Introduction to Financial Accounting BUS ADM 201 Lecture 4.1

Chapter 4: Accrual Accounting Concepts Explain the accrual basis of accounting and the reasons for adjusting entries Prepare adjusting entries for deferrals Prepare adjusting entries for accruals Prepare an adjusted trial balance and closing entries

Revisiting the Accounting Cycle We ended the last chapter with a prepared Trial Balance The next step involves adjusting entries, but what does that mean? Prepare a Trial Balance Analyze business transactions Journalize the transaction Post to ledger accounts Adjusting Entries Adjusted Trial Balance Financial Statements Closing Entries Post-Closing Trial Balance

Recap of Accounting Transactions Transactions are economic events that require recording in the financial statements Not all activities represent transactions Assets, liabilities, or stockholders’ equity items change as a result of some economic event Typically it is an exchange Dual effect on the accounting equation

Periodicity Assumption Periodicity Assumption: Accountants divide the economic life of a business entity into artificial time periods (reporting periods) Transactions are aggregated into financial statements for a given period of time Generally, these are months, quarters, and/or years A reporting period year is called a fiscal year Fiscal years and calendar years are NOT always the same

Periodicity Assumption

Periodicity Assumption Why do we care about periodicity? Accountants need to know what period they are summarizing with financial statements so they can determine which transactions belong in which period Some transactions are complex and belong to different periods based on the basis of accounting used! There are two general methods of accounting Cash Basis Accrual Basis

Cash Basis Accounting Revenues are recognized only when cash is received Expenses are recognized only when cash is paid Not in accordance with generally accepted accounting principles (GAAP)

Accrual Basis Accounting Revenues are recognized only when goods are delivered or services are performed Expenses are recognized only when incurred (even if no cash is paid) This is the basis of accounting for the rest of the course

Accrual Basis Accounting Revenue Recognition Principle Companies recognize revenue in the accounting period in which the performance obligation is satisfied Recognition for Accrual Accounting Recognition for Cash Accounting

Accrual Basis Accounting Expense Recognition Match expenses to the corresponding revenues in the period when the company makes efforts to generate those revenues This is called the Matching Principle

Accrual Basis Accounting Example Suppose that Dennis Painting Co. paints 2 large buildings for Bernie Buildings, Inc. One in late 2016 and one in early 2017. Dennis bills the customer $80,000 for each job, but does not receive payment from Bernie for both until 2017. Suppose that in 2016 Dennis pays $50,000 cash for paint and supplies. Half of these were used on each job above. Built Building 1 Built Building 2 Bills for Both Paid for Both 1/1/2017 Bought Paint & Supplies

Accrual Basis Accounting Dennis’ Accounting 2016 2017 Cash Basis Revenue Expense Net Income Accrual basis $ 0 $ 160,000 50,000 $ ( 50,000) $ 160,000 $ 80,000 $ 80,000 25,000 25,000 $ 55,000 $ 55,000 Built Building 1 Built Building 2 Bills for Both Paid for Both 1/1/2017 Bought Paint & Supplies

Adjusting Journal Entries The way we account for the transactions during the year may require adjusting entries Journalize and Post Adjusting Entries Analyze business transactions Journalize Post Trial Balance Adjusted Trial Balance Financial Statements Closing Entries Post-Closing Trial Balance

Accrual Basis Accounting Adjusting Journal Entries Used to adjust for timing issues across periods Ensure that the revenue recognition and expense recognition principles are followed This allows for proper “cut-off” Required every time a company prepares financial statements

Adjusting Journal Entries We look at facts related to the original transactions to determine if adjustments need to be made to our trial balance

Accrual Basis Accounting Example Dennis paid $50,000 cash for paint and supplies, half of these were used in 2016 and half in 2017 2016 Paint & Supplies Inventory 50,000 Cash 50,000 2016 Paint & Supplies Expense 25,000 Paint & Supplies Inventory 25,000

Adjusting Journal Entries Deferrals Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed Unearned revenues: Cash received before service are performed Accruals Accrued revenues: Revenues for services performed but not yet received in cash or recorded Accrued expenses: Expenses incurred but not yet paid in cash or recorded

Deferrals – Prepaid Expenses Expenses paid in cash before they are used or consumed Examples 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 Insurance Advertising Equipment Supplies Rent Buildings

