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Accrual Accounting Concepts

CHAPTER. Accrual Accounting Concepts. 4. Time Period Assumption. Divides the economic life of a business into artificial time periods Interim period (month, quarter) Year (fiscal, calendar) WHY? To provide immediate feedback on how the business is doing. Revenue Recognition Principle.

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Accrual Accounting Concepts

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  1. CHAPTER Accrual Accounting Concepts 4

  2. Time Period Assumption • Divides the economic life of a business into artificial time periods • Interim period (month, quarter) • Year (fiscal, calendar) • WHY? • To provide immediate feedback on how the business is doing

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

  4. Matching Principle • Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded

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

  6. GAAP Accrual Basis Accounting • Adheres to the time period assumption and revenue recognition and matching principles • Revenue is recorded when earned, rather than when cash is received • Expense recorded when incurred, rather than when cash is paid • Accrual accounting records events when the economic event occurs

  7. Adjusting Entries • Adjusting entries are made to adjust or update accounts at the end of the accounting period • Adjusting entries can be categorized as • Prepayments • Accruals

  8. Types of Adjusting Entries • Prepayments • Prepaid expenses • Unearned revenues • Accruals • Accrued revenues • Accrued expenses

  9. Prepayments • Cash has been spent but the item acquired has not been used or consumed (prepaid expenses) • Cash has been collected but the revenue has not been earned (unearned revenues)

  10. Supplies On January 5 the company paid $2,500 for advertising supplies. Advertising Supplies Advertising Supplies Expense Cash Jan. 5 2,500 Jan. 5 2,500 GENERAL JOURNALDebitCredit Jan. 5 Advertising Supplies 2,500 Cash 2,500 Purchased advertising supplies

  11. Supplies An inventory on January 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. ($2,500 - $1,000) =$ 1,500 Advertising Supplies Expense Advertising Supplies Cash Jan. 5 2,500 Jan. 31 1,500 Jan. 5 2,500 Jan. 31 1,500 Bal. 1,000 GENERAL JOURNALDebitCredit Jan. 5 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 To record advertising supplies consumed

  12. Insurance Expense Prepaid Insurance Cash Prepaid Expenses On February 4 the company paid $600 for a 1-year insurance policy; coverage began February 1. Feb. 4 600 Feb. 4 600 GENERAL JOURNALDebit Credit Feb. 4 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective February 1

  13. Prepaid Expenses On February 28, $50 ($600/12 months) of the insurance had been used or had expired. Insurance Expense Prepaid Insurance Cash Feb. 4 600 Feb. 4 600 Feb. 28 50 Feb. 28 50 GENERAL JOURNALDebit Credit Feb. 28 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month

  14. Amortization • How do you apply the matching principle to the cost of a long-lived asset?

  15. Amortization • Allocate the cost of an asset to expense over its useful life • Amortization is an allocation concept, not a valuation concept Note: This is not an attempt to reflect the actual change in value of an asset.

  16. Amortization Example • Assume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 years • Straight-line amortization calculation is: Cost - Salvage value = $5,000 - $200 = $480/yr Useful Life 10 OR $40/mo

  17. Amortization Example Accumulated Amortization-Office Equipment Amortization Expense Office Equipment Mar. 2 5,000 Mar. 31 40 Mar. 31 40 GENERAL JOURNALDebit Credit Mar. 31 Amortization Expense 40 Accumulated Amortization – 40 Office Equipment To record monthly amortization Accumulated Amortization is acontra assetaccount – an offset (deduction) against the asset account.

  18. Net book value Balance Sheet Presentation

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

  20. Unearned Service Revenue Service Revenue Cash Unearned Revenues During August, $400 of the revenue was earned. Aug. 2 1,200 Aug. 31 400 Aug. 2 1,200 Aug. 31 400 Bal. 800 GENERAL JOURNALDebitCredit Aug. 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned

  21. Accruals • Revenue has been earned, but not collected (accrued revenues) • Expenses were incurred, but not yet paid (accrued expenses) Note: Entry has not yet been recorded!

  22. Accrued Revenues • Revenues earned but not yet received in cash or recorded at the end of period

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

  24. Accrued Expenses • Expenses incurred but not yet paid or recorded at the end of period

  25. Accrued Interest Expense Interest expense is the cost a company incurs to use money. Information needed to calculate interest expense: • Face value of note • Interest rate (always expressed in annual rate) • The length of time note is outstanding

  26. Face Value of Note Annual Interest Rate Time in Terms of One Year Interest $ 5,000 X 12% = $50 Accrued Interest Expense Formula for Calculating Interest X 1/2

  27. Interest Expense Interest Payable Accrued Interest Expense Oct. 31 50 Oct. 31 200 GENERAL JOURNALDebitCredit Oct. 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month

  28. Accrued Salaries Expense • Assume that the employees receive total salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day. • Salaries were last paid on October 26 and the next payment of salaries will be November 9. As shown on the calendar on the following slide there are three unpaid work days remain as of October 31.

  29. Accrued Salaries Expense (Salaries paid after the service has been performed)

  30. Salaries Expense Salaries Payable Accrued Salaries Expense Oct. 31 1,200 Oct. 31 1,200 GENERAL JOURNALDebitCredit Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month

  31. Adjusted Trial Balance • Adjusted trial balance proves 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

  32. Closing the Books • Closing entries • Transfer the temporary account balances to update the retained earnings account • Reduce the balances in the temporary accounts to zero to prepare for the next period’s postings

  33. TemporaryPermanent Illustration 4-17 All revenue accounts All asset accounts All expense accounts All liability accounts Dividends account Shareholders’ equity accounts

  34. 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

  35. Required Steps in the Accounting Cycle • Analyse business transactions • Journalize the transactions • Post to general ledger accounts • Prepare a trial balance • Journalize and post adjusting entries (prepayments and accruals)

  36. Required Steps in the Accounting Cycle • Prepare an adjusted trial balance • Prepare financial statements • Journalize and post closing entries • Prepare a post-closing trial balance

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