Chapter 6 Accrual Accounting Concepts and the Accounting Cycle.
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Transcript of Chapter 6 Accrual Accounting Concepts and the Accounting Cycle.
Chapter 6
Accrual Accounting Concepts and the Accounting Cycle
In Chapter 3
You learned how to:
o Prepare Journal Entries
o Prepare an Unadjusted Trial Balance
o And use the Unadjusted Balances to prepare Financial Statements
We made it through Step 3 of the Accounting Cycle
In this chapter we need to complete the cycle…
Did she say WRONG!?
All of the transactions
were recorded correctly
Here are the financial
statements from Chapter 3
The unadjusted trial balance
was in balance…
And so was the balance sheet…
Too Bad the Balances are
wrong!
What’s the Accrual Basis of Accounting!?
Our Cash Balance is Correct!
How can the balances be
wrong…
Every Cash Receipt and
Disbursement was recorded.
So what are we missing?
Financial Statements must
be prepared using the Accrual Basis
of Accounting
The Accrual Basis is required by
GAAP
Not just the Cash Flow…..
And the Matching Principle.
Can you give us a refresher
on those?
The Accrual Basis of Accounting
looks at the economic activity…
Right! Two important Principles
are the Revenue Recognition
Principle
Generally Accepted
Accounting Principles,
right?
Revenue Recognition Principle
Requires that revenues be recorded in the time period when the work is performed.
The Earnings process is complete.Governs the Timing of Revenues
Income Statement
Revenues:Service Revenue 45,000Rental Revenue 0
Total Revenues 45,000
Expenses:Wages Expense 26,300Equipment Rental Expense 1,500Rent Expense 0Advertising expense 2,600Repairs Expense 900
0 0Total Expenses 31,300
Net Income (Loss) 13,700
Revenue
Reco
gnitio
n
Prin
ciple
Matching Principle
Requires that expenses be recorded in the same time period as the revenues they helped generate.
Governs the Timing of Expenses
Income Statement
Revenues:Service Revenue 45,000Rental Revenue 0
Total Revenues 45,000
Expenses:Wages Expense 26,300Equipment Rental Expense 1,500Rent Expense 0Advertising expense 2,600Repairs Expense 900
0 0Total Expenses 31,300
Net Income (Loss) 13,700
Revenue
Reco
gnitio
n
Prin
ciple
Match
ing
Prin
ciple
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
Illustration 4-2
Here’s an example of adhering to the matching principle…..
The unadjusted balance in the Supplies account may not be accurate.
Just because we purchased $500 of supplies……
Doesn’t mean we still have them.
500
0 0 0 0
Supplies
Unless we used none of the supplies
the balance in Supplies is
TOO HIGH!
And the Balance in Supplies Expense
500 0
0 0 0 0
Supplies Supplies Expense
is TOO LOW!
What Happened?
The Journal Entry Process (at the time of Purchase)
Was not simultaneous with the Economic Activity (Usage of the supplies)
It would be silly to prepare a journal entry every time we used the stapler?!
In order for the financial statements to be correct….
500
0 0 0 0
Supplies
The Economic Activity needs to be recorded
This is done by recording an Adjusting Entry
Recording Supplies
Expense of $350
in the time period when we
actually used the supplies is
an
Example of the Matching
Principle
500350 350
150 0 350 0
Supplies Supplies Expense
It’s all about Timing!
Timing of the journal entry
Versus Timing of the economic activity
Sometimes the cash flow precedes the economic activity
Insurance Premium paid
Use SuppliesPurchase Supplies
Policy Term
Customer Pays In Advance We Perform Services
Purchase Equipment We Use Equipment
Cash Flow has already been recorded
The Economic Activity has not yet been recorded.
Each of these prepayments
Insurance Premium paid
Use SuppliesPurchase Supplies
Policy Term
Customer Pays In Advance We Perform Services
Purchase Equipment We Use Equipment
Cash Flow has already been recorded
The Economic Activity has not yet been recorded.
Requires an adjusting
entry called a DEFERRAL
Sometimes the economic activity precedes the Cash Flow
Employees are paid.Employees Work
We Perform Services We Bill The Customer
Journal Entry for Cash flow will be recorded next period
The Economic Activity has not yet been recorded.
Each of these unpaid items….
Employees are paid.Employees Work
We Perform Services We Bill The Customer
Journal Entry for Cash flow will be recorded next period
The Economic Activity has not yet been recorded.
Requires an adjusting
entry called an ACCRUAL
The purpose of every adjusting entry:
Is to ensure that all Assets and Liabilities
And the resulting Revenues and Expenses
Are Properly Valued
Prior to the Preparation of Financial Statements.
Okay, so the unadjusted
balances are incorrect…..