Deferrals – Prepaid Expenses Adjusting Journal Entry for Prepaid Expenses Increases (debits) an expense account and Decreases (credits) an asset account Illustration 4-5

Deferrals – Prepaid Expenses Depreciation Depreciation is essentially an adjustment to a prepaid expense Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired Depreciation is the process of allocating the cost of an asset to expense (depreciation) over its useful life Accumulated Depreciation is a contra asset account All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate

Deferrals – Unearned Revenues Receipt of cash recorded as a liability before services are performed Adjusting entry is made to record the revenue for services performed during the period 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 Rental Income Magazine Subscriptions Airline Tickets Customer Deposits

Deferrals – Unearned Revenues Adjusting Journal Entry for Unearned Revenues Decreases (debits) a liability account and Increases (credits) a revenue account Illustration 4-11

Deferrals – Accrued Revenues Revenues for services performed but not yet received in cash or recorded Examples An adjusting entry serves two purposes: Shows the receivable that exists Records the revenues for services performed Interest Services Performed

Deferrals – Accrued Revenues Adjusting Journal Entry for Accrued Revenues Increases (debits) an asset account and Increases (credits) a revenue account Illustration 4-14

Deferrals – Accrued Expenses Expenses incurred but not yet paid in cash or recorded Examples An adjusting entry serves two purposes: Records the obligations Recognizes the expenses Interest Utilities Taxes Salaries

Deferrals – Accrued Expenses Adjusting Journal Entry for Accrued Expenses Increases (debits) an expense account and Increases (credits) a liability account Illustration 4-17

Summary of Basic Relationships Illustration 4-23

Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 EXAMPLE: Assume Sierra Corporation starts Sierra Corporation business in early October 2016. Trial Balance Statements are prepared every month. October 31, 2016 PowerPoint Slides Unadjusted Trial Balance Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 Rent Expense 900 Insurance Expense 0 Interest Expense 0 Depreciation Expense 0 28,700 28,700 9

Information for Sierra Corporation’s October AJEs (monthly statements) Supplies: Per count, only $1,000 are left at Oct 31 Insurance: Paid $600 for a 1 year policy on Oct 1 Equipment (Depreciation): Assume depreciation expense = $40/month Notes Payable (Interest): Interest is due when note is paid next year. Rate is 12% per year. Unearned Revenue: 1/3 of the $1,200 received was earned during October Service Revenue: 50% of a $400 project was completed during the last day of October. Nothing was recorded Salaries Expense: Oct 31 is a Wednesday. Employees are paid Fridays for the M->F week. Salaries total $400/day

Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 Rent Expense 900 Insurance Expense 0 Interest Expense 0 Depreciation Expense 0 28,700 28,700 9

This is called a worksheet PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 Rent Expense 900 Insurance Expense 0 Interest Expense 0 Depreciation Expense 0 28,700 28,700 We use it to track the accounts from unadjusted trial balance through the adjustments and into the financial statements This is called a worksheet 9

Supplies: Per count, only $1,000 are left at 10/31. PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Supplies: Per count, only $1,000 are left at 10/31. Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 Prepaid Insurance 600 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 Rent Expense 900 Insurance Expense 0 Interest Expense 0 Depreciation Expense 0 28,700 28,700 1,500 1,000 1,500 1,500 9

Insurance: Paid $600 for a 1 year policy. $600/12 months = $50/month PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Insurance: Paid $600 for a 1 year policy. $600/12 months = $50/month Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 Interest Expense 0 Depreciation Expense 0 28,700 28,700 50 550 50 50 9

Equipment (Depreciation): Assume depreciation expense = $40/month Sierra Corporation Trial Balance October 31, 2016 PowerPoint Slides Equipment (Depreciation): Assume depreciation expense = $40/month Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 Accumulated Depreciation 0 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 50 50 Interest Expense 0 Depreciation Expense 0 28,700 28,700 40 40 40 40 9

