Accrual Accounting Concepts

Time Period Assumption... Divides the economic life of a business into reporting (time) periods. Generally a month, a quarter, semi-annual or a year. An accounting time period that is one year long is called fiscal year. A fiscal year ending December 31 is called a calendar year.

Accounting Method... Determines which time period revenues and expenses are recorded. For example, when I sell something in December but get paid the cash in January, which income statement should show the revenue, December’s or January’s? Two general methods exist: - Cash Basis - Accrual Basis

Cash Basis Method Defined Record revenue when cash is received. Record expense when cash is paid out. Not GAAP -> We won’t use in class Possible manipulation. (Receipt or payment of cash can be controlled.) Allowed for Income Taxes (sometimes).

Accrual Basis Method Defined: Record revenues when earned. - (when goods are sold or services performed) - Called Revenue Recognition Principle Record expenses when incurred. - (When they were used up to produce revenue) - Called Matching Principle. GAAP -> We will concentrate on in class. Requires adjustments and additional accounts.

EXAMPLE: Magazine Inc sells only 3 year subscriptions for Rs.60 each. On 1/1/08 sold 10,000 subscriptions and received full payment of Rs.600,000. Wages, rent, and miscellaneous operating expenses incurred and paid are Rs.50,000 per year. On 1/1/08, a special deal came along and the company bought Rs.200,000 of paper which should be enough to complete the 10,000 subscriptions for 2 years. Compute net income for 2008 and 2009 using cash method and then using accrual method.

Cash Method: 2008 2009 Revenues 600,000 0 Oper Exp - 50,000 - 50,000 Paper Exp -200,000 - 0 Net Income 350,000 - 50,000 Accrual: 2008 2009 Revenues 200,000 200,000 Oper Exp - 50,000 - 50,000 Paper Exp -100,000 - 100,000 Net Income 50,000 50,000

Adjusting Journal Entries (AJEs) PowerPoint Slides Adjusting Journal Entries (AJEs) Are needed only for the accrual method Are used to handle inter-period timing issues Split up a revenue or expense (when needed) and record part of it in one accounting period and the rest of it in a later period. For example, in the previous example 1/3 of the revenue and 1/2 of the paper. Getting revenues and expenses in the correct accounting periods is referred to as achieving a proper “Cut-Off” of the accounting period. 10

Types of Adjusting Entries PowerPoint Slides Types of Adjusting Entries Advance receipts or payments Unearned Revenues: We receive cash in advance (before revenue is earned) and we don’t complete the job before year end. Prepaid expenses: We pay cash for an item in the current period, but the item acquired has not been used up by year end. 10

Types of Adjusting Entries PowerPoint Slides Types of Adjusting Entries Delayed receipts or payments Accrued revenues: We earn revenue in the current period, but we have not received the cash or recorded the revenue by period end. Accrued expenses: We have used up an item in the current period but we have not paid for it in cash or recorded the expense by period end. 10

Unadjusted Trial Balance PowerPoint Slides Example: Sierra Corporation Unadjusted Trial Balance October 31, 2008 Debit Credit Cash Rs.15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable Rs. 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 Rs.28,700 Rs.28,700 9

Information for Sierra October AJEs (monthly statements) PowerPoint Slides Information for Sierra October AJEs (monthly statements) Supplies: Per count, only Rs.1,000 are left at 10/31. Insurance: Paid Rs.600 for a 1 year policy. Equipment (Depreciation): Assume depreciation expense = Rs.480/month Notes Payable (Interest): Interest is due when note is paid next year. Rate is 12% per year. Unearned Revenue: 1/3 of the Rs.1,200 received was earned during October. Service Revenue: 50% of a Rs.400 project was completed during the last day of October. Nothing was recorded. Salaries Expense: 10/31 is a Wednesday. Employees are paid Fridays for the M->F week. Salaries total Rs.400/day. 10

Supplies: Per count, only Rs.1,000 are left at 10/31. PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Supplies: Per count, only Rs.1,000 are left at 10/31. Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 1,500 Advert Supply Expense 1,500 9

Insurance: Paid Rs.600 for a 1 year policy. Sierra Corporation Trial Balance October 31, 2008 PowerPoint Slides Insurance: Paid Rs.600 for a 1 year policy. Rs.600/12 months = Rs.50/month Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 9

