Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrual Accounting Concepts Chapter 4...

Accrual Accounting ConceptsAccrual Accounting Concepts

Chapter 4Chapter 4

Prepared by Carol A. HartleyPrepared by Carol A. Hartley

Providence CollegeProvidence College

Principles of AccountingPrinciples of AccountingKimmel • Weygandt • KiesoKimmel • Weygandt • Kieso

Study ObjectivesStudy Objectives1.1. Explain the revenue recognition principle Explain the revenue recognition principle

and the matching principle.and the matching principle.

2.2. Differentiate between the cash basis and Differentiate between the cash basis and the accrual basis of accounting.the accrual basis of accounting.

3.3. Explain why adjusting entries are needed Explain why adjusting entries are needed and identify the major types of adjusting and identify the major types of adjusting entries.entries.

4.4. Prepare adjusting entries for prepayments.Prepare adjusting entries for prepayments.

Study ObjectivesStudy Objectives

5.5. Prepare adjusting entries for accruals.Prepare adjusting entries for accruals.

6.6. Describe the nature and purpose of the Describe the nature and purpose of the adjusted trial balanceadjusted trial balance

7.7. Explain the purpose of closing entries.Explain the purpose of closing entries.

8.8. Describe the required steps in the Describe the required steps in the accounting cycle.accounting cycle.

Recall:Recall: Time Period Assumption Time Period Assumption

• Divides life of business into artificial time Divides life of business into artificial time periods: monthly, quarterly, yearlyperiods: monthly, quarterly, yearly

##11 Revenue Recognition Revenue Recognition

PrinciplePrinciple• Dictates that revenue be recognized in Dictates that revenue be recognized in

the accounting period in which it is the accounting period in which it is earned.earned.

• Considered earned when the service Considered earned when the service has been provided or when the goods has been provided or when the goods are delivered.are delivered.

##11 Revenue Recognition Revenue Recognition

PrinciplePrinciple

##11 Matching Principle Matching Principle

• Requires that Requires that expensesexpenses be be recorded in the same period in recorded in the same period in which the which the revenuesrevenues they they helped produce are recorded.helped produce are recorded.

##22 Differentiate Differentiate

Between Cash Basis Between Cash Basis and and

Accrual Basis of Accounting Accrual Basis of Accounting

Cash BasisCash Basis

Revenue recorded only when cash is received.Revenue recorded only when cash is received.

Expenses recorded only when cash is paid.Expenses recorded only when cash is paid.

Cash Basis is not Cash Basis is not GAAPGAAP

Accrual Basis AccountingAccrual Basis Accounting

• Follows both . . . Follows both . . .

• Revenue Recognition PrincipleRevenue Recognition Principle

• Matching PrincipleMatching Principle

Accrual Basis is GAAPAccrual Basis is GAAP

• Revenue recorded only when earned Revenue recorded only when earned not when cash is receivednot when cash is received

• Expense recorded only when incurred Expense recorded only when incurred not when cash paidnot when cash paid

Let’s ReviewLet’s Review

Which principle dictates that efforts (expenses) Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)?be recorded with accomplishments (revenues)?

a.a. Cost principle.Cost principle.

d.d. Revenue recognition principle.Revenue recognition principle.

c.c. Periodicity principle.Periodicity principle.

b.b. Matching principle.Matching principle.

a.a. Cost principle.Cost principle.

d.d. Revenue recognition principle.Revenue recognition principle.

c.c. Periodicity principle.Periodicity principle.

b.b. Matching principle.Matching principle.

Which principle dictates that efforts (expenses) Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)?be recorded with accomplishments (revenues)?

Let’s ReviewLet’s ReviewWhen would When would revenuerevenue be recorded for the be recorded for the following scenario . . .following scenario . . .

Ad agency is hired for a project in May, Ad agency is hired for a project in May, does work in June and is paid in July?does work in June and is paid in July?

The answer is June!The answer is June!

Let’s ReviewLet’s ReviewWhen would When would expensesexpenses be recorded for this be recorded for this companion scenario . . .companion scenario . . .

The Ad agency on this project incurs The Ad agency on this project incurs $1,500 of expenses in May, $3,000 in June, $1,500 of expenses in May, $3,000 in June, and none in July?and none in July?

The answer is June! Matching says the The answer is June! Matching says the expenses should follow the revenue.expenses should follow the revenue.

Let’s ReviewLet’s ReviewWhen would When would revenuerevenue be recorded for the be recorded for the following scenario . . .following scenario . . .

