Chp6 accrual basis of acctg

INTRODUCTORY ACCOUNTING

CHAPTER 6Accrual Basis of Accounting

ACCT 100

Adjusting Journal Entries

Fundamentals of Accounting

Chapter 5

Objectives of the Chapter

I. Introduce the accrual accounting concept.

II. Introduce the adjusting entries.

Accrual Accounting and the Financial Statements

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Adjusting the Accounts

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After studying this chapter, you should be able to:

CHAPTER 6 Accrual Basis of AccountingCHAPTER 6 Accrual Basis of Accounting

1 Explain the time period assumption.

2 Explain the accrual basis of accounting.

3 Explain why adjusting entries are needed.

4 Identify the major types of adjusting entries.

5 Prepare adjusting entries for prepayments.

6 Prepare adjusting entries for accruals.

I. Accrual Accounting

1. The time-period concept, the revenue recognition and the matching principles.

2. Accrual versus cash basis accounting.


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The Time-Period Concept (Periodicity)

Income and financial position of a business are reported periodically, not until the end of life of a business.


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Revenue Recognition Principle (Accrual Basis)

Revenue is recognized when it is earned and realized.

Earned : the entity has substantially accomplished what it must do to be entitled to compensation.

Realized: goods are exchanged for cash or claims.

In general, these conditions are met at time of sale (delivery) or when services are rendered regardless whether cash is collected or not.

Income Measurement And Profit Analysis

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OPERATING CYCLES FOR A SERVICE COMPANY

OPERATING CYCLES FOR A SERVICE COMPANY

Accounts Receivable

Cash

Service Company

Receive Cash

Perform Service

s

Revenue Recognition Principle (Accrual Basis)

The Matching Principle

If revenues are recognized in a period, all related expenses should be recognized in the same period regardless whether expenses are paid or not.

The related expenses include traceable costs (i.e., product costs), period costs, (i.e.,

interest and rent expenses) and estimated/allocation expenses (i.e., depreciation expense and bad debt expense).


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II. Adjusting Entries

Due to the periodicity concept, financial reports are prepared periodically.

Based on revenue recognition principle, adjusting entries are prepared at the end of a period to recognize revenues earned during the period but not yet recorded (i.e., accrued revenues).


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Adjusting Entries (contd.)

Based on the matching principle, the accrued expenses (i.e., expenses incurred but not yet paid/recorded) and estimated expenses (i.e., depreciation expense and bad debt expense) are recorded at the end of a period.


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Types of Adjusting Entries

A. Accruals

B. Deferrals

C. Estimated Expenses


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A. Accruals

Unrecorded revenues or expenses (i.e., revenues earned or expenses inccurred but not yet recorded).

a. Accrued expenses.

b. Accrued revenues.


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Accrued expenses are expenses incurred but not paid yet.

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

ACCRUED EXPENSESACCRUED EXPENSES


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ADJUSTING ENTRIES FOR ACCRUALS

ACCRUED INTERESTADJUSTING ENTRIES FOR ACCRUALS

ACCRUED INTEREST

Interest PayableOct. 31 50

Interest ExpenseOct. 31 50

Date Account Titles and Explanation Debit Credit Oct. 31 Interest Expense 50

Interest Payable 50 (To accrue interest on notes payable)

JOURNAL ENTRYJOURNAL ENTRY

POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.


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ACCRUED SALARIESADJUSTING ENTRIES FOR ACCRUALS

ACCRUED SALARIES

Salaries PayableOct. 31 1,200

Date Account Titles and Explanation Debit Credit Oct. 31 Salaries Expense 1,200

Salaries Payable 1,200 (To record accrued salaries)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, accrued salaries are calculated to be $1,200.

Salaries ExpenseOct. 26 4,000 31 1,200 31 5,200

a. Accrued Expenses- An Example

A one-year note payable was issued on 11/1/11 to purchase an equipment. The full amount of the note is $2,400. The annual interest rate is 10% and interests are paid on 4/30/12 and 11/1/12.

11/1/11 Equipment2,400 Note Payable 2,400

Adjusting Entry:

12/31/11 Interest Expense 40

Interest payable 40


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ACCRUED REVENUESADJUSTING ENTRIES FOR ACCRUALS

ACCRUED REVENUES

Service RevenueOct. 31 10,000 31 400 31 200 31 10,600

Accounts ReceivableOct. 31 200

Date Account Titles and Explanation Debit Credit Oct. 31 Accounts Receivable 200

Service Revenue 200 (To accrue revenue for services provided)

October 31, the agency earned $200 for advertising services that were not billed to clients before October 31.


POSTINGPOSTING

ADJUSTMENTADJUSTMENT

b. Accrued Revenues – An Example

A one year note was received from a credit sale with a face amount of $3,000 and an annual interest rate of 12% on 9/1/12. Interests are received on 3/1/13 and 9/1/13.

9/1/x1 Note Receivable 3,000

Sales Revenue 3,000

Adjusting Entry:

12/31/x1 Interest Receivable 120

Interest Revenue 120


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B. Deferrals

Postponing the recognition of Revenues or expenses

a. Unearned revenues

b. Prepaid expenses


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Unearned revenues are revenues received and recorded as liabilities before they are earned.

Unearned revenues are subsequently earned by rendering a service to a customer.

A liability-revenue account relationship exists with unearned revenues.

UNEARNED REVENUESUNEARNED REVENUES


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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, and customer deposits for future services.