Sierra Corporation Trial Balance October 31, 2016 PowerPoint Slides Notes Payable (Interest): Interest is due on note paid next year. Rate is 12% per year. $5,000 x .12 x 1/12 = $50/month Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 Accumulated Depreciation 0 40 40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 50 50 Interest Expense 0 Depreciation Expense 0 40 40 28,700 28,700 50 50 50 50 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Unearned Revenue: 1/3 of the $1,200 received was earned during October. $1,200 x 1/3 = $400 earned Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 Accumulated Depreciation 0 40 40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Salaries Payable 0 Interest Payable 0 50 50 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 50 50 Interest Expense 0 50 50 Depreciation Expense 0 40 40 28,700 28,700 400 800 400 10,400 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Service Revenue: 50% of a $400 project was completed during the last day of October. Nothing was recorded. $400 x .5 = $200 to be recorded. Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 Accumulated Depreciation 0 40 40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 400 800 Salaries Payable 0 Interest Payable 0 50 50 Common Stock 10,000 Dividends 500 Service Revenue 10,000 400 10,400 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 50 50 Interest Expense 0 50 50 Depreciation Expense 0 40 40 28,700 28,700 200 200 200+ 10,600 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Salaries Expense: 10/31 is a Wednesday. Employees are paid Fridays for the M->F week. Salaries total $400/day. $400 x 3 = $1,200 to be recorded. Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Accounts Receivable 0 200 200 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 Accumulated Depreciation 0 40 40 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 400 800 Salaries Payable 0 Interest Payable 0 50 50 Common Stock 10,000 Dividends 500 Service Revenue 10,000 400+200 10,600 Salaries Expense 4,000 Supply Expense 0 1,500 1,500 Rent Expense 900 Insurance Expense 0 50 50 Interest Expense 0 50 50 Depreciation Expense 0 40 40 28,700 28,700 1,200 1,200 1,200 5,200 9

Use to prepare Financial Statements PowerPoint Slides Sierra Corporation Trial Balance October 31, 2016 Use to prepare Financial Statements Unadjusted Trial Balance Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 15,200 Accounts Receivable 0 200 200 Advertising Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 5,000 Accumulated Depreciation 0 40 40 Notes Payable 5,000 5,000 Accounts Payable 2,500 2,500 Unearned Service Rev 1,200 400 800 Salaries Payable 0 1,200 1,200 Interest Payable 0 50 50 Common Stock 10,000 10,000 Dividends 500 500 Service Revenue 10,000 400+200 10,600 Salaries Expense 4,000 1,200 5,200 Supply Expense 0 1,500 1,500 Rent Expense 900 900 Insurance Expense 0 50 50 Interest Expense 0 50 50 Depreciation Expense 0 40 40 28,700 28,700 30,190 30,190 ILLUSTRATION 4-26 Adjusted trial balance 9

Revisiting the Accounting Cycle Once we have an Adjusted Trial Balance, we can prepare our financial statements Analyze business transactions Journalize Post Trial Balance Adjusting Entries Adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance

Preparing Financial Statements Financial statements are prepared directly from the Adjusted Trial Balance. Income Statement Retained Earnings Statement Balance Sheet

Preparing Financial Statements ILLUSTRATION 4-26 Preparation of the income statement and retained earnings statement from the adjusted trial balance

Preparing Financial Statements ILLUSTRATION 4-27 Preparation of the balance sheet from the adjusted trial balance

Revisiting the Accounting Cycle Once we have an Adjusted Trial Balance, we can prepare our financial statements Analyze business transactions Journalize Post Trial Balance Adjusting Entries Adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance

Journalize and Post Closing Entries At the end of the accounting period, we transfer temporary account balances to the permanent stockholders’ equity account—Retained Earnings This process follows the same path as the flow of information across the financial statements we just prepared In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account

Journalize and Post Closing Entries Temporary Permanent All revenue accounts All expense accounts Dividends All asset accounts All liability accounts All stockholders’ equity accounts Illustration 4-30

Journalize and Post Closing Entries Illustration 4-31

Journalize and Post Closing Entries Illustration 4-31

Journalize and Post Closing Entries Posting the entries results in a zero balance in all temporary accounts Note that the third entry matches our net income number from the Income Statement

Journalize and Post Closing Entries Posting the entries results in a zero balance in all temporary accounts Note that the third entry matches our net income number from the Income Statement Note that the T Account for Retained Earnings matches the Statement of Retained Earnings

Revisiting the Accounting Cycle With closing entries posted, we are ready to start the next fiscal period Analyze business transactions Analyze business transactions Journalize Post Trial Balance Adjusting Entries Adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance

Next Steps Starting next week we will get into detail on exactly how to do accounting for the various business transactions We will roughly follow the order of the balance sheet

Thank You!