Sell plane ticket on September 1 for a Sell plane ticket on September 1 for a flight on October 15?flight on October 15?

The answer is October – when the The answer is October – when the service is provided!service is provided!

Let’s ReviewLet’s ReviewWhen would When would expensesexpenses be recorded for the be recorded for the following scenario . . .following scenario . . .

The airline pays pilot salaries on The airline pays pilot salaries on October 7October 7thth for the week ended for the week ended September 30th?September 30th?

The answer is September – the pilots The answer is September – the pilots provided labor services for September provided labor services for September flights during that month.flights during that month.

Now let’s discuss how accounting Now let’s discuss how accounting makes this happens . . .makes this happens . . .

##33 Explain Why Adjusting Explain Why Adjusting

Entries are Needed Entries are Needed and and

Identify the Major Types of Identify the Major Types of Adjusting Entries Adjusting Entries

Adjusting EntriesAdjusting Entries

• Trial balance is not up to date.Trial balance is not up to date.

• To produce accurate financial statements, To produce accurate financial statements, we record adjusting entries . . .we record adjusting entries . . .

• Revenues are recognized (Revenues are recognized (recordedrecorded) when ) when they are they are earned.earned.

• Expenses are recognized (Expenses are recognized (recordedrecorded) when ) when they are they are incurredincurred (used up). (used up).

Adjusting EntriesAdjusting Entries

Adjusting entries ensure that Adjusting entries ensure that Revenue Recognition and Revenue Recognition and Matching Principles are Matching Principles are

followed!followed!

Types of Adjusting EntriesTypes of Adjusting Entries

Prepayments:Prepayments:• Prepaid expenses:Prepaid expenses: Expenses paid in cash Expenses paid in cash

and recorded as assets before they are used and recorded as assets before they are used or consumed. or consumed. (cash paid in advance)(cash paid in advance)

• Unearned Revenues:Unearned Revenues: Cash received and Cash received and recorded as liabilities before revenue is recorded as liabilities before revenue is earned. earned. (cash received in advance)(cash received in advance)

Types of Adjusting EntriesTypes of Adjusting Entries

Accruals:Accruals:• Accrued revenues:Accrued revenues: Revenues earned but not Revenues earned but not

yet received in cash or recorded yet received in cash or recorded (someone (someone owes us).owes us).

• Accrued expenses:Accrued expenses: Expenses incurred but Expenses incurred but not yet paid in cash or recorded not yet paid in cash or recorded (we owe (we owe someone else).someone else).

##44 Prepare Adjusting Entries for Prepare Adjusting Entries for

Prepayments – Prepayments – Prepaid ExpensesPrepaid Expenses• Expenses paid in cash and recorded as Expenses paid in cash and recorded as assets before they are used or consumed. assets before they are used or consumed. (paid in advance)(paid in advance)

• Prepaid expenses expire with the passage Prepaid expenses expire with the passage of time of time OROR they are consumed they are consumed (used)(used)

• Time: rent, insuranceTime: rent, insurance

• Consumed: suppliesConsumed: supplies

Prepaid ExpensesPrepaid Expenses

Amount equals cost of goods or services used up or expired

If not adjusted, expenses would be understated and assets overstated

Prepayments – Prepayments – Prepaid ExpensesPrepaid Expenses

• Start with the Start with the trial balancetrial balance to find to find information to adjust prepaymentsinformation to adjust prepayments

• Let’s use the Sierra Corporation examples Let’s use the Sierra Corporation examples in the book . . .in the book . . .

Prepaid Expenses -Prepaid Expenses - Supplies Supplies

What is the entry when you What is the entry when you purchase supplies?purchase supplies?

Prepaid Expenses -Prepaid Expenses - SuppliesSupplies

GENERAL JOURNALGENERAL JOURNAL Debit Credit Debit Credit

Oct 5 Supplies 2,500Oct 5 Supplies 2,500 Cash 2,500Cash 2,500

Purchased Advertising SuppliesPurchased Advertising Supplies

SuppliesSupplies2,5002,500Oct 5Oct 5

CashCash2,5002,500Oct 5Oct 5

Supplies Supplies ExpenseExpense

What is the adjusting entry?What is the adjusting entry?