Equipment (Depreciation): Assume depreciation expense = Rs.480/month PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Equipment (Depreciation): Assume depreciation expense = Rs.480/month Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 480 Depreciation Expense 480 480 Accumulated Deprec. 480 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Notes Payable (Interest): Interest is due on note paid next year. Rate is 12% per year. Rs.5,000 x .12 x 1/12 = Rs.50/month Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 Depreciation Expense 480 480 Accumulated Deprec. 480 480 50 Interest Expense 50 50 Interest Payable 50 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Unearned Revenue: 1/3 of the Rs.1,200 received was earned during October. Rs.1,200 x 1/3 = Rs.400 earned Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 400 800 400 10,400 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 Depreciation Expense 480 480 Accumulated Deprec. 480 480 50 Interest Expense 50 Interest Payable 50 50 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Service Revenue: 50% of a Rs.400 project was completed during the last day of October. Nothing was recorded. Rs.400 x .5 = Rs.200 to be recorded. Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 400 800 +200 400 10,400 10,600 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 Depreciation Expense 480 480 Accumulated Deprec. 480 480 Interest Expense 50 50 Interest Payable 50 200 Accounts Receivable 200 9

PowerPoint Slides Sierra Corporation Trial Balance October 31, 2008 Salaries Expense: 10/31 is a Wednesday. Employees are paid Fridays for the M->F week. Salaries total Rs.400/day. Rs.400 x 3 = Rs.1,200 to be recorded. Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 50 550 400 800 400+200 10,400 10,600 1,200 5,200 Advert Supply Expense 1,500 1,500 50 Insurance Expense 50 Depreciation Expense 480 480 Accumulated Deprec. 480 480 Interest Expense 50 50 Interest Payable 50 1,200 Salaries Payable 1,200 9

Rs.600/12 months = Rs.50/month x 3 months (Oct, Nov, Dec) Sierra Corporation Trial Balance October 31, 2008 PowerPoint Slides Modification: Prepare insurance entry as of 12/31/08 assuming Sierra prepares statements only annually? Insurance: On 10/1 paid Rs.600 for a 1 year policy. Rs.600/12 months = Rs.50/month x 3 months (Oct, Nov, Dec) Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 15,200 Advertising Supplies 2,500 Prepaid Insurance 600 Office Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Rev 1,200 Common Stock 10,000 Dividends 500 Service Revenue 10,000 Salaries Expense 4,000 Rent Expense 900 28,700 28,700 1,500 1,000 150 450 Advert Supply Expense 1,500 1,500 150 Insurance Expense 150 9

CLOSING ENTRIES All accounts are classified as either permanent or temporary.

Permanent Accounts Also called Real accounts Consist of all balance sheet accounts Beginning balances are needed to arrive at ending balances DO NOT get closed

Temporary Accounts Also called nominal accounts Consist of all income statement accounts and a few more Have a temporary life = 1 accounting period Are closed (zeroed out) at the end of each accounting period

The CLOSING PROCESS PURPOSE: TIMING: Set the stage for the next accounting cycle. (Revenue & Expense accounts will contain info for the next period only). Summarize income and expenses for the period just past and record this result in the RETAINED EARNINGS account. TIMING: Performed just after the period end. (after adjusting entries)

CLOSING PROCEDURE STEP 1 Debit all revenue accounts. Credit a new account called INCOME SUMMARY. LEDGER INCOME SUMMARY SERVICE REVENUE 9000

CLOSING PROCEDURE STEP 1 Debit all revenue accounts. Credit a new account called INCOME SUMMARY. LEDGER INCOME SUMMARY 9000 SERVICE REVENUE 9000 9000 JOURNAL SERVICE REVENUE 9000 INCOME SUMMARY 9000

CLOSING PROCEDURE STEP 1 Debit all revenue accounts. Credit a new account called INCOME SUMMARY. STEP 2 Credit all expense accounts. DEBIT goes to INCOME SUMMARY. LEDGER OPERATING EXPENSE INCOME SUMMARY 9000 SERVICE REVENUE 5000 9000 9000 JOURNAL SERVICE REVENUE 9000 INCOME SUMMARY 9000

