Chapter 4

1. Chapter 4

2. Chapter 4Accrual Accounting Concepts After studying Chapter 4, you should be able to: • Explain the revenue recognition principle and the matching 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 prepayments.

3. Chapter 4Accrual Accounting Concepts After studying Chapter 4, you should be able to: • 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.

4. Time Period Assumption... Divides the economic life of a business into artificial time periods WHY? to provide immediate feedback on how the business is doing.

5. Time Period Assumption... • Generally a month, a quarter, or a year. An accounting time period that is one year long is called fiscal year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year.

6. Revenue Recognition Principle... • dictates that revenue be recognized in the accounting period in which it is earned. • is considered earned • when the service has been provided or • when the goods are delivered.

7. Matching Principle... requires that expensesbe recorded in the same period in which the revenues they helped produce are recorded. (or in the period to which they relate)

8. Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid.

9. GAAP Cash Basis in not GAAP

10. Accrual Basis Accounting • Adheres to the: • Revenue Recognition Principle • Matching Principle

11. Accrual Basis Accounting • Revenue recorded only when earned, not when cash is received • Expense recorded only when incurred, not when cash paid

12. Accrual Basis adheres to... • Generally • Accepted • Accounting • Principles

13. Year 1 Year 2 Activity Purchased paint, painted building , paid employees Received payment for work done in year one Accrual basis Revenue $80,000 Expense 50,000 Net Income $30,000 Revenue $ 0 Expense 0 Net Income $ 0 Cash basis Revenue $ 0 Expense 50,000 Net Loss ( $50,000) Revenue $80,000 Expense 0 Net Income $80,000

14. Adjusting Entries Adjusting entries make the: • revenue recognition & • matching principles HAPPEN!

15. Types of Adjusting Entries • Prepayments: • Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed. • Unearned Revenues: Cash received and recorded as liabilities before revenue is earned. • Accruals: • Accrued revenues: Revenues earned but not yet received in cash or recorded. • Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

16. Prepayments • Cash or other asset has been spent but the item acquired has not been used or consumed • Cash has been collected before revenue is earned

17. You can start with the trial balance to find information to adjust prepayments.

18. Sierra Corporation Trial Balance October 31, 2004 Debit Credit Cash $15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable $ 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 $28,700 $28,700

19. Illustration 4-6 Supplies On October 5 the company paid $2,500 for advertising supplies. Supplies Expense Cash Supplies Oct 5 2,500 Oct 5 2,500 GENERAL JOURNAL Debit Credit Oct 5 Supplies 2,500 Cash 2,500 Purchased advertising supplies

20. Oct 31 1,500 Oct 31 1,500 Illustration 4-6 Supplies An inventory on October 31 reveals that $1,000 of supplies remain on hand; therefore $1,500 of supplies have been used. ($2,500 - $1,000) =$ 1,500 Supplies Expense Cash Supplies Oct 5 2,500 Oct 5 2,500 GENERAL JOURNAL Debit Credit Oct 5 Supplies Expense 1,500 Supplies 1,500 To record advertising supplies consumed

21. Supplies Expense Oct $1,500 Nov $1,800 Dec $1,410 Jan $1,425 Feb $1,601 Mar $1,435 Apr $1,510 May $1,592 June $1,652 July $1,621 Aug $1,427 Sept $1,555 Supplies expense is based on usage... so different amounts appear each month

22. Insurance Expense Prepaid Insurance Cash Oct 1 600 Oct 1 600 Prepaid Expenses On October 1 the company paid $600 for a 1-year insurance policy. Coverage began October 1. GENERAL JOURNAL Debit Credit Oct 1 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective October 1

23. Insurance Policy 1 Year $ 600 Oct $50 Nov $50 Dec $50 Jan $50 Feb $50 Mar $50 Apr $50 May $50 June $50 July $50 Aug $50 Sept $50

24. Oct 31 50 Oct 31 50 Prepaid Expenses On October 31st, $50 ($600/12 months) of the insurance was used-up or expired. Insurance Expense Prepaid Insurance Cash Oct 1 600 Oct 1 600 GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month

25. Depreciation How do you apply the Matching Principle to the cost of a long lived asset ?

26. Depreciation Allocate the cost of an asset to expense over its useful life Depreciation is an ALLOCATIONCONCEPT- not a VALUATION CONCEPT. We’re not attempting to reflect the actual change in value of an asset!