Oct. 31: Take inventory and it shows Oct. 31: Take inventory and it shows $1,000 of supplies still on hand$1,000 of supplies still on hand

Oct 31 Supplies Expense 1,500Oct 31 Supplies Expense 1,500 Supplies Supplies 1,5001,500

To record supplies usedTo record supplies used

SuppliesSupplies2,5002,500Oct 5Oct 5

CashCash2,5002,500Oct 5Oct 5

Supplies Supplies ExpenseExpense

Oct 31Oct 31 1,5001,5001,5001,500Oct 31Oct 31

Oct 31Oct 31 1,0001,000

Supplies ExpenseSupplies ExpenseOctober

$1,500

November

$1,800

December

$1,410

January

$1,425

February

$1,601

$1,435

$1,530

$1,592

$1,622

$1,652

August

$1,427

September

$1,557

Expense varies each month with usageExpense varies each month with usage

Prepaid Expenses -Prepaid Expenses - Insurance Insurance

What is the entry when you What is the entry when you purchase the insurance policy?purchase the insurance policy?

Prepaid Expenses -Prepaid Expenses - InsuranceInsurance

Oct 4 Prepaid Insurance 600Oct 4 Prepaid Insurance 600 Cash 600Cash 600

Purchased one-year fire insurance policy.Purchased one-year fire insurance policy.

600600Oct 4Oct 4CashCash

600600Oct 4Oct 4

Insurance Insurance ExpenseExpense

Prepaid Prepaid InsuranceInsurance

Oct. 31: You are at the end of the Oct. 31: You are at the end of the month. How much of the insurance month. How much of the insurance

policy has expired?policy has expired?

$600 / 12 months = $50 per month$600 / 12 months = $50 per month

Oct 31 Insurance Expense 50Oct 31 Insurance Expense 50 Prepaid Insurance 50Prepaid Insurance 50 To record expired insurance coverageTo record expired insurance coverage

600600Oct 4Oct 4CashCash

600600Oct 4Oct 4

Insurance Insurance ExpenseExpense

Oct 31Oct 31 50505050Oct 31Oct 31

Oct 31Oct 31 550550

Prepaid Prepaid InsuranceInsurance

Insurance ExpenseInsurance ExpenseOctober

November

December

January

February

August

September

Policy Expense is the same each monthPolicy Expense is the same each month

DepreciationDepreciation

What is the entry when you What is the entry when you purchase equipment?purchase equipment?

Oct 2 Office Equipment 5,000Oct 2 Office Equipment 5,000 Cash 5,000Cash 5,000

To record purchase of office equipmentTo record purchase of office equipment

5,0005,000Oct 2Oct 2CashCash

5,0005,000Oct 2Oct 2

Depreciation Depreciation ExpenseExpense

Office Office EquipmentEquipment

• Following the matching principle, the cost Following the matching principle, the cost of assets with long lives must be allocated of assets with long lives must be allocated over their useful livesover their useful lives

• As we use the asset, we recognize a portion As we use the asset, we recognize a portion of its cost as expense: of its cost as expense: depreciationdepreciation

• Depreciation expense is an estimateDepreciation expense is an estimate

• It is an allocation of cost, NOT valuationIt is an allocation of cost, NOT valuation

Depreciation ExpenseDepreciation ExpenseOctober

November

December

January

February

August

September

Let’s say expense is estimated at $480 per year Let’s say expense is estimated at $480 per year

Oct 31 Depreciation Expense 40Oct 31 Depreciation Expense 40 Accumulated Depreciation 40Accumulated Depreciation 40

To record monthly depreciation of annual $480 estimateTo record monthly depreciation of annual $480 estimate

5,0005,000

Accumulated Accumulated DepreciationDepreciation

4040 4040Oct 31Oct 31

Depreciation Depreciation ExpenseExpense

Office Office EquipmentEquipment

Oct 2Oct 2 Oct 31Oct 31

Adjustment for DepreciationAdjustment for Depreciation

Accumulated Depreciation Depreciation Expense

Adjusting EntryCredit

Adjusting EntryDebit

Amount equals cost Amount equals cost of asset allocatedof asset allocated

to accounting periodto accounting period

CONTRA-ASSET CONTRA-ASSET ACCOUNTACCOUNT

EXPENSE EXPENSE ACCOUNTACCOUNT

Office equipmentOffice equipment $ 5,000 $ 5,000

Less: accumulated depreciationLess: accumulated depreciation 40 40

$4,960$4,960

Balance Sheet PresentationBalance Sheet Presentation

Book ValueBook Value

Accumulated depreciation Accumulated depreciation is a is a contra asset accountcontra asset account, , an offset against the fixed an offset against the fixed asset account.asset account.