UNEARNED REVENUESUNEARNED REVENUES


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ADJUSTING ENTRIES FOR PREPAYMENTS

UNEARNED REVENUESADJUSTING ENTRIES FOR PREPAYMENTS

UNEARNED REVENUES

Service RevenueOct. 31 10,000 31 400

Unearned RevenueOct. 31 400 Oct. 2 1,200

31 800


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.

Date Account Titles and Explanation Debit Credit Oct. 31 Unearned Revenue 400

Service Revenue 400 (To record revenue for services provided)

a. Unearned Revenues

Receiving $2,400 for a one-year advanced rent payment from a tenant on 12/1/11


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(B/S Approach)12/1/11Cash 2,400

Unearned Rent2,400

12/30/11Unearned Rent 200

Rent Revenue200

(I/S Approach)12/1/11Cash 2,400

Rent Revenue2,400

12/30/11Rent Revenue 2,200

Rent Unearned 2,200


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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.

PREPAID EXPENSESPREPAID EXPENSES


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Advertising Supplies ExpenseOct. 31 1,500

Advertising Supplies Oct. 5 2,500 Oct. 31 1,500 31 1,000

Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500

Advertising Supplies 1,500 (To record supplies used)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.


SUPPLIESADJUSTING ENTRIES FOR PREPAYMENTS

SUPPLIES


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INSURANCEADJUSTING ENTRIES FOR PREPAYMENTS

INSURANCE

Insurance Expense 63Oct. 31 50

Prepaid Insurance 10 Oct. 4 600 Oct. 31 50 31 550

Date Account Titles and Explanation Debit Credit Oct. 31 Insurance Expense 50

Prepaid Insurance 50 (To record insurance expired)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month.

b. Prepaid Expense

Prepaid a 12 month insurance premium of $1,200 on 11/1/11


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(B/S Approach)Prepaid Insur. 1,200

Cash 1,200

12/31/11Insurance Exp. 200 Prepaid Insurance

200

(I/S Approach)Insurance Exp. 1,200

Cash 1,200

12/31/11Prepaid Insur. 1,000

Insurance Exp.1,000


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ALTERNATIVE TREATMENTOF PREPAID EXPENSES AND UNEARNED REVENUES

ALTERNATIVE TREATMENTOF PREPAID EXPENSES AND UNEARNED REVENUES

Some businesses use an alternative treatment for prepaids and unearned revenues.

Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account.

Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account.

This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.


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ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

SUPPLIESALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

SUPPLIES

Advertising Supplies Expense Oct. 5 2,500 Oct. 31 1,000 31 1,500Advertising Supplies

Oct. 31 1,000

Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies 1,000

Advertising Supplies Expense 1,000 (To record supplies inventory)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.


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ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

UNEARNED REVENUESALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS

UNEARNED REVENUES

Service RevenueOct. 31 800 Oct. 2 1,200

31 400

Date Account Titles and Explanation Debit Credit Oct. 31 Service Revenue 800

Unearned Revenue 800 (To record unearned revenue)


POSTINGPOSTING

ADJUSTMENTADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.

Unearned RevenueOct. 31 800

Accounting Estimates

• Some assets are not fully used up in a single fiscal period.– A truck may last five years, but its value as a

resource declines with time and usage.


• Some assets are not fully used up in a single fiscal period.– A truck may last five years, but its value as a

resource declines with time and usage.

• Assets that benefit more than one year are called long-term or “fixed” assets.

http://vrpacioli.loyola.edu/ac101/chapter3/25.ram


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Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner.

The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.

DEPRECIATIONDEPRECIATION


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Depreciation is an estimate rather than a factual measurement of the cost that has expired.

In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited

Depreciation Expense

XXX

Accumulated Depreciation

XXX


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In the balance sheet, Accumulated Depreciation is offset against the asset account.

The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.



The portion of an asset’s utility that is used up must be expensed in the period used.


Cash (credit)

Cash (credit)

Fixed Asset (debit)

Fixed Asset (debit)

Journal entry when

payment is made.


Cash (credit)

Cash (credit)

Fixed Asset (debit)

Fixed Asset (debit)

Journal entry when

payment is made.

The asset’s usefulness is

partially consumed during the

period.





(credit)


(credit)

Depreciation Expense (debit)

Depreciation Expense (debit)Cash

(credit)

Cash (credit)

Fixed Asset (debit)

Fixed Asset (debit)

Journal entry when

payment is made.

The asset’s usefulness is

partially consumed during the

period.



AJE at end of period




(credit)


(credit)



This is called a contra-asset account and has a credit balance.







(credit)


(credit)








Balance Sheet Presentation Asset (at cost) $40,000Less: Accumulated Depr. 5,000Book Value $35,000





(credit)


(credit)








Definition of Book Value

Asset cost - Accumulated Depreciation



Book Value = $35,000

Truck

Bal. 40,000

Accumulated Dep’n - Truck

5,000 Bal.



GENERAL JOURNALPage: 1

Date Description PR Debit Credit

Accounting EstimatesExample

On 12/31/97, Putnam Plumbing, recorded $2,000 of Depreciation Expense on a

$10,000 truck.

Prepare the proper adjusting journal entry.

Prepare the proper adjusting journal entry.

On 12/31/97, Putnam Plumbing, recorded $2,000 of Depreciation Expense on a

$10,000 truck.

GENERAL JOURNALPage: 1

Date Description PR Debit Credit

31-Dec Depreciation Expense 2,000

Accumulated Depreciation 2,000

to record depreciation

expense on truck for the year

Accounting EstimatesExample

Chp6 accrual basis of acctg

Business

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