted to show the ending merchandise on hand.
All sales of merchandise are credited to the revenue account Sales.
Sales

6. Merchandise Inventory
Notice that no entries are made directly to the Merchandise Inventory account during the accounting period.
when the trial balance is prepared at the end of the period, the Merchandise Inventory account still shows the beginning inventory for the period.
When the trial balance is prepared at the end of the period, the Merchandise Inventory account still shows the beginning inventory for the period.
Merchandise Inventory
Purchases
Sales

7. Adjustment for Merchandise Inventory
The first step in determining the ending inventory is to count the number of units of each type of item on hand.
As the merchandise is counted, the quantity on hand is entered on an inventory sheet.
At the end of the period, a merchandiser takes a physical inventory count to determine how much inventory is still on hand.

8. The adjustment is made in two steps.
Based on a count taken on December 31, merchandise inventory for Simpson Antiques totaled $47,000.
Simpson Antiques needs to adjust the Merchandise Inventory account to reflect the balance at the end of the year.
The adjustment is made in two steps.
Simpson Antiques needs to adjust the Merchandise Inventory account to reflect the balance at the end of the year.
The adjustment is made in two steps: 1) the beginning inventory is taken off the books by transferring the account balance to the Income Summary account and 2) the ending inventory is placed on the books by debiting Merchandise Inventory and crediting Income Summary.
Each step needs two general ledger accounts:
Merchandise Inventory
Income Summary

9. The first step is to remove beginning inventory from the books
The first step is to remove beginning inventory from the books. Simpson Antiques began the year with $52,000 in inventory.
Beginning
Inventory
the amount of the first
inventory adjustment
Let’s try removing the old balance of Simpson Antiques.
$52,000

10. Adjustment for Beginning Inventory Merchandise Inventory
Income Summary
Merchandise Inventory
(a) 52,000 +
Bal. 52,000 -
52,000 (a)
Here is the entry in T account form.

11. The next step is to place ending inventory on the books
The next step is to place ending inventory on the books. Simpson Antiques ended the year with $47,000 in inventory.
Ending
Inventory
the amount of the next
inventory adjustment
Next, we need to put the new ending inventory balance into the Merchandise Inventory account.
$47,000

12. Adjustment for Ending Inventory Merchandise Inventory
Income Summary +
(b) 47,000
47,000 (b)
This is what the T accounts would look like.

13. Adjustment for Losses from Uncollectible Accounts
Credit sales are made with the expectation that the customers will pay the amount due
Sometimes the account receivable is never collected.
Losses from uncollectible accounts are classified as operating expenses.
Losses from uncollectible accounts are classified as operating expenses.

14. Uncollectible Accounts Expense
Under accrual accounting, the expense for uncollectible accounts is recorded in the same period as the related sale (matching principle).
The expense is estimated because the actual amount of uncollectible accounts is not known until later periods.
The estimated expense is debited to an account named Uncollectible Accounts Expense.
The business wants to match the expense for uncollectible accounts with the sales revenue for the same period.

15. Percentage of Sales Method
In the percentage of net credit sales method
The rate used is based on the company's past experience with uncollectible accounts and management's assessment of current business conditions.
There are several ways to estimate the amount of the uncollectible accounts. Simpson Antiques uses percentage of net credit sales.

16. Net credit sales for the year were $100,000.
Simpson Antiques estimates that 0.80 percent of net credit sales will be uncollectible.
Net credit sales for the year were $100,000.
The estimated expense for uncollectible accounts is $800 ($100,000 x ).
If .8 percent of net credit sales are estimated to be uncollectible then the business needs to record $800 of expense.

17. Allowance for Doubtful Accounts <1,050>
The entry to record the expense for uncollectible accounts includes a credit to a contra asset account, Allowance for Doubtful Accounts.
This account appears on the balance sheet as follows.
Accounts Receivable $32,000
Allowance for Doubtful Accounts <1,050>
Net Accounts Receivable $30,950
When the adjustment is made, Uncollectible Accounts Expense is debited and a contra-asset account Allowance for Doubtful Accounts is credited.

