Chapter 4

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Chapter 4

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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.

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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.

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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.

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Time Period Assumption...

Generally a month, a quarter, or a year.

An accounting time period that starts on January 1 and ends December 31 is

called a calendar year.

An accounting time period that is one year long is called fiscal year.

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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.

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Matching Principle...

requires that expenses be recorded

in the same period in which the

revenues they helped produce are

recorded. (or in the period to

which they relate)

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Cash Basis

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

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Cash Basis in not GAAP

GA

AP

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Accrual Basis Accounting

Adheres to the:• Revenue Recognition Principle• Matching Principle

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Accrual Basis Accounting

•Revenue recorded only when earned, not when cash is received•Expense recorded only when incurred, not when cash paid

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Accrual Basis adheres to...

•Generally•Accepted•Accounting•Principles

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Year 1 Year 2

Purchased paint, painted building , paid employees

Received payment for work done in year one

Activity

Accrualbasis

Cashbasis

Revenue $80,000

Expense 50,000

Net Income $30,000

Revenue $ 0

Expense 50,000

Net Loss ( $50,000)

Revenue $80,000

Expense 0

Net Income $80,000

Revenue $ 0

Expense 0

Net Income $ 0

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Adjusting Entries

Adjusting entries make the:

revenue recognition &

matching principles

HAPPEN!

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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.

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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

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You can start with the trial balance to find information to

adjust prepayments.

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Sierra CorporationTrial Balance

October 31, 2004

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

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On October 5 the company paid

$2,500 for advertising supplies.

GENERAL JOURNAL Debit Credit

Oct 5 Supplies 2,500 Cash 2,500

Purchased advertising supplies

Supplies2,500Oct 5

Cash2,500Oct 5

Supplies Expense

SuppliesIllustration 4-6

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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


Oct 5 Supplies Expense 1,500 Supplies 1,500

To record advertising supplies consumed

Supplies2,500 Oct 5

Cash2,500Oct 5

Supplies Expense

Supplies

1,500Oct 311,500Oct 31

Illustration 4-6

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Oct $1,500

Mar $1,435

Apr $1,510

May $1,592

Feb $1,601

Nov $1,800

Dec $1,410

Jan $1,425

June $1,652

July $1,621

Aug $1,427

Sept $1,555

Supplies expense is based on usage... so different amounts appear each month

Supplies Expense

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Prepaid Expenses

On October 1 the company paid $600 for a 1-year insurance policy. Coverage began

October 1.


Oct 1 Prepaid Insurance 600 Cash 600

Purchased one-year policy effective October 1

Prepaid Insurance

600Oct 1

Cash600Oct 1

Insurance Expense

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Insurance Policy

1 Year $ 600

Oct $50

Mar $50

Apr $50

May $50

Feb $50

Nov $50

Dec $50

Jan $50

June $50

July $50

Aug $50

Sept $50

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Prepaid ExpensesOn October 31st, $50 ($600/12 months) of the insurance was used-up

or expired.


Oct 31 Insurance Expense 50

Prepaid Insurance 50

Record insurance expense for the month

Prepaid Insurance

600Oct 1

Cash600Oct 1

Insurance Expense

50 Oct 3150 Oct 31

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

Depreciation

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Allocate the cost of an asset to expense over its useful life

Depreciation is an ALLOCATION CONCEPT- not a VALUATION CONCEPT.

We’re not attempting to reflect the actual change in value of an asset!

Depreciation

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Office Equipment

Depreciation= $480/year

Oct $40

Mar $40

Apr $40

May $40

Feb $40

Nov $40

Dec $40

Jan $40

June $40

July $40

Aug $40

Sept $40

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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.

Accumulated Depreciation-

Office Equipment40Oct 31

Office Equipment5,000Oct 2

Depreciation Expense

40 Oct 31

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Office equipment $ 5,000

Less : accumulated depreciation 40

$4,960

Balance Sheet Presentation

Book Value or Carrying Value

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Unearned RevenuesReceived on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31.

Unearned Service RevenueCash

1,200Oct 21,200Oct 2

Service Revenue


Oct 2 Cash 1,200

Unearned Service Revenue 1,200

Collected money for work to be performed by Dec 31.

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Unearned RevenuesDuring October $400 of the revenue was

earned.

Unearned Service RevenueCash

1,200Oct 2

Service Revenue

1,200Oct 2


Oct 31 Unearned Service Revenue 400

Service Revenue 400

To record revenue earned

Oct. 31 400 Oct. 31 400

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Accrual

•Revenue has been earned, but not collected.

•Expenses have been incurred, but not yet paid.

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Accrued Revenues

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

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Accrued Revenues

Earned $200 for advertising services to clients in October, but they were not billed until after October 31st.


Oct 31 Accounts Receivable 200

Service Revenue 200

Accounts Receivable

200Oct 31

Service Revenue

200Oct 31

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Accrued Expenses

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

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Formula for Computing Interest

Face Value of Note Interest

Timein term of One Year

Annual Interest

Rate

$ 5,000 X 12% 1/12 = $50

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

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Interest Expense Interest Payable

Oct 31 50 Oct 31 50


Oct 31 Interest Expense 50 Interest Payable 50

Accrue interest expense for the month

Accrued Interest

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

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Salaries Expense Salaries Payable

Oct 31 1,200 Oct 31 1,200


Oct 31 Salaries Expense 1,200

Salaries Payable 1,200

Accrue salary expense for the month

Accrued Salaries

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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.

Adjusted Trial Balance

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SIERRA CORPORATIONAdjusted Trial Balance

For the Month Ended October 31, 2004

SIERRA CORPORATIONRetained Earnings Statement




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Balance as Oct. 31 fromRetained Earnings Statement



SIERRA CORPORATION Balance Sheet

October 31, 2004

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Closing the BooksClosing entries transfer the temporary account balances to the retained earnings account in stockholders’ equity ...

and reduce the balances in the temporary accounts to zero.

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Temporary Permanent

All revenues accounts All asset accounts

All expense accounts All liability accounts

DividendsStockholders’ equity

accounts

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Retained Earnings is a permanent account; the others shown hereare temporary

Individual Expenses

Retained Earnings

Income Summary

Individual Revenues

Dividends

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3

4

2

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The Accounting Cycle

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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.

Chapter 4

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