CHAPTER 4

Accrual Accounting and

Completing the Accounting Cycle

CHARACTERISTICS OF THEACCOUNTING MODEL

Periodic Reporting

Accrual-Basis Accounting

Adjusting Entries

Closing Entries

PERIODIC REPORTING

Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be summarized each period.

Fiscal Year--An accounting period that lasts 12 months.

Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely.

PERIODIC REPORTING

Fiscal Year--An accounting period that lasts 12 months.

Calendar Year—A fiscal year that lasts 12 months and ends on December 31.

Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely.

PERIODIC REPORTING

Fiscal Year-- For publicly traded companies, the period covered by annual financial statements which are prepared for the public (Annual Report), and the SEC (Form 10K ).

PERIODIC REPORTING

Quarter--An accounting period that lasts 3 months. For publicly traded companies quarterly financial reports are prepared and sent to the SEC (Form 10Q).

Month--May be a calendar month or a series of periods lasting 4 and 5 weeks.

Time Periods are often further divided into Quarters and Months

PERIODIC REPORTING

LIFE CYCLE OF A BUSINESS ENTITY

Accounting Period

1

Accounting Period

2

Accounting Period

3

Balance Sheet

Balance Sheet

Balance Sheet

Inc Statement, Statement of RE,

Cash Flow Statement

Inc Statement, Statement of RE,

Cash Flow Statement

Inc Statement, Statement of RE,

Cash Flow Statement

ACCRUAL ACCOUNTING

Accrual-basis accounting is a concept in which revenues and expenses are recorded when earned or incurred, not when cash is received or paid.

Revenues and expenses must be assigned to the proper accounting period.

“Revenue recognition principle” and the “matching principle” determine the accounting period items are recorded in.

REVENUE RECOGNITION

1. The earning process is “substantially complete.”

2. An exchange has taken place.

Revenue is recognized when two criteria are met:

THE MATCHING PRINCIPLE

All expenses incurred to generate revenues must be recognized in the same period as the related revenues.

Example: The cost of goods sold for an item must be matched with the sales revenue generated in any time period.

DETERMINING ACCRUAL INCOME

Recognized Revenues of 2009 - Matched Expenses of 2009

= Net Income for 2009

STEPS IN THE ACCOUNTING CYCLE

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to the general ledger.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare the adjusted trial balance.

7. Prepare financial statements.

8. Journalize and post the closing entries.

9. Balance the accounts and prepare a post-closing trial balance.

STEP 5 - ADJUSTING ENTRIES

Adjusting entries are required at the end of each accounting period for accrual-basis accounting, prior to preparing the financial statements.

The purpose for adjusting entries are to:

1. Bring Balance Sheet accounts current.

2. Reflect proper amounts of revenues and expenses on the Income Statement.

TIPS REGARDING ADJUSTING ENTRIES

Analytical Process. You must determine what original entry was made (if any) and what the ending balances should be before you know what adjusting entry to make. You cannot memorize adjusting entries.

Adjusting entries always include a Balance Sheet account and an Income Statement account.

Adjusting entries never involve a CASH account.

3-STEP PROCESS FORADJUSTING ENTRIES

1 Identify the original entries that were made, if any. (Original entries were only made for unearned revenues and prepaid expenses.)

2 Determine what the correct balances should be at this point in time.

3 Make the adjustments needed to correct the balances.

MOST COMMON ADJUSTING ENTRIES

Prepaid Expenses--Expenses that have been recorded (paid) but not yet incurred.

Unearned Revenues--Revenues that have been recorded (received) but not yet earned.

Accrued Revenues--Revenues that have been earned but not yet recorded.

Accrued Expenses--Expenses that have been incurred but not yet recorded.

On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry?

EXAMPLE: PREPAID EXPENSES

On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry?

EXAMPLE: PREPAID EXPENSES

Original Entry 3,600 3,600

Correct Balances1,800 1,800

Prepaid Rent CashRent

Expense

On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry?

EXAMPLE: PREPAID EXPENSES

Original Entry 3,600 3,600

Correct Balances1,800 1,800

Prepaid Rent CashRent

Expense

Adjusting Entry 1,800 1,800

Adjusting Entry: 12/31 Rent Expense 1,800 Prepaid Rent 1,800

On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach?

PREPAID EXPENSES

On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach?

PREPAID EXPENSES

Original Entry 3,600 3,600

Correct Balances1,800 1,800

Prepaid Rent Cash Rent Expense

On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach?

