Accrual Accounting Concepts Chapter 4 Accrual Accounting Concepts

Time Period Assumption Divides the economic life of a business into artificial time periods Interim period (month, quarter) Year (fiscal, calendar) Chapter 4

Revenue Recognition Principle Dictates that revenue be recognized in the accounting period in which it is earned Chapter 4

Revenue Recognition Principle Merchandising company Revenue is earned when the merchandise is sold (normally at the point of sale) Service company Revenue is considered earned at the time the service is performed Chapter 4

Discussion Questions Discuss how revenue might be recognized for a construction company? Compare this to how revenue might be recorded for a small convenience store. Discussion points: For Question 1 there is no need to describe percentage of completion vs. completed contract in great detail. Introduce the idea of there being different points for revenue recognition. For question 2 note how the point at which revenue is earned is more distinct. Chapter 4

Matching Principle Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded Chapter 4

Discussion Question Identify some expenses that can be easily matched to revenue and some that aren’t as easily directly matched to the revenue they help produce. Discussion points: Easily matched expenses: cost of goods sold, some salaries expense (e.g., direct labour) Less easily matched expenses: some salaries expense (e.g., administrative salaries), depreciation expense, utilities expense Chapter 4

Cash Basis of Accounting Revenue is recorded only when cash is received Expenses are recorded only when cash is paid Not in accordance with GAAP Violates revenue recognition and matching principles Chapter 4

Accrual Basis Accounting Revenue is recorded when earned, rather than when cash is received Expenses are recorded when incurred, rather than when cash is paid Chapter 4

Adjusting Entries Adjusting entries are made to adjust or update accounts at the end of the accounting period Adjusting entries can be categorized as Prepayments Accruals Chapter 4

Types of Adjusting Entries Prepayments Prepaid expenses Unearned revenues Accruals Accrued revenues Accrued expenses Chapter 4

Prepayments Cash has been spent but the item acquired has not been used or consumed (prepaid expenses) Cash has been collected but the revenue has not been earned (unearned revenues) Chapter 4

Discussion Question Why are prepaid expenses a current asset? Why are unearned revenues a current liability? Discussion Points: For prepaid assets use prepaid insurance as an example (future economic benefits) For unearned revenues use deposits from customers as an example. Chapter 4

Accruals Revenue has been earned, but not collected (accrued revenues) Expenses were incurred, but not yet paid (accrued expenses) Note: Entry has not yet been recorded! Chapter 4

Adjusted Trial Balance Proves the equality of total debit balances and total credit balances after the adjusting entries have been made Financial statements can be easily prepared from the adjusted trial balance Chapter 4

Closing the Books Closing entries Transfer the temporary account balances to update the retained earnings account Reduce the balances in the temporary accounts to zero to prepare for the next period’s postings Chapter 4

All liability accounts Temporary Permanent All revenue accounts All asset accounts All expense accounts All liability accounts Dividends account Shareholders’ equity accounts Chapter 4

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 Chapter 4

Post-Closing Trial Balance Proves the equality of total debit balances and total credit balances after the closing entries have been made Should contain only permanent accounts Chapter 4

Required Steps in the Accounting Cycle Analyze business transactions Journalize the transactions Post to general ledger accounts Prepare a trial balance Journalize and post adjusting entries (prepayments and accruals) Chapter 4

Required Steps in the Accounting Cycle Prepare an adjusted trial balance Prepare financial statements Journalize and post closing entries Prepare a post-closing trial balance Chapter 4

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