Prepayments – Prepayments – Unearned RevenuesUnearned Revenues• Cash received and recorded as Cash received and recorded as

liabilities before revenue is earned. liabilities before revenue is earned. (cash received in advance)(cash received in advance)

• Earned when services are providedEarned when services are provided

• Rent, magazine subscriptions, Rent, magazine subscriptions, customer depositscustomer deposits

Unearned RevenuesUnearned Revenues

Amount equals price of services performed or goods delivered

If not adjusted, revenues would be understated and liabilities overstated

What is the entry when you are What is the entry when you are paid in advance for services?paid in advance for services?

Oct 2 Cash Oct 2 Cash 1,200 1,200 Unearned Revenue Unearned Revenue 1,2001,200

To record customer payment received in advance of servicesTo record customer payment received in advance of services

1,2001,200

RevenueRevenueUnearned Unearned RevenueRevenueCashCash

Oct 2Oct 2 Oct 2Oct 2 1,2001,200 Oct 3Oct 3 10,00010,000

Oct. 31: Some of the work has been Oct. 31: Some of the work has been performed, $400 has been earnedperformed, $400 has been earned

Oct 31 Unearned Revenue 400Oct 31 Unearned Revenue 400 Revenue Revenue 400 400

To record revenue earnedTo record revenue earned

1,2001,200

RevenueRevenue 10,00010,000 400400Oct 31Oct 31

Unearned Unearned RevenueRevenueCashCash

Oct 2Oct 2 Oct 3Oct 3Oct 2Oct 2 1,2001,200

Oct 31Oct 31 800800 Oct 31Oct 31 400400Oct 31Oct 31 10,40010,400

##55 Prepare Adjusting Entries for Prepare Adjusting Entries for Accruals – Accruals – Accrued RevenuesAccrued Revenues

• Accrued revenuesAccrued revenues: revenues earned but not yet : revenues earned but not yet received in cash or recorded at the statement date received in cash or recorded at the statement date

• Adjusting entry is required to show the Adjusting entry is required to show the receivable that exists at the balance sheet datereceivable that exists at the balance sheet date

Accrued RevenuesAccrued Revenues

Amount equals price of services performed

If not adjusted, revenues would be understated and assets understated

What is the adjusting entry for What is the adjusting entry for $200 of services performed but $200 of services performed but not billed before October 31?not billed before October 31?

Oct 31 Accounts Receivable Oct 31 Accounts Receivable 200200 Service Revenue Service Revenue 200 200

To record revenue earned but not billedTo record revenue earned but not billed

200200

Service Service RevenueRevenue

Accounts Accounts ReceivableReceivable

Oct 31Oct 31

Oct 31Oct 31 200200

Oct 3Oct 3 10,00010,000Oct 31Oct 31 400400

Oct 31Oct 31 10,60010,600

##55 Prepare Adjusting Entries for Prepare Adjusting Entries for Accruals – Accruals – AccruedAccrued ExpensesExpenses

• Accrued expenses:Accrued expenses: expenses incurred but not yet expenses incurred but not yet paid in cash or recorded at the statement datepaid in cash or recorded at the statement date

• Adjusting entry is required to show the payable that Adjusting entry is required to show the payable that exists at the balance sheet dateexists at the balance sheet date

Accrued ExpensesAccrued Expenses

Amount equals cost of expense incurred

If not adjusted, expenses would be understated and liabilities understated

Where is the Where is the interest expense interest expense

for this note?for this note?

Interest expense has Interest expense has not been recorded yet not been recorded yet for this period, so we for this period, so we need an adjustment!need an adjustment!

Accrued Expenses - InterestAccrued Expenses - Interest

Oct. 31: Signed $5,000 note on Oct. 1Oct. 31: Signed $5,000 note on Oct. 1stst with annual interest rate of 12%with annual interest rate of 12%

Use formula to calculate interest:Use formula to calculate interest:

Accrued InterestAccrued Interest

Oct 31 Interest Expense Oct 31 Interest Expense 50 50 Interest Payable Interest Payable 50 50

To record interest on notes payableTo record interest on notes payable

Interest Interest PayablePayable

Interest Interest ExpenseExpense

Oct 31Oct 31 Oct 31Oct 31 5050

Accrued Expenses - SalariesAccrued Expenses - Salaries

Oct. 31: Employees are paid every two weeks. Oct. 31: Employees are paid every two weeks. There are 3 days of October that will not be paid There are 3 days of October that will not be paid until November. Wages are $2,000 for 5 days until November. Wages are $2,000 for 5 days