PREPAID EXPENSES

Original Entry 3,600 3,600

Correct Balances1,800 1,800

Prepaid Rent Cash Rent Expense

•Adjusting Entry 1,800 1,800

Adjusting Entry: 12/31 Prepaid Rent 1,800 Rent Expense 1,800

On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it?

EXAMPLE: UNEARNED REVENUE

On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it?

EXAMPLE: UNEARNED REVENUE

Original Entry 5,000 5,000

Correct Balances 2,500 2,500

Unearned Rev Cash Show Rev

On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it?

EXAMPLE: UNEARNED REVENUE

Original Entry 5,000 5,000

Correct Balances 2,500 2,500

Unearned Rev Cash Show Rev

•Adjusting Entry 2,500 2,500

Adjusting Entry: 12/31 Unearned Rev 2,500 Show Rev 2,500

EXAMPLE: ACCRUED REVENUE

The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice nor receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry?

EXAMPLE: ACCRUED REVENUE

The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice nor receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry?

Original Entry none none

Correct Balances 500 500

Rent Receivable Rent Revenue

EXAMPLE: ACCRUED REVENUE

The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice or receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry?

Original Entry none none

Correct Balances 500 500

Rent Receivable Rent Revenue

Adjusting Entry: 12/31 Rent Receivable 500 Rent Revenue 500

The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry?

EXAMPLE: ACCRUED EXPENSE

The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry?

EXAMPLE: ACCRUED EXPENSE

Original Entry none none

Correct Balances 1,000 1,000

Property Tax Expense

Property Tax Payable

The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry?

EXAMPLE: ACCRUED EXPENSE

Original Entry none none

Correct Balances 1,000 1,000

Property Tax Expense

Property Tax Payable

Adjusting Entry: 12/31 Property Tax Expense 1,000 Property Tax Payable 1,000

•Which of the following is not a True statement? 

a) Accumulated depreciation is a contra-asset.

b) Depreciation expense is a contra-expense.

c) Accumulated depreciation has a normal credit balance.

d) Depreciation expense has a normal debit balance.

Accrued EXPENSE

There are 9 steps in the Accounting Cycle. List them in order.

(Hint: Three of them contain the words “Trial Balance”)

1. __________________________

2. __________________________

3. __________________________

4. __________________________

5. __________________________

6. __________________________

7. __________________________

8. __________________________

9. __________________________

STEPS IN THE ACCOUNTING CYCLE

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to the general ledger.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare the adjusted trial balance.

7. Prepare financial statements.

8. Journalize and post the closing entries.

9. Balance the accounts and prepare a post-closing trial balance.

Prepare Financial

Statements

Record Trans-actions

Prepare Trial

Balance

Make Adjusting Entries

• After all transactions have been recorded, a trial balance prepared, and adjusting entries made . . . the financial statements can be prepared.

Step 7Preparing Financial Statements

STEP 8THE CLOSING PROCESS

Nominal Accounts (temporary accounts) are closed to a zero balance at the end of each accounting period.

Real Accounts (permanent accounts) are not closed to a zero balance at the end of the accounting period. These accounts are carried forward to the next period.

Closing Entries reduce all nominal accounts to a zero balance.

Examples

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)

Nominal Accounts

Revenues

Expenses

Dividends

(Income Statement Accounts)

Examples

CLOSING ENTRIES

Dec 31 Sales Revenue....................... 1,500

Rent Revenue........................ 100

Cost of Goods Sold............ 1,100

Salaries Expense............... 200

Other Expenses................. 150

Retained Earnings............. 150

The Goal: Move all Revenue and Expense items (Net Income) into Retained Earnings.

This is not

the actual

entry!

Closing the books ALWAYS requires

4 closing entries

CLOSING ENTRIES

Closing Entry 1.Close all revenue accounts by debiting them.

Dr. Cr. Sales Revenue............ 13,000 Rent Revenue………... 2,000

Income Summary... 15,000

CLOSING ENTRIES

Revenues

Bal. xxx

Income Summary

Revenues

The Closing Process

xxxxxx

Since the revenue account is Since the revenue account is a nominal account, it is a nominal account, it is closed at the end of the closed at the end of the period to Income Summary.period to Income Summary.

xxxxxx

Closing Entry 2.Close all expense accounts by creditingthem.

Dr. Cr.Income Summary…............. 13,600 Cost of Goods Sold….... 12,800 Insurance Expense........ 500 Supplies Expense.......... 300

The Closing Process

Expenses

Bal. YYY YYYYYYThe expense accounts are The expense accounts are credited in order to close credited in order to close the account at the end of the account at the end of the period.the period.

xxx Rev.Exp.

Income Summary

YYYYYY

The Closing Process

Closing Entry 3.Close Income Summary.

