ACCRUAL ACCOUNTING CONCEPTS

1. ACCRUAL ACCOUNTING CONCEPTS 4 Financial Accounting, Sixth Edition

2. Study Objectives • Explain the revenue recognition principle and the expense recognition 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 deferrals. • 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.

3. Accrual Accounting Concepts Timing Issues The Basics of Adjusting Entries The Adjusted Trial Balance and Financial Statements Closing the Books Quality of Earnings Revenue recognition principle Expense recognition principle Accrual versus cash basis of accounting Types of adjusting entries Adjusting entries for deferrals Adjusting entries for accruals Summary of basic relationships Preparing the adjusted trial balance Preparing financial statements Preparing closing entries Preparing a post-closing trial balance Summary of the accounting cycle Earnings management Sarbanes-Oxley

4. Timing Issues Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption). . . . . . Jan. Feb. Mar. Apr. Dec. • Generally a month, a quarter, or a year. • Fiscal year vs. calendar year SO 1 Explain the revenue recognition principle and the expense recognition principle.

5. Timing Issues The Revenue Recognition Principle Companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed. SO 1 Explain the revenue recognition principle and the expense recognition principle.

6. Timing Issues Illustration: Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. The journal entries for June and July would be: SO 1 Explain the revenue recognition principle and the expense recognition principle.

7. Timing Issues Illustration 4-1 (Partial) “Let the expenses follow the revenues.” This is commonly referred to as the “Matching Principle”. SO 1 Explain the revenue recognition principle and the expense recognition principle.

8. Timing Issues Accrual versus Cash Basis of Accounting • Accrual-BasisAccounting • Transactions recorded in the periods in which the events occur. • Revenues are recognized when earned, even if cash was not received. • Expenses are recognized when incurred, even if cash was not paid. SO 2 Differentiate between the cash basis and the accrual basis of accounting.

9. Timing Issues Accrual versus Cash Basis of Accounting • Cash-BasisAccounting • Revenues are recognized only when cash is received. • Expenses are recognized only when cash is paid. • Prohibited under generally accepted accounting principles (GAAP). SO 2 Differentiate between the cash basis and the accrual basis of accounting.

10. Timing Issues Illustration: Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012. Illustration 4-2 (Partial) SO 2 Differentiate between the cash basis and the accrual basis of accounting.

11. The Basics of Adjusting Entries • Adjusting entries are necessary for accounts to reflect “Economic Reality” at the financial statement date. • Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. • A company must make adjusting entries every time it prepares financial statements. • Includes one income statement account and one balance sheet account. SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

12. The Basics of Adjusting Entries • Revenues- recorded in the period in which they are earned. • Expenses - recognized in the period in which they are incurred. • Adjusting entries- needed to ensure that the revenue recognition and expense recognition (Matching) principles are followed. SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

13. Types of Adjusting Entries Illustration 4-3 Categories of adjusting entries Deferrals: 1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. 2. Unearned revenues: Cash received and reported as liabilities before revenue is earned. 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. SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

14. Types of Adjusting Entries Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. Does it reflect Economic Reality? Illustration 4-4 SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

15. Adjusting Entries for Deferrals • Deferralsare either: • Prepaid expenses • OR • Unearned revenues. SO 4 Prepare adjusting entries for deferrals.

16. Adjusting Entries for “Prepaid Expenses” • Prepaid Expenses • Costs that expire either with the passage of time or through use. • Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account. SO 4 Prepare adjusting entries for deferrals.

17. Adjusting Entries for “Prepaid Expenses” Illustration: Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Oct. 31 Supplies Expense 1,500 Supplies 1,500 ($2,500 – 1,000 = $1,500) Illustration 4-6 (Partial) SO 4 Prepare adjusting entries for deferrals.

18. Adjusting Entries for “Prepaid Expenses” Illustration: On October, 4 Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 ÷ 12) expires each month. Oct. 31 Insurance Expense 50 Prepaid Insurance 50 Illustration 4-7 (Partial) SO 4 Prepare adjusting entries for deferrals.

19. Adjusting Entries for “Prepaid Expenses” • Depreciation • Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired. • Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life. • Depreciation does not attempt to report the actual change in the value of the asset. SO 4 Prepare adjusting entries for deferrals.

20. Adjusting Entries for “Prepaid Expenses” Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Oct. 31 Depreciation Expense 40 Accumulated Depreciation-Equipment 40 Illustration 4-8 (Partial) SO 4 Prepare adjusting entries for deferrals.