CLOSING PROCEDURE STEP 1 Debit all revenue accounts. Credit a new account called INCOME SUMMARY. STEP 2 Credit all expense accounts. DEBIT goes to INCOME SUMMARY. LEDGER OPERATING EXPENSE INCOME SUMMARY 5000 9000 SERVICE REVENUE 5000 5000 9000 9000 JOURNAL SERVICE REVENUE 9000 INCOME SUMMARY 9000 INCOME SUMMARY 5000 OPERATING EXPENSE 5000

STEP 3 Determine the balance in the INCOME SUMMARY account. Then close it out. Use RETAINED EARNINGS for the other debit or credit. LEDGER INCOME SUMMARY RETAINED EARNINGS 5000 9000 Beginning balance 4000

STEP 3 Determine the balance in the INCOME SUMMARY account. Then close it out. Use RETAINED EARNINGS (or CAPITAL) for the other debit or credit. LEDGER INCOME SUMMARY RETAINED EARNINGS 5000 9000 Beginning balance 4000 4000 4000 JOURNAL INCOME SUMMARY 4000 RETAINED EARNINGS 4000

STEP 4 Close the DIVIDENDS PAID (or Drawing) out directly to the RETAINED EARNINGS account. Not to Income Summary! LEDGER DIVIDENDS PAID RETAINED EARNINGS 1000 Beginning balance 4000 Income Summary

STEP 4 Close the DIVIDENDS PAID out directly to the RETAINED EARNINGS account. Not to Income Summary! LEDGER DIVIDENDS PAID RETAINED EARNINGS 1000 Beginning balance 4000 Income Summary 1000 1000 Ending balance JOURNAL RETAINED EARNINGS 1000 DIVIDENDS PAID 1000

Required Steps in the Accounting Cycle PowerPoint Slides Required Steps in the Accounting Cycle 1. Analyze business transactions. 2. Journalize the transactions. 3. Post to ledger accounts. 4. Prepare a trial balance. 5. Journalize and post adjusting entries. Prepare an adjusting trial balance. Prepare financial statements Journalize and post closing entries Prepare a post closing trial balance 20

Example: On the next slide is the adjusted trial balance for Konk Co. Required: Prepare closing journal entries.

Accumulated Depreciation Rs.35,000 Accounts Payable 5,000 PowerPoint Slides Cash Rs.11,000 Accounts Receivable 21,500 Art Supplies 6,000 Prepaid Insurance 2,500 Printing Equipment 60,000 Accumulated Depreciation Rs.35,000 Accounts Payable 5,000 Interest Payable 150 Notes Payable 5,000 Unearned Advertising Revenue 5,600 Salaries Payable 1,300 Common Stock 20,000 Retained Earnings 5,500 Dividends 12,000 Advertising Revenue 61,500 Salaries Expense 11,300 Insurance Expense 850 Depreciation Expense 7,000 Art Supplies Expense 2,400 Rent Expense 4,350 Rs.139,050 Rs.139,050 D O N’ T C L S E 9

To close revenue accounts 12/31 Income Summary 26050 General Journal 12/31 Advertising Revenue 61500 Income Summary 61500 To close revenue accounts 12/31 Income Summary 26050 Salaries Expense 11300 Insurance Expense 850 Interest Expense 150 Depreciation Expense 7000 Art Supplies Expense 2400 Rent Expense 4350 To close expense accounts (11300+850+150+7000+2400+4350=26050)

To close income summary and update retained earnings General Journal 12/31 Income summary 35450 Retained Earnings 35450 To close income summary and update retained earnings (61500cr net with 26050dr = 35450cr). Close with 35450dr. 12/31 Retained Earnings 12000 Dividends 12000 To close dividends paid against retained earnings

Post Closing Trial Balance PowerPoint Slides Konk Co. Agency Post Closing Trial Balance December 31, 2008 Debit Credit Cash Rs.11,000 Accounts Receivable 21,500 Art Supplies 6,000 Prepaid Insurance 2,500 Printing Equipment 60,000 Accumulated Depreciation Rs.35,000 Accounts Payable 5,000 Interest Payable 150 Notes Payable 5,000 Unearned Advertising Revenue 5,600 Salaries Payable 1,300 Common Stock 20,000 Retained Earnings (Begin 5,500 + 35,450 - 12,000) 28,950 Rs.101,000 Rs.101,000 9