Accrual Accounting Concepts CHAPTER 4

Time Period Assumption Divides the economic life of a business into artificial time periodsDivides the economic life of a business into artificial time periods –Interim period (month, quarter) –Year (fiscal, calendar) WHY?WHY? –To provide immediate feedback on how the business is doing

Revenue Recognition Principle Dictates that revenue be recognized in the accounting period in which it is earnedDictates that revenue be recognized in the accounting period in which it is earned Revenue is considered earned when the service has been provided or when the goods are deliveredRevenue is considered earned when the service has been provided or when the goods are delivered

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

Cash Basis Revenue is recorded only when cash is receivedRevenue is recorded only when cash is received Expense is recorded only when cash is paidExpense is recorded only when cash is paid

Accrual Basis Accounting Adheres to the time period assumption and revenue recognition and matching principlesAdheres to the time period assumption and revenue recognition and matching principles Revenue is recorded when earned, rather than when cash is receivedRevenue is recorded when earned, rather than when cash is received Expense recorded when incurred, rather than when cash is paidExpense recorded when incurred, rather than when cash is paid Accrual accounting records events when the economic event occursAccrual accounting records events when the economic event occurs GAAP

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

Types of Adjusting Entries –Prepayments Prepaid expensesPrepaid expenses Unearned revenuesUnearned revenues –Accruals Accrued revenuesAccrued revenues Accrued expensesAccrued expenses

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

On January 5 the company paid $2,500 for advertising supplies. GENERAL JOURNAL Debit Credit Jan. 5 Advertising Supplies2,500 Cash 2,500 Purchased advertising supplies Purchased advertising supplies Advertising Supplies Cash Jan. 5 2,500 Advertising Supplies Expense Supplies Jan. 5 2,500

An inventory on January 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. ($2,500 - $1,000) =$ 1,500 GENERAL JOURNAL Debit Credit Jan. 5 Advertising Supplies Expense1,500 Advertising Supplies 1,500 To record advertising supplies consumed Advertising Supplies Cash Jan. 5 2,500 Advertising Supplies Expense Supplies Jan. 5 2,500 Jan. 31 1,500 Bal. 1,000

Prepaid Expenses On February 4 the company paid $600 for a 1-year insurance policy; coverage began February 1. GENERAL JOURNAL Debit Credit Feb. 4 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective February 1 Prepaid Insurance Cash Insurance Expense Feb

Prepaid Expenses On February 28, $50 ($600/12 months) of the insurance had been used or had expired. GENERAL JOURