Ch04

Accrual Accounting Concepts Accounting, Third Edition

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 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. Understand the causes of differences between net income and cash provided by operating activities. Study Objectives

Types of adjusting entries Adjusting entries for deferrals Adjusting entries for accruals Summary of basic relationships Timing Issues The Basics of Adjusting Entries The Adjusted Trial Balance and Financial Statements Closing the Books Quality of Earnings Revenue recognition principle Matching principle Accrual versus cash basis of accounting 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 Accrual Accounting Concepts

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

Timing Issues 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 matching principle.

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 matching principle.

Timing Issues “ Let the expenses follow the revenues.” SO 1 Explain the revenue recognition principle and the matching principle.

Timing Issues SO 1 Explain the revenue recognition principle and the matching principle.

Timing Issues Accrual-Basis Accounting Transactions recorded in the periods in which the events occur Revenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. Accrual- vs. Cash-Basis Accounting SO 2 Differentiate between the cash basis and the accrual basis of accounting.

Timing Issues Cash-Basis Accounting Revenues are recognized when cash is received. Expenses are recognized when cash is paid. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Accrual- vs. Cash-Basis Accounting SO 2 Differentiate between the cash basis and the accrual basis of accounting.

Timing Issues Illustration: Suppose that Fresh Colors paints a large building in 2009. In 2009 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 2010. SO 2 Differentiate between the cash basis and the accrual basis of accounting. Illustration 4-2

The Basics of Adjusting Entries 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. Every adjusting entry will include one income statement account and one balance sheet account…but NEVER Cash SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

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 matching principles are followed. SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

Types of Adjusting Entries 1. Prepaid Expenses. Expenses paid in cash and recorded as assets before they are used or consumed. Deferrals 3. Accrued Revenues. Revenues earned but not yet received in cash or recorded. 4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded. Unearned Revenues. Cash received and recorded as liabilities before revenue is earned. Accruals Illustration 4-3 Categories of adjusting entries SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

Trial Balance – Each account is analyzed to determine whether it is complete and up-to-date. Which of these accounts could be outdated? Types of Adjusting Entries SO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Illustration 4-4

Adjusting Entries for Deferrals Deferrals are either: Prepaid expenses OR Unearned revenues. Cash 1 st ! Income Statement effect is deferred SO 4 Prepare adjusting entries for deferrals.

Payment of cash, that is recorded as an asset because service or benefit will be received in the future. Adjusting Entries for “Prepaid Expenses” insurance supplies advertising Cash Payment Expense Recorded BEFORE rent maintenance on equipment fixed assets (depreciation) Prepayments often occur in regard to: SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Prepaid Expenses Costs that expire either with the passage of time or through use. Adjusting entries (1) record the expenses that apply to the current accounting period, and (2) show the unexpired costs in the asset accounts. SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses” Adjusting entries for prepaid expenses Increases (debits) an expense account and Decreases (credits) an asset account. SO 4 Prepare adjusting entries for deferrals. Illustration 4-5

Adjusting Entries for “Prepaid Expenses” Illustration: Sierra Corporation purchased advertising supplies costing $2,500 on October 5. Sierra recorded the payment by increasing (debiting) the asset Advertising 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. Advertising supplies 1,500 Advertising supplies expense 1,500 Oct. 31 SO 4 Prepare adjusting entries for deferrals. Illustration 4-6 ($2,500 – 1,000 = $1,500)

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. Prepaid insurance 50 Insurance expense 50 Oct. 31 SO 4 Prepare adjusting entries for deferrals. Illustration 4-7

Adjusting Entries for “Prepaid Expenses” Depreciation Buildings, equipment, and 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 ( Matching Principle ).

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

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

Adjusting Entries for “Prepaid Expenses” SO 4 Prepare adjusting entries for deferrals. Summary Illustration 4-10

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

Adjusting Entries for “Unearned Revenues” Unearned Revenues Company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains. The adjusting entry for unearned revenues 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.

Adjusting Entries for “Unearned Revenues” SO 4 Prepare adjusting entries for deferrals. Adjusting entries for unearned revenues Decrease (a debit) to a liability account and Increase (a credit) to a revenue account. Illustration 4-11

Adjusting Entries for “Unearned Revenues” SO 4 Prepare adjusting entries for deferrals. Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for advertising services 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 work Sierra performed for Knox during October, the company determines that it has earned $400 in October. Service revenue 400 Unearned service revenue 400 Oct. 31 Illustration 4-12

SO 4 Prepare adjusting entries for deferrals. Summary Adjusting Entries for “Unearned Revenues” Illustration 4-13

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

Revenues earned but not yet received in cash or recorded. Adjusting Entries for “Accrued Revenues” rent interest services performed BEFORE Accrued revenues often occur in regard to: Cash Receipt Revenue Recorded Adjusting entry results in: SO 5 Prepare adjusting entries for accruals.

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

Adjusting Entries for “Accrued Revenues” Adjusting entries for accrued revenues Increases (debits) an asset account and Increases (credits) a revenue account. SO 5 Prepare adjusting entries for accruals. Illustration 4-14

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

Summary Illustration 4-16 Adjusting Entries for “Accrued Revenues” SO 5 Prepare adjusting entries for accruals.

Expenses incurred but not yet paid in cash or recorded. Adjusting Entries for “Accrued Expenses” rent interest BEFORE Accrued expenses often occur in regard to: Cash Payment Expense Recorded taxes salaries Adjusting entry results in: SO 5 Prepare adjusting entries for accruals.

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

Adjusting Entries for “Accrued Expenses” Adjusting entries for accrued expenses Increases (debits) an expense account and Increases (credits) a liability account. SO 5 Prepare adjusting entries for accruals. Illustration 4-17

Adjusting Entries for “Accrued Expenses” SO 5 Prepare adjusting entries for accruals. 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%. Interest payable 50 Interest expense 50 Oct. 31 Illustration 4-19 Illustration 4-18

Adjusting Entries for “Accrued Expenses” SO 5 Prepare adjusting entries for accruals. Illustration: Sierra Corporation last paid salaries on Friday, October 26 for wages through that day; 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). Salary payable 1,200 Salary expense 1,200 Oct. 31 Illustration 4-21

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

Adjusting Entries for “Accrued Expenses” SO 5 Prepare adjusting entries for accruals. Summary Illustration 4-22

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

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 ). Its purpose is to prove the equality of debit balances and credit balances in the ledger. SO 6 Describe the nature and purpose of the adjusted trial balance.

Which of the following statements is incorrect concerning the adjusted trial balance? An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. The adjusted trial balance provides the primary basis for the preparation of financial statements. The adjusted trial balance lists the account balances segregated by assets and liabilities. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. Review Question The Adjusted Trial Balance SO 6 Describe the nature and purpose of the adjusted trial balance.

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

Preparing Financial Statements

Preparing Financial Statements Illustration 4-28

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

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

Closing the Books Illustration 4-31

Closing the Books SO 7 Explain the purpose of closing entries.

Preparing a Post-Closing Trial Balance The purpose of this 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.

Summary of the Accounting Cycle 1. Analyze business transactions 2. Journalize the transactions 6. Prepare an adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare a post-closing trial balance 4. Prepare a trial balance 3. Post to ledger accounts 5. Journalize and post adjusting entries SO 8 Describe the required steps in the accounting cycle.

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: SO 8 Describe the required steps in the accounting cycle. 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.

Keep an Eye on Cash Sierra Corporation’s income statement shows net income of $2,860 . Net income and net cash provided by operating activities often differ. SO 9 Understand the causes of differences between net income and cash provided by operating activities. Net income on a cash basis is referred to as “Net cash provided by operating activities.” The statement of cash flows, reports net cash provided by operating activities.

Keep an Eye on Cash Sierra Corporation’s income statement shows net income of $2,860 . Net income and net cash provided by operating activities often differ.

Keep an Eye on Cash The difference for Sierra is $2,840 ($5,700 - $2,860). The following summary shows the causes of this difference of $2,840.

Adjusting Entries – Using a Worksheet (Appendix) Illustration 4A-1 Form and procedure for a worksheet SO 10 Describe the purpose and the basic form of a worksheet.

Copyright “ Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.”

Ch04

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