But are the Balances on the Unadjusted Trial
Balance Too High
Or
Too Low?Let me
Summarize the Adjusting Entry
Process
Let’s look at the example found on page 181 in your text….
Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Unearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$
321,200$ 321,200$
Unadjusted Trial Balance
These Assets and Liabilities
are Already Recorded on the Unadjusted Trial
Balance These balances were accurate
as of the date of the cash receipt or payment, but
No longer accurately reflect the economic
activity. They will need to be
adjusted.
Items that were Prepaid and Previously Recorded
Each of these unadjusted balances is TOO HIGH!
$3,000
Unearned Revenue
$12,000
Supplies
$1,500
Prepaid Insurance
$48,000
Book Value Equipment
And needs to be reduced to its proper balance
$3,000
Unearned Revenue
$12,000
Supplies
$1,500
Prepaid Insurance
$48,000
Book Value Equipment
$3,000
$2,500
Unearned Revenue
$12,000
$8,000
Supplies
$1,500
$1,000
Prepaid Insurance
$48,000
$36,000
Book Value Equipment
Unearned Revenues
500$
500$
$3,000 Unadjusted $80,000$500 AJE $500
$2,500 Adjusted $80,500
Unearned Revenue Service Revenue
Unearned Revenue
Service Revenue
Required Adjusting Entry
This adjusting entry recognizes the amount of revenue earned in the current period, and reduces
the liability, Unearned Revenues, by $500
Supplies
4,000$
4,000$
Unadjusted $12,000$4,000 AJE $4,000
$4,000 Adjusted $8,000
Required Adjusting Entry
Supplies
Supplies Expense
Supplies
Supplies Expense
This adjusting entry recognizes the amount of supplies used in the current period, and reduces
the asset, Supplies, by $4,000.
Prepaid Insurance
500$
500$
Unadjusted $1,500$500 AJE $500
$500 Adjusted $1,000
Prepaid Insurance
Insurance Expense
Prepaid Insurance
Required Adjusting Entry
Insurance Expense
This adjusting entry recognizes the amount of insurance coverage used in the current period, and
reduces the asset, Prepaid Insurance by $500.
Each of the preceding examples
Affected current accounts:Supplies
Prepaid Insurance
Unearned Revenues
The Adjusting EntryReduced the Account Directly
Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Unearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$
321,200$ 321,200$
Unadjusted Trial Balance
Equipment is a Depreciable
Asset
There are two general ledger
accounts related to
Equipment.
Now Let’s Look at the Long-Term Accounts
Equipment and Accumulated
Depreciation
The Equipment will be used for several years to help generate revenues
Year 1 2 3 4 5
Revenues: 20% 20% 20% 20% 20%
Expense: 20% 20% 20% 20% 20%
The Matching Principle requires that we match the expense against the revenue
The Process of allocating the cost of a long-term asset over time….
Year 1 2 3 4 5
Revenues: 20% 20% 20% 20% 20%
Expense: 20% 20% 20% 20% 20%
The Matching Principle requires that we match the expense against the revenue
Is Called DEPRECIATION!
60,000
60,000
Equipment
12,000
Accumulated Depreciation
Its purpose is to reduce Equipment
Accumulated Depreciation is a Contra-Asset Account
Assets are reduced
with credits
60,000
60,000
Equipment
12,000
Accumulated Depreciation
We still own $60,000 of equipment
In a manner that preserves the historical cost information
60,000
Equipment
12,00012,000
24,000
Accumulated Depreciation
Depreciation Expense $12,000Accumulated Depreciation
$12,000
12,000
12,000
Depreciation Exp
When Long-Term Assets are used, the adjusting entry decreases the book value of the Equipment indirectly
This must be the
second year
Balance Sheet Presentation:
Equipment $60,000Less: Accumulated Depreciation ($24,000)Book Value – Equipment $36,000
This provides better information…
The Equipment cost $60,000
Balance Sheet Presentation:
Equipment $60,000Less: Accumulated Depreciation ($24,000)Book Value – Equipment $36,000
Of Which $24,000 has been charged against Prior Revenues:
Balance Sheet Presentation:
Equipment $60,000Less: Accumulated Depreciation ($24,000)Book Value – Equipment $36,000
The Remaining $36,000 Cost will be charged against Future Revenues:
Summary of Deferrals
Cash Flow preceded the Economic Activity Balance is already recorded on the
unadjusted trial balance The recorded balance is TOO HIGH And must be reduced to its proper balance
Most Accounts are reduced directlyDepreciable Assets are reduced indirectly using a contra-account.
Now Let’s look at Accruals
Accruals are required for transactions if The economic activity has occurred But is unrecorded Because the cash flow will not be recorded
until the next period.
Cash 125,200$ Accounts Receivable 20,000$ Supplies 12,000$ Interest ReceivablePrepaid Insurance 1,500$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 12,000$ Other AssetsAccounts Payable 10,000$ Salaries Payable -$ Interest PayableUnearned Revenue 3,000$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Dividends 5,000$ Retained Earnings 67,000$ Service Revenue 80,000$ Salaries Expense 37,500$ Miscellaneous Operating Expense 15,000$
321,200$ 321,200$
Unadjusted Trial Balance
These Assets and Liabilities
are Not Recorded on the Unadjusted Trial
Balance Because there has not been
any cash flow as of year end.
They are Unpaid and
Unrecorded.
But Since the Economic
Activity has already
occurred, these balances will
also need to be adjusted
Items that are Unpaid and Unrecorded
0
Interest Payable
Each of these unadjusted balances is TOO LOW
0
Salaries Payable
0
750
Salaries Payable
And needs to be increased to its proper balance.
0
2,520
Interest Payable
To Accrue Salaries
750$
750$
$37,500 Unadjusted
$750 AJE $750
$38,250 Adjusted $750
Salaries Payable
Salaries Expense
Salaries Payable
Required Adjusting Entry
Salaries Expense
This adjusting entry recognizes the amount owed to the employees at year-end and increases the
liability, Salaries Payable by $750.
To Accrue Interest
2,520$
2,520$
Unadjusted
$2,520 AJE $2,520
$2,520 Adjusted $2,520
Interest Payable
Interest Expense
Interest Payable
Required Adjusting Entry
Interest Expense
This adjusting entry recognizes the amount of interest incurred in the current period, and
increases the liability, Interest Payable, by $2,520.
Other Common Accruals
Accounts Receivable – Services have been performed, but customer has not yet been billed
Accrued Interest on Notes Receivable
Summary of Accruals
Economic Activity has Preceded the Cash Flow
Balance is NOT recorded on the unadjusted trial balance
The recorded balance is TOO LOW And must be increased to its proper balance
Journal Entries for Accruals
$ Amount Earned
$ Amount Earned
Receivable
Revenue
Required Adjusting Entry
If a liability is previously unrecorded:
If an asset is previously unrecorded:
$ Amount Incurred
$ Amount Incurred
Expense
Payable
For each item under consideration, ask if the Item has been Previously Recorded
Yes No
There is a balance that is TOO
HIGH!
There is a balance that is TOO LOW!
Ask if the Item has been Previously Recorded
Yes, Prepare
a Deferral
No, Prepare
an Accrual
Find the Account that is
Overstated and Reduce it to its proper balance
Find the Account that is
Understated and Increase it to its
proper balance
The Dollar Amount of the Adjusting Entry will Be:
For a
DeferralFor an
Accrual
The Journal Entry is for the Amount to be Deducted
from the account
The Journal Entry is for the Amount to be
Added to the Account
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Unearned Fees
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Accrued Salaries
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Supplies Used
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Insurance Expired
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Depreciation
Every Adjusting Entry affects both the Income Statement and Balance Sheet
Accrued Interest
Why do we need Closing Entries?
They are consistent with
GAAP
Here are the financial
statements using the Adjusted
Balances
Now is the Accounting
Cycle Complete?
Not Yet. It’s time for Closing
Entries
Purpose of Closing Entries
To achieve zero balances in all of the temporary equity accounts:
Revenues
Expenses
Dividends
Transfer the temporary equity amounts to Retained Earnings, which is a permanent equity account
Closing Entries Parallel the Transfer of Temporary Equity Amounts to the Statement of Retained Earnings
Revenues and Expenses are
closed to Retained Earnings
Dividends are also closed to Retained
Earnings
67,000
67,000
Retained Earnings
Closing the Income Statement to Retained Earnings….
67,0008,230
75,230
Retained Earnings
Closing Dividends Account to Retained Earnings
Beg BalNet Loss Net Income
DividendsEnd Bal
Retained Earnings
67,0005,000 8,230
70,230
Retained Earnings
Cash 125,200$ Accounts Receivable 20,000$ Supplies 8,000$ Interest ReceivablePrepaid Insurance 1,000$ Prepaid Rent 45,000$ Equipment 60,000$ Accum Depr- Equip 24,000$ Other AssetsAccounts Payable 10,000$ Salaries Payable 750$ Interest Payable 2,520$ Unearned Revenue 2,500$ Long-Term Notes Payable 25,200$ Common Stock 124,000$ Retained Earnings 70,230$ DividendsService RevenueSalaries ExpenseMiscellaneous Operating Expense
259,200$ 259,200$
Post-ClosingTrial BalanceThe Balance
Sheet Accounts are Permanent
Accounts. Their balances are Not Closed
Revenues, Expenses and Dividends are
Temporary Equity Accounts. Their
balances are zero after closing
After Closing Entries are posted, only the Balance Sheet Accounts have balances
Congratulations! You’ve completed the Accounting Cycle
End – Chapter 6