21. Adjusting Entries for “Prepaid Expenses” • Statement Presentation • Accumulated Depreciation-Equipment is a contraasset account. • Appears just after the account it offsets (Equipment) on the balance sheet. Illustration 4-9 SO 4 Prepare adjusting entries for deferrals.

22. Adjusting Entries for “Unearned Revenues” Receipt of cash that is recorded as a liability because the revenue has not been earned. Cash Receipt Revenue Recorded BEFORE Unearned revenues often occur in regard to: • magazine subscriptions • customer deposits • rent • airline tickets SO 4 Prepare adjusting entries for deferrals.

23. Adjusting Entries for “Unearned Revenues” • Unearned Revenues • Adjusting entry to record the revenue that has been earned and to show the liability that remains. • Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. SO 4 Prepare adjusting entries for deferrals.

24. Adjusting Entries for “Unearned Revenues” Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Sierra performed for Knox during October, the company determines that it has earned $400 in October. Oct. 31 Unearned Service Revenue 400 Service Revenue 400 Illustration 4-12 (Partial) SO 4 Prepare adjusting entries for deferrals.

25. Adjusting Entries for Accruals • Made to record: • Revenues earned and • OR • Expenses incurred • in the current accounting period that have not been recognized through daily (routine) entries. SO 5 Prepare adjusting entries for accruals.

26. Adjusting Entries for “Accrued Revenues” Accrued Revenues An adjusting entry serves two purposes: (1) Shows the receivable that exists, and (2) Records the revenues earned. SO 5 Prepare adjusting entries for accruals.

27. Adjusting Entries for “Accrued Revenues” Illustration:In October, Sierra Corporation earned $200 for guide services that were not billed to clients before October 31. Oct. 31 Accounts Receivable 200 Service Revenue 200 Illustration 4-15 SO 5 Prepare adjusting entries for accruals.

28. Adjusting Entries for “Accrued Expenses” Accrued Expenses An adjusting entry serves two purposes: (1) Records the obligations, and (2) Recognizes the expenses. SO 5 Prepare adjusting entries for accruals.

29. Adjusting Entries for “Accrued Expenses” Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%. Illustration 4-18 Oct. 31 Interest Expense 50 Interest Payable 50 Illustration 4-19 (Partial) SO 5 Prepare adjusting entries for accruals.

30. Adjusting Entries for “Accrued Expenses” Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days). Illustration 4-20 SO 5 Prepare adjusting entries for accruals.

31. Adjusting Entries for “Accrued Expenses” Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days). Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Illustration 4-21 SO 5 Prepare adjusting entries for accruals.

32. Summary of Basic Relationships SO 5 Prepare adjusting entries for accruals.

33. The Adjusted Trial Balance After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance). The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger. The adjusted trial balance is the primary basis for the preparation of the financial statements. SO 6 Describe the nature and purpose of the adjusted trial balance.

34. The Adjusted Trial Balance SO 6

35. Preparing Financial Statements Financial statements are prepared directly from the Adjusted Trial Balance. Income Statement Retained Earnings Statement Balance Sheet SO 6 Describe the nature and purpose of the adjusted trial balance.

36. Preparing Financial Statements Illustration 4-27

37. Preparing Financial Statements Illustration 4-28

38. Closing the Books At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings. Illustration 4-29 SO 7 Explain the purpose of closing entries.

39. Closing the Books In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. Illustration 4-30 SO 7 Explain the purpose of closing entries.

40. Closing the Books • There are 4 Closing Entries • Close all revenue accounts to income summary. • Close all expense accounts to income summary. • Close income summary to R.E. • Close dividends to R.E. • That’s all there is to it!

41. Closing the Books 2012 Illustration 4-31

42. Preparing a Post-Closing Trial Balance The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. All temporary accounts will have zero balances. SO 7 Explain the purpose of closing entries.

43. Summary of the Accounting Cycle Illustration 4-33 Required steps in the accounting cycle 1. Analyze business transactions 9. Prepare a post-closing trial balance 2. Journalize the transactions 8. Journalize and post closing entries 3. Post to ledger accounts 7. Prepare financial statements 4. Prepare a trial balance 6. Prepare an adjusted trial balance • Journalize and post adjusting entries: • Deferrals/Accruals SO 8 Describe the required steps in the accounting cycle.

44. Quality of Earnings Quality of Earnings– company provides full and transparent information. Earnings Management- the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Companies may manage earnings by: • one-time items to prop up earnings numbers. • inflate revenue numbers in the short-run. • improper adjusting entries. As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting. SO 8 Describe the required steps in the accounting cycle.