27. Office Equipment Depreciation= $480/year Oct $40 Nov $40 Dec $40 Jan $40 Feb $40 Mar $40 Apr $40 May $40 June $40 July $40 Aug $40 Sept $40

28. Oct 2 5,000 Oct 31 40 Oct 31 40 Accumulated Depreciation-Office Equipment Depreciation Expense Office Equipment GENERAL JOURNAL Debit Credit Oct 31 Depreciation Expense 40 Accumulated Depreciation-Office Equip 40 To record monthly depreciation Accumulated depreciation is a contra asset account - an offset against the fixed asset account.

29. Book Value or Carrying Value Balance Sheet Presentation Office equipment $ 5,000 Less : accumulated depreciation 40 $4,960

30. Unearned Service Revenue Service Revenue Cash Oct 2 1,200 Oct 2 1,200 Unearned Revenues Received on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31. GENERAL JOURNAL Debit Credit Oct 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by Dec 31.

31. Oct. 31 400 Oct. 31 400 Oct 2 1,200 Oct 2 1,200 Unearned Revenues During October $400 of the revenue was earned. Service Revenue Unearned Service Revenue Cash GENERAL JOURNAL Debit Credit Oct 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned

32. Accrual • Revenue has been earned, but not collected. • Expenses have been incurred, but not yet paid.

33. Accrued Revenues Revenues earned but not yet received in cash or recorded at the statement date

34. Accrued Revenues Accounts Receivable Service Revenue Oct 31 200 Oct 31 200 Earned $200 for advertising services to clients in October, but they were not billed until after October 31st. GENERAL JOURNAL Debit Credit Oct 31 Accounts Receivable 200 Service Revenue 200

35. Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date.

36. Formula for Computing Interest Face Value of Note Annual Interest Rate Time in term of One Year Interest $ 5,000 X 12% = $50 1/12 • Interest expense is the cost a company incurs to use money: • Information needed to compute interest expense: • face value of note • interest rate (always expressed in annual rate) • the length of time note is outstanding

37. Interest Expense Interest Payable Oct 31 50 Oct 31 50 Accrued Interest GENERAL JOURNAL Debit Credit Oct 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month

38. Accrued Salaries - Salaries Paid for after the Service Has Been Performed.

39. Salaries Expense Salaries Payable Oct 31 1,200 Oct 31 1,200 Accrued Salaries GENERAL JOURNAL Debit Credit Oct 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month

40. Adjusted Trial Balance The adjusted trial balance is used to prove the equity of total debit balances and total credit balances after the adjusting entries have been made. Financial statements can be easily prepared from the adjusted trial balance.

41. SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 SIERRA CORPORATION Retained Earnings Statement For the Month Ended October 31, 2004

42. SIERRA CORPORATION Balance Sheet October 31, 2004 SIERRA CORPORATION Adjusted Trial Balance For the Month Ended October 31, 2004 Balance as Oct. 31 from Retained Earnings Statement

43. Closing the Books Closing entries transfer the temporary account balances to the retained earnings account in stockholders’ equity ... and reduce the balances in the temporary accounts to zero.

44. Temporary Permanent All revenues accounts All asset accounts All expense accounts All liability accounts Dividends Stockholders’ equity accounts

45. Individual Revenues Individual Expenses 2 1 Income Summary 3 Retained Earnings is a permanent account; the others shown here are temporary Retained Earnings 4 Dividends

46. The Accounting Cycle

47. Required Steps in the Accounting Cycle • Analyze business transactions. • Journalize the transactions. • Post to ledger accounts. • Prepare a trial balance. • Journalize and post adjusting entries--prepayments and accruals. • Prepare an adjusting trial balance.