18. Adjustment for Uncollectible Accounts
Uncollectible Accounts Expense
Allowance for Doubtful Accounts +
250 BEG BAL +
© 800
©008

19. Because the expense was already recorded based on the estimate.
Why doesn’t Uncollectible Accounts Expense increase when a customer’s account is written off?
Because the expense was already recorded based on the estimate.
When an account is written off, we reduce the customer’s Accounts Receivable with a credit and debit Allowance for Doubtful Accounts. We do not debit Uncollectible Accounts Expense.

20. Adjustments for Depreciation
Property, plant, and equipment are long-term assets that are used in the operation of a business. Plant & Equipment are subject to depreciation.
Property, plant, and equipment are long-term assets that are used in the operation of a business and that are subject to depreciation. We will use the straight-line method to depreciate the store’s equipment.
Land (property) is not depreciated.

21. Adjustments for Accrued Expenses
Accrued expenses are expense items that relate to the current period but have not yet been paid and do not yet appear in the accounting records.
Accrued expenses are expense items that relate to the current period but have not yet been paid and do not yet appear in the accounting records.

22. Simpson Antiques makes adjustments for three types of accrued expenses:
Accrued salaries (f)
Accrued payroll taxes (g)
Accrued interest on notes payable (i)
Because accrued expenses involve amounts that must be paid in the future, the adjustment for each item is a debit to an expense account and a credit to a liability account.
We will be making end of period adjustments to accrue salaries expenses, payroll tax expenses and interest expense on a note payable.

23. Adjustment for Accrued Salaries
From December 28 to January 3, the firm hired several part-time clerks for the year-end sale.
Through December 31, 2007, these employees earned $1,200.
The part-time salaries expense has not been recorded because the employees will not be paid until January 3, 2008.
Salaries owed to employees but not due to be paid until the following month are $1,200.

24. Adjustment for Accrued Salaries Salaries Expense – Sales
Salaries Payable +
(f) 1,200 +
1,200 (f)
And here are the T account postings.

25. Accrued Payroll Taxes
Payroll taxes are not legally owed until the salaries are paid.
Businesses that want to match revenue and expenses in the appropriate period make adjustments to accrue the employer's payroll taxes even though the taxes are technically not yet due.
Businesses that want to match revenue and expenses in the appropriate period make adjustments to accrue the employer's payroll taxes even though the taxes are technically not yet due.

26. Accrued Payroll Taxes
None of the part-time clerks employed by Simpson Antiques have reached the social security wage base limit.
The entire $1,200 of accrued salaries is subject to the employer's share of social security and Medicare taxes.
The entire $1,200 of accrued salaries is subject to the employer's share of social security and Medicare taxes.

27. The accrued employer's payroll taxes are:
Social security tax $1,200 x = $ 74.40
Medicare tax ,200 x =
Total accrued payroll taxes $91.80
$74.40 of social security tax will be accrued and $17.40 of medicare tax will be recorded in the adjustment.

28. Adjustment for Accrued Payroll Taxes Social Security Tax Payable
Payroll Taxes Expense
Social Security Tax Payable
Medicare Tax Payable +
(g) 91.80 +
(g) +
17.40 (g)
Here is how the adjustment would look in the T accounts.

29. The entire $1,200 is also subject to unemployment taxes.
The accrued unemployment taxes are:
Federal unemployment tax $1,200 x = $ 9.60
State unemployment tax $1,200 x =
Total accrued unemployment taxes for federal and state are $74.40.
Total accrued taxes $

30. Adjustment for Accrued Payroll Taxes
Payroll Taxes Expense
FUTA Payable
SUTA Payable +
74.40 (h) +
9.60 (h) +
64.80 (h)
Here we see the adjustment.

31. Accrued Interest on Notes Payable
On December 1, 2007, Simpson Antiques issued a two-month note for $2,000, with annual interest of 12 percent.
Simpson Antiques will pay the interest when the note matures on February 1, 2008.
However, the interest expense is incurred day by day and should be allocated to each fiscal period involved in order to obtain a complete and accurate picture of expenses.
We need to accrue one month of interest expense on the note payable.

32. The accrued interest expense amount is determined by using the interest formula:
Principal x Rate x Time
$2, x x 1/ = $20
The fraction 1/12 represents one month, which is 1/12 of a year.
Using our interest formula, we calculate $20 of interest has accrued on the note.
Date of note: December 1, 2007
Expense for 2007 = 1 month (Dec )

33. Adjustment for Accrued Interest on Notes Payable
Interest Expense
Interest Payable +
(i) 20 +
20 (i)
Here we see the adjustment.

