Accrual Accounting & Adjusting Entries Chapter 4

Chapter 4 Highlights Examine Revenue Recognition and Matching Principles What is an accrual? What type of accrual entries do we need? Prepare adjusting entries, closing entries and an adjusted Trial Balance

Revenue Recognition Accounting rule: revenue must be recorded in the books in the period it is “earned” For example: If purchase a CD on May 1st but don’t pay for it until June Record sale in May

Matching Principle Expenses must be matched to revenue i.e.. must record all expenses associated with the revenue you are recording Not following either of this principles will distort results!

Cash Basis of Accounting Revenue recorded only when cash received Expense recorded only when cash paid Not GAAP

Accrual Basis of Accounting Adheres to the Revenue recognition principle Matching principle Revenue recorded when earned, not only when cash received Expense recorded when incurred, not only when cash paid

Adjusting Entries Required to ensure matching and rev recognition followed Normally req’d each time statements are prepared

Common Adjusting Entries Unearned Revenue = cash rec’d and recorded before revenue has been earned Should appear as a liability Example: maintenance fees, deposits Prepaid Expense = item paid for that have not been used or consumed (ie shown as assets) Example: autopac insurance

Common Adjusting Entries Accrued Revenue = revenue earned but not yet recorded and/or cash not rec’d yet Example: Home builder Accrued Expenses = expenses incurred but not yet billed or paid for Example: place ad in the newspaper on April 27 not billed until May

Summary of Adjustments Type of Adjustment Adjusting Entries Prepd Exp. Dr. Exp Cr. Assets Unearned Rev. Dr. Liab Cr. Rev. Accrued Rev. Dr. Assets Accrued Exp. Dr. Exp. Cr. Liab.

Adjusted Trial Balance 1st need to journalize the adjusting entries Next post adjusting entries Prepare the “new” adjusted Trial balance reflecting these changes Note: all should still balance between Dr & Cr balances

Adjusted Trial Balance Once adjusted TB has been prepared and reviewed create financial stmts Note: Top of financial statement(s) should have 3 lines 1st – Organization name 2nd – Type of report 3rd – reporting period and date

Closing the Books Involves preparing the books for a new year of activity I/S related accounts must be closed as they represent the activity for a period only I.e. not cumulative

Closing the Books Temporary Accounts Temporary accounts are closed (i.e. record entry to create a zero balance in that account) at the end of the period All Rev & Exp are closed out to a summary acct. called “Income Summary” which is then closed out to Retained Earnings Temporary Accounts All revenue accounts All expense accounts Dividends

Retained Earnings is a permanent account; the others shown here are temporary Individual Expenses Retained Earnings Income Summary Individual Revenues Dividends 1 3 4 2

The Accounting Cycle Review Analyze business transactions Journalize the transactions Post to ledger accounts Prepare a trial balance Journalize and post adjusting entries-prepayments and accruals

The Accounting Cycle Review Prepare an adjusting trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance

Chapter 4 – The End