Dr. Cr.Income Summary…............. 1,400 Retained Earnings.….... 1,400

The Closing Process

Retained Earnings

Net IncomeNet Income

The Income Summary The Income Summary account is closed with a account is closed with a debit ordebit or credit depending credit depending on its balance.on its balance.

xxx Rev.Exp.

Income Summary

Net IncomeNet Income

YYY

The Closing Process

Closing Entry 4.Close Dividends (if any).

Dr. Cr.Retained Earnings…............ 500 Dividends………….….... 500

The Closing Process

ABOUT DIVIDENDS

Dividends are not expenses. They are distributions to stockholders of part of the corporation’s earnings.

Dividends reduce Retained Earnings.

For example: If a company earns $1,400 of Net Income, paying dividends to shareholders does not change Income.

Declaration of Dividends:Dividends...................... 500 Dividends Payable.... 500

EXAMPLE: DIVIDENDS

Declaration of Dividends:Dividends...................... 500 Dividends Payable.... 500

Payment of Dividends:Dividends Payable......... 500 Cash........................ 500

EXAMPLE: DIVIDENDS

Declaration of Dividends:Dividends...................... 500 Dividends Payable.... 500

Payment of Dividends:Dividends Payable......... 500 Cash........................ 500

Closing Entry for Dividends:Retained Earnings......... 500 Dividends................. 500

EXAMPLE: DIVIDENDS

The dividends The dividends account, which is also account, which is also nominal, is credited to nominal, is credited to close out the balance.close out the balance.

Net Inc.Div.

Retained Earnings

dddddd

Dividends

Bal. ddd dddddd

The Closing Process

Retained Earnings

Beg. Bal. BBB

Rev.

Exp.

Div.

End. Bal. EEE

Retained Earnings Retained Earnings is a is a realreal account account and always carries and always carries a balance.a balance.

Net IncomeNet Income for the for the period is added by period is added by these two entries.these two entries.

The Closing Process

STEP 8. POST-CLOSING TRIAL BALANCE

Provides a listing of all real account balances at the end of the closing balance.

The Trial Balance assures that total debits equal total credits prior to the beginning of the new accounting period.

Revenues and expenses will not appear because they have no balances.

Only real accounts will have a balance at this time.

Jim Brewster, Inc.Post-Closing Trial Balanceas of December 31, 2008

Debits CreditsCash $ 8,200Accounts Receivable 4,000Inventory 3,000Supplies 1,000Accounts Payable $ 5,000Capital Stock 10,000Retained Earnings _____ _ 1,200Totals $16,200 $16,200

Post Closing Trial BalanceExample

STEPS IN THE ACCOUNTING CYCLE

1. Analyze transactions and business documents.

2. Journalize transactions.

3. Post journal entries to the general ledger.

4. Determine account balances and prepare a trial balance.

5. Journalize and post adjusting entries.

6. Prepare the adjusted trial balance.

7. Prepare financial statements.

8. Journalize and post the closing entries.

9. Balance the accounts and prepare a post-closing trial balance.

CASH-BASIS ACCOUNTING

Revenue and expenses are recognized only when cash is received or payments are made.

Mainly used by small businesses.

Not an accurate picture of true profitability.

Example: Accrual vs. Cash-Basis

Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31.

Example: Accrual vs. Cash-Basis

Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31.

Brewster EnterprisesReported Income for 20XX

Cash-Basis AccountingCash Receipts $41,000Cash Disbursement 28,000 Income $13,000

Example: Accrual vs. Cash-Basis

Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31.

Brewster EnterprisesReported Income for 20XX

Cash-Basis Accounting Accrual Basis AccountingCash Receipts $41,000 Revenues Earned $48,000Cash Disbursement 28,000 Expenses Incurred 31,000Income $13,000 Income $17,000

CASH BASIS IS NOT GAAP

GAAP

APPENDIX -- WORKSHEETS

May be useful for you to review to clarify the Adjusting Entry process and the surrounding Trial Balances.

Worksheets are used to simplify the process of preparing financial statements.

Worksheets are also used to analyze end-of-period adjustments.

Most accountants use a spreadsheet to prepare the worksheet electronically.

Trial balances are used to test whether total debits equal total credits.

ADJUSTING ENTRIES – USING A WORKSHEET ADJUSTING ENTRIES – USING A WORKSHEET (APPENDIX)(APPENDIX)

ADJUSTING ENTRIES – USING A WORKSHEET ADJUSTING ENTRIES – USING A WORKSHEET (APPENDIX)(APPENDIX)

•Illustration 4A-1•Form and procedure for a worksheet

THE END