34. Adjustments for Prepaid Expenses
Prepaid expenses (also called deferred expenses) are expenses that are paid for and recorded before they are used, such as rent or insurance.
Simpson Antiques makes adjustments for three types of prepaid expenses:
Prepaid expenses, also called deferred expenses, are expenses that are paid for and recorded before they are used, such as rent or insurance.
Prepaid supplies
Prepaid insurance
Prepaid interest on notes payable

35. Adjustment for Prepaid Interest on Discounted Notes Payable
On November 1, 2007, Simpson Antiques borrowed $9,000 from its bank and signed a three-month note at an annual interest rate of 10 percent. The bank deducted the entire amount of interest in advance.
Two months of prepaid interest on the note payable has expired.

36. Adjustment for Prepaid Interest on Discounted Notes Payable
Principal x Rate x Time
$9,000 x 0.10 x 3/12
We will reduce the prepaid interest amount by 2/3 of the $225 amount..
the amount of interest prepaid for three months
= $225

37. 2 months (November and December)
The interest expense for 1 month is $75:
$225  3 months = $75 OR
$9,000 x 10% x 1/12 = $75
$ 75
X 2
2 months (November and December)
the interest expense
for 2007
$150 of the prepaid interest has expired.
$150

38. Adjustment for Prepaid Interest on Discounted Notes Payable
Interest Expense
Prepaid Interest +
(i) +
Bal -
150 (i)
Here is what the adjustment would look like.

39. Adjustments for Accrued Income
Accrued income is income that has been earned but not yet received and recorded.
On December 31, 2007, Simpson Antiques had two types of accrued income:
Accrued income is income that has been earned, but not yet received and recorded.
Accrued interest on notes receivable
Accrued commission on sales tax

40. Accrued Interest on Notes Receivable
On November 1, 2007, Simpson Antiques accepted from a customer a four-month, 12.5 percent note for $1,200.
The interest income is recorded when it is received, which is normally when the note matures.
However, interest income is earned day by day.
At the end of the period, an adjustment is made to recognize accrued interest income earned but not yet received or recorded.
Simpson will record 2 months of interest earned on the note receivable.

41. The amount of earned interest income is determined by using the interest formula:
Principal x Rate x Time
$1, x x 2/ = $30
The fraction 1/12 represents one month, which is 1/12 of a year.
Two months of interest is $30.
Date of note: November 1, 2007
Income for 2007 = 2 months (Nov.1 – Dec. 31)

42. Adjustment for Accrued Interest on Notes Receivable
Interest Receivable
Interest Income +
(i) 30 +
Bal
(i)
Here is the adjustment in the T accounts.

43. Adjustments for Unearned Income
Unearned income (also called unearned revenue or advances from customers) is income received before it is earned.
Unearned income, also called deferred income, is income received before it is earned.

44. Simpson Antiques has no unearned income.
Under the accrual basis of accounting, only income that has been earned appears on the income statement.
Simpson Antiques has no unearned income.
Simpson Antiques has no unearned income.

45. Unearned Income Items include:
Subscription income
Management fees
Rental income
Legal fees
Architectural fees
Construction fees
Advertising income
These are examples of unearned income items which may exist in a firm.

46. The Adjusted Trial Balance section of the worksheet is completed as follows.
1. Combine the amount in the Trial Balance section and the Adjustments section for each account.
2. Enter the results in the Adjusted Trial Balance section.
The accounts that do not have adjustments are simply extended from the Trial Balance section to the Adjusted Trial Balance section.
The accounts that are affected by adjustments are recomputed. Follow these rules to combine amounts on the worksheet.
Let’s review how to prepare the adjusted trial balance on the worksheet.

47. Notice that the debit and credit amounts in Income Summary are not combined in the Adjusted Trial Balance section.
Both the beginning and ending balances in the Merchandise Inventory accounts need to be seen in the Income Summary account on the adjusted trial balance. Do not combine the two numbers. They will both be needed when we prepare the income statement.

48. Preparing the Income Statement Columns
The Income Summary debit and credit amounts are also entered in the Income Statement section of the worksheet.
Carry both debit and credit amounts in the Income Summary account to the Income Statement section. (Do not combine them.)
Assets, liability, owner’s capital and the owner’s drawing account are carried to the balance sheet section.