Accrued SalariesAccrued Salaries

Oct 31 Salaries Expense Oct 31 Salaries Expense 1,200 1,200 Salaries Payable Salaries Payable 1,200 1,200

To record accrued salaries ( $400 a day To record accrued salaries ( $400 a day timestimes 3 days ) 3 days )

4,0004,000

Salaries Salaries PayablePayable

Salaries Salaries ExpenseExpense

Bal.Bal. Oct 31Oct 31 1,2001,200Oct 31Oct 31

Oct 31Oct 31

1,2001,200

5,2005,200

Summary of Adjusting EntriesSummary of Adjusting Entries

Note that each adjusting entry affects at least one Note that each adjusting entry affects at least one balance sheet account and at least one income balance sheet account and at least one income

statement account!statement account!

##66 Describe the nature and purpose Describe the nature and purpose

of the of the Adjusted Trial BalanceAdjusted Trial Balance

• Prepared after adjusting entries Prepared after adjusting entries journalized and postedjournalized and posted

• Shows balances of all accountsShows balances of all accounts• See the adjusting journal entry See the adjusting journal entry

changes on next slide. . .changes on next slide. . .

Adjusted Trial BalanceAdjusted Trial Balance

• Purpose is to Purpose is to prove the equalityprove the equality of total of total debit balances and total credit balances debit balances and total credit balances after the adjusting entries have been after the adjusting entries have been made.made.

• Financial statements are prepared from Financial statements are prepared from the adjusted trial balancethe adjusted trial balance

##77 Explain the Purpose of Explain the Purpose of

Closing Entries Closing Entries

• Closing entries transfer the Closing entries transfer the temporary accounting balances to temporary accounting balances to the permanent stockholders’ the permanent stockholders’ equity account – Retained equity account – Retained Earnings.Earnings.

Close Temporary Accounts OnlyClose Temporary Accounts Only

Zero balance Zero balance after closing after closing

entries!entries!

Do not close!Do not close!

Closing EntriesClosing Entries

At the start of the next period, temporary account At the start of the next period, temporary account balances are zero so you can accumulate data balances are zero so you can accumulate data

separately from data in prior periods.separately from data in prior periods.

##8 8 Describe the required steps in the Describe the required steps in the

Accounting Cycle Accounting Cycle

• Steps are performed in sequence Steps are performed in sequence and are repeated in each and are repeated in each accounting period . . .accounting period . . .

Which is Which is notnot a temporary account?a temporary account?

a.a. Salaries expense.Salaries expense.

d.d. Dividends.Dividends.

c.c. Accounts receivable.Accounts receivable.

b.b. Service revenue.Service revenue.

Which is Which is notnot a temporary account?a temporary account?

a.a. Salaries expense.Salaries expense.

d.d. Dividends.Dividends.

c.c. Accounts receivable.Accounts receivable.

b.b. Service revenueService revenue

Which account will have a zero balance Which account will have a zero balance after closing entries?after closing entries?

a.a. Service Revenue.Service Revenue.

d.d. Accumulated Depreciation.Accumulated Depreciation.

c.c. Prepaid Insurance.Prepaid Insurance.

b.b. Advertising Supplies.Advertising Supplies.

Which account will have a zero balance Which account will have a zero balance after closing entries?after closing entries?

a.a. Service Revenue.Service Revenue.

d.d. Accumulated Depreciation.Accumulated Depreciation.

c.c. Prepaid Insurance.Prepaid Insurance.

b.b. Advertising Supplies.Advertising Supplies.

Which types of accounts will appear in the Which types of accounts will appear in the post-closing trial balance?post-closing trial balance?

a.a. Permanent accounts.Permanent accounts.

d.d. None of the above. None of the above.

c.c. Accounts shown in income statement. Accounts shown in income statement.

b.b. Temporary accounts. Temporary accounts.

Which types of accounts will appear in the Which types of accounts will appear in the post-closing trial balance?post-closing trial balance?

a.a. Permanent accounts.Permanent accounts.

d.d. None of the above. None of the above.

c.c. Accounts shown in income statement. Accounts shown in income statement.

b.b. Temporary accounts. Temporary accounts.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that named in Section 117 of the United States Copyright Act without the express written consent of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2005 John Wiley & Sons, Inc. All rights reserved. Accrual Accounting Concepts Chapter 4...

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