C4 Accrual Accounting Concept

8/13/2019 C4 Accrual Accounting Concept

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4-2

1. Explain the revenue recognition principle and the expense recognitionprinciple.

2. Differentiate between the cash basis and the accrual basis of

accounting.

3. Explain why adjusting entries are needed, and identify the major

types of adjusting entries.

4. Prepare adjusting entries for deferrals.

5. Prepare adjusting entries for accruals.

6. Describe the nature and purpose of the adjusted trial balance.

7. Explain the purpose of closing entries.

8. Describe the required steps in the accounting cycle.

9. Understand the causes of differences between net income and cash

provided by operating activities.

Study Objectives


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Types ofadjustingentries

Adjustingentries fordeferrals

Adjustingentries foraccruals

Summary ofbasicrelationships

Timing Issues

The Basics of

Adjusting

Entries

The Adjusted

Trial Balance

and Financial

Statements

Closing the

Books

Quality of

Earnings

Revenuerecognitionprinciple

Expenserecognitionprinciple

Accrual versuscash basis ofaccounting

Preparing theadjusted trialbalance

Preparingfinancialstatements

Preparingclosing entries

Preparing apost-closingtrial balance

Summary ofthe accountingcycle

Earningsmanagement

Sarbanes-Oxley

Accrual Accounting Concepts


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Generally a month, a quarter, or a year.Fiscal year vs. calendar year

Accountants divide the economic life of a business intoartificial time periods (Periodicity Assumption).

SO 1 Expla in the revenue recogni t ion p r inc ip leand the expense recogni t ion pr inc ip le.

Jan. Feb. Mar. Apr. Dec.. . . . .

Timing Issues


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What is the periodicity assumption?

a. Companies should recognize revenue in the

accounting period in which it is earned.

b. Companies should match expenses with revenues.

c. The economic life of a business can be divided into

artificial time periods.d. The fiscal year should correspond with the calendar

year.

Review Question

Timing Issues



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Timing Issues

The 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.



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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:



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Timing Issues

Let the expenses follow the revenues.


Illustration 4-1 (Partial)


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Timing Issues


Illustration 4-1GAAP

relationships in revenueand expense recognition


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Accrual-BasisAccounting

Transactions recorded in the periods in which the

events occur.

Revenuesare recognized when earned, even if cash

was not received.

Expensesare recognized when incurred, even if cash

was not paid.

Timing Issues

Accrual versus Cash Basis of Accounting

SO 2 Differentiate between the cash basisand the accrual basis of account ing .


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Cash-BasisAccounting

Revenues are recognized only when cash is received.

Expenses are recognized only when cash is paid.

Prohibited under generally accepted accounting

principles (GAAP).

Timing Issues


Accrual versus Cash Basis of Accounting


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Timing Issues

Illustration: Suppose that Fresh Colors paints a largebuilding in 2011. In 2011, 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 2012.




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Which one of these statements about the accrual basis of

accounting is false?

a. Companies record events that change their financial

statements in the period in which events occur, even ifcash was not exchanged.

b. Companies recognize revenue in the period in which it is

earned.

c. This basis is in accord with generally accepted accountingprinciples.

d. Companies record revenue only when they receive cash,

and record expense only when they pay out cash.

Review Question

Timing Issues



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Adjusting entries make it possible to report correct

amounts on the balance sheetand on the income

statement.

A company must make adjusting entries every time

it prepares financial statements.

Includes one income statement account and one

balance sheet account.

The Basics of Adjusting Entries

SO 3 Expla in why adjust ing entr ies are needed, andident i fy the major types of adjust ing entr ies


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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 expense recognition

principles are followed.




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Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which

they are incurred.b. revenues are recorded in the period in which they

are earned.

c. balance sheet and income statement accounts

have correct balances at the end of an accountingperiod.

d. All of the above.

Review Question




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Types of Adjusting Entries

Illustration 4-3Categories of adjusting entries


Deferrals:1. Prepaid expenses: Expenses paid in cash

and recorded as assets before they are used orconsumed.

2. Unearned revenues: Cash received andreported as liabilities before revenue is earned.

Accruals:

1. Accrued revenues: Revenues earned butnot yet received in cash or recorded.2. Accrued expenses: Expenses incurred

but not yet paid in cash or recorded.


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Trial Balance

Each account is

analyzed to

determinewhether it is

complete and up-

to-date.

Types of Adjusting Entries


Illustration 4-4


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Deferralsare either:

Prepaid expenses

OR

Unearned revenues.

Adjusting Entries for Deferrals

SO 4 Prepare adjus t ing entr ies for deferrals.


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Payment of cash, that is recorded as an asset becauseservice or benefit will be received in the future.

Adjusting Entries for Prepaid Expenses

insurance

suppliesadvertising

Cash Payment Expense RecordedBEFORE

rent

equipmentbuildings

Prepayments often occur in regard to:



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Prepaid Expenses

Costs that expire either with the passage of time or

through use.

Adjusting entry results in an increase (a debit) to an

expense account and a decrease (a credit) to an asset

account.




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Adjusting entries for prepaid expenses

Increases (debits) an expense account andDecreases (credits) an asset account.


Illustration 4-5


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Illustration: Sierra Corporation purchased supplies costing $2,500on October 5. Sierra recorded the purchase by increasing (debiting)

the asset 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.

Supplies 1,500

Supplies Expense 1,500Oct. 31



Illustration 4-6 (Partial)($2,5001,000 = $1,500)


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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 50Oct. 31





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Depreciation

Buildings, equipment, and motor 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 assets useful life.

Depreciation does not attempt to report the actual

change in the value of the asset.




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Illustration: For Sierra Corporation, assume that depreciation onthe office equipment is $480 a year, or $40 per month.

Accumulated Depreciation-Equipment 40

Depreciation Expense 40Oct. 31





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Statement Presentation

Accumulated Depreciation-Equipment is a contra asset

account.

Appears just after the account it offsets (Equipment) on

the balance sheet.



Illustration 4-9


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Summary Illustration 4-10


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Receipt of cash that is recorded as a liability because therevenue has not been earned.

Adjusting Entries for Unearned Revenues

rent

airline tickets

Cash Receipt Revenue RecordedBEFORE

magazine subscriptions

customer deposits

Unearned revenues often occur in regard to:



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Unearned Revenues

Adjusting entry to record the revenue that has been

earned and to show the liability that remains.

Adjusting entry results in a decrease (a debit) to a

liability account and an increase (a credit) to a revenue

account.




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4-31 SO 4 Prepare adjus t ing entr ies 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


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Illustration: Sierra Corporation received $1,200 on October 2 fromR. Knox for guide services for multi-day trips 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 service Sierra performed for Knox during October, the company

determines that it has earned $400 in October.

Service Revenue 400

Unearned Service Revenue 400Oct. 31



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Illustration 4-13Summary


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Made to record:

Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

Adjusting Entries for Accruals

SO 5 Prepare adjus t ing entr ies for accr uals.


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Revenues earned but not yet received in cash orrecorded.

Adjusting Entries for Accrued Revenues

rentinterest

services performed

BEFORE

Accrued revenues often occur in regard to:

Cash ReceiptRevenue Recorded

Adjusting entry results in:



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Accrued Revenues

An adjusting entry serves two purposes:

(1) Shows the receivable that exists, and

(2) Records the revenues earned.




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Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 4-14


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Illustration: In October, Sierra Corporation earned $200 forguide services that were not billed to clients before October 31.

Service Revenue 200

Accounts Receivable 200Oct. 31



Illustration 4-15


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SummaryIllustration 4-16




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Expenses incurred but not yet paid in cash or recorded.

Adjusting Entries for Accrued Expenses

BEFORE

Accrued expenses often occur in regard to:

Cash PaymentExpense Recorded

taxes

salaries

Adjusting entry results in:


rent

interest


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Accrued Expenses

An adjusting entry serves two purposes:

(1) Records the obligations, and

(2) Recognizes the expenses.




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Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 4-17


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Illustration: Sierra Corporation signed a three-month notepayable 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 50Oct. 31


Illustration 4-18


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Illustration 4-20

Illustration: Sierra Corporation last paid salaries on October 26;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 3 days).


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Illustration: Sierra Corporation last paid salaries on October 26;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).

Salaries Payable 1,200

Salaries Expense 1,200Oct. 31

Illustration 4-21


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SummaryIllustration 4-22


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Summary of Basic Relationships



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After all adjusting entries are journalized and posted the

company prepares another trial balance from the ledger

accounts (Adjusted Trial Balance).

The adjusted trial balances purpose is to prove the

equality of debit balances and credit balances in the

ledger.

The adjusted trial balance is the primary basis for the

preparation of the financial statements.

The Adjusted Trial Balance

SO 6 Describ e the nature and pur po se of the adjust ed tr ial balance.


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SO 6


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Which of the following statements is incorrect concerning theadjusted trial balance?

a. An adjusted trial balance proves the equality of the total

debit balances and the total credit balances in the ledgerafter all adjustments are made.

b. The adjusted trial balance provides the primary basis for thepreparation of financial statements.

c. The adjusted trial balance lists the account balances

segregated by assets and liabilities.

d. The adjusted trial balance is prepared after the adjustingentries have been journalized and posted.

Review Question




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Financial statements are prepared directly from theAdjusted Trial Balance.

BalanceSheet

IncomeStatement

RetainedEarnings

Statement

Preparing Financial Statements


P i Fi i l St t t


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Illustration 4-27

P i Fi i l St t t


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Illustration 4-28


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At the end of the accounting period, companies transfer thetemporary account balances to the permanent stockholders

equity accountRetained Earnings.

Closing the Books

SO 7 Expla in the purp ose of closing entr ies.

Illustration 4-29


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In addition to updating Retained Earnings to its correctending balance, closing entries produce a zero balance in

each temporary account.

Closing the Books


Illustration 4-30

Cl i th B k


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Closing the Books

Illustration 4-31

2012

Cl i th B k


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Closing the Books

SO 7 Expla in the purp ose

of clo sing entr ies.


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The purposeof the post-closing trial balance is to provethe equality of the permanent account balances that the

company carries forward into the next accounting period.

Preparing a Post-Closing Trial Balance

All temporary accounts will have zero balances.



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Summary of the Accounting Cycle

1. Analyze business transactions

2. Journalize thetransactions

6. Prepare an adjusted trialbalance

7. Prepare financialstatements

8. Journalize and postclosing entries

9. Prepare a post-closingtrial balance

4. Prepare a trial balance

3. Post to ledger accounts

5. Journalize and postadjusting entries:Deferrals/Accruals

SO 8 Descr ibe the required steps in the accou nt ing cy cle.

Illustration 4-33

Required steps in theaccounting cycle


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Quality of Earningscompany provides full and transparentinformation.

Earnings Management- the planned timing of revenues,

expenses, gains, and losses to smooth out bumps in net income.

Companies may manage earnings by:

Quality of Earnings

SO 8 Descr ibe the required steps in the accou nt ing cy cle.

one-time items to prop up earnings numbers.

inflate revenuenumbers in the short-run.

improper adjusting entries.

As a result of theSarbanes-Oxley Act, many companies are trying toimprove the quality of their financial reporting.

Keep an Eye on Cash


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Sierra Corporations income statement shows net income of

$2,860. Net income and net cash provided by operatingactivities often differ.

Keep an Eye on Cash

SO 9 Understand the causes of di f ferences between net

incom e and cash p rovided by operat ing act iv i t ies.

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 byoperating activities.

Illustration 4-27

Keep an Eye on Cash


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The difference for Sierra is $2,840($5,700 - $2,860). The

following summary shows the causes of this difference.

Keep an Eye on Cash

SO 9

Adjusting Entries in an Automated World


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Trial Balance

Each account is

analyzed to

determine

whether it is

complete and up-

to-date.

SO 10

Illustration 4-4

Adjusting Entries in an Automated WorldUsing a Worksheet (Appendix)

Adjusting Entries in an Automated World


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basic form of a worksh eet.

Adjusting Entries in an Automated WorldUsing a Worksheet (Appendix)

1 Prepare a Trial Balance on the Worksheet


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Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.

Cash 15,200Supplies 2,500

Prepaid Insurance 600

Equipment 5,000

Notes Payable 5,000

Accounts Payable 2,500

Unearned Service Revenue 1,200

Common Stock 10,000

Retained Earnings -

Dividends 500Service Revenue 10,000

Salaries Expense 4,000

Rent 900

Totals 28,700 28,700

Balance Sheet

Adjusted Income

Trial Balance Adjustments Trial Balance Statement

1. Prepare a Trial Balance on the Worksheet

Trial balance amounts comedirectly from ledger accounts.

Include all accountswith balances.

SO 10 Descr ibe the purpos e and the basic form of a works heet.

Using a Worksheet


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Illustration 4-24General journal

showing adjustingentries

Adjusting

JournalEntries

Using a Worksheet

2012

2 Enter the Adjustments in Adjustments Columns


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Cash 15,200Supplies 2,500 1,500

Prepaid Insurance 600 50

Equipment 5,000

Notes Payable 5,000

Accounts Payable 2,500

Unearned Service Revenue 1,200 400

Common Stock 10,000

Retained Earnings -

Dividends 500Service Revenue 10,000 400

200

Salaries Expense 4,000 1,200

Rent 900

Totals 28,700 28,700

Supplies Expense 1,500

Insurance Expense 50

Accumulated

Depreciation-

Equipment 40

Depreciation Expense 40

Interest Expense 50

Accounts Receivable 200

Interest Payable 50

Salaries Payable 1,200

Totals 3,440 3,440

Net income

Totals

Balance Sheet

Adjusted Income


(a)

(b)

(d)

(e)

(c)

(f)(g)

(d)

(g)

(a)

(b)

(c)

(f)

(e)

2. Enter the Adjustments in Adjustments Columns

Enter adjustment amounts, totaladjustments columns, and check

for equality.

Add additional accounts as needed.

Adjustments Key:

(a) Supplies Used.

(b) Insurance Expired.

(c) Depreciation Expensed.

(d) Service Revenue Earned.(e) Service Revenue Accrued.

(f) Interest Accrued.

(g) Salaries Accrued.

SO 10

3 Complete the Adjusted Trial Balance Columns


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Cash 15,200 15,200Supplies 2,500 1,500 1,000

Prepaid Insurance 600 50 550

Equipment 5,000 5,000

Notes Payable 5,000 5,000

Accounts Payable 2,500 2,500

Unearned Service Revenue 1,200 400 800

Common Stock 10,000 10,000

Retained Earnings -

Dividends 500 500Service Revenue 10,000 400 10,600

200

Salaries Expense 4,000 1,200 5,200

Rent 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500

Insurance Expense 50 50

Accumulated

Depreciation-

Equipment 40 40

Depreciation Expense 40 40

Interest Expense 50 50

Accounts Receivable 200 200

Interest Payable 50 50

Salaries Payable 1,200 1,200

Totals 3,440 3,440 30,190 30,190

Net income

Totals

Balance Sheet

Adjusted Income


3. Complete the Adjusted Trial Balance Columns

Total the adjusted trial balance

columns and check for equality. SO 10

(d)

(g)

(a)

(b)

(c)

(f)

(e)

(a)

(b)

(d)

(e)

(c)

(f)(g)

4. Extend Amounts to Financial Statement Columns


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Cash 15,200 15,200Supplies 2,500 1,500 1,000

Prepaid Insurance 600 50 550

Equipment 5,000 5,000

Notes Payable 5,000 5,000

Accounts Payable 2,500 2,500

Unearned Service Revenue 1,200 400 800

Common Stock 10,000 10,000

Retained Earnings -

Dividends 500 500Service Revenue 10,000 400 10,600 10,600

200

Salaries Expense 4,000 1,200 5,200 5,200

Rent 900 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500 1,500

Insurance Expense 50 50 50

Accumulated

Depreciation-

Equipment 40 40

Depreciation Expense 40 40 40

Interest Expense 50 50 50

Accounts Receivable 200 200

Interest Payable 50 50

Salaries Payable 1,200 1,200

Totals 3,440 3,440 30,190 30,190 7,740 10,600

Net income

Totals

Balance Sheet

Adjusted Income


Extend all revenue and expense account

balances to the income statement columns.


SO 10

(d)

(g)

(a)

(b)

(c)

(f)

(e)

(a)

(b)

(d)

(e)

(c)

(f)(g)



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Cash 15,200 15,200 15,200Supplies 2,500 1,500 1,000 1,000

Prepaid Insurance 600 50 550 550

Equipment 5,000 5,000 5,000

Notes Payable 5,000 5,000 5,000

Accounts Payable 2,500 2,500 2,500

Unearned Service Revenue 1,200 400 800 800

Common Stock 10,000 10,000 10,000

Retained Earnings -

Dividends 500 500 500Service Revenue 10,000 400 10,600 10,600

200

Salaries Expense 4,000 1,200 5,200 5,200

Rent 900 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500 1,500

Insurance Expense 50 50 50

Accumulated

Depreciation-

Equipment 40 40 40

Depreciation Expense 40 40 40

Interest Expense 50 50 50

Accounts Receivable 200 200 200

Interest Payable 50 50 50

Salaries Payable 1,200 1,200 1,200

Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590

Net income

Totals

Balance Sheet

Adjusted Income



Extend all asset, liability, and equity account

balances to the balance sheet columns. SO 10

(d)

(g)

(a)

(b)

(c)

(f)

(e)

(a)

(b)

(d)

(e)

(c)

(f)(g)


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Exercise P4-2A (page 209)

C4 Accrual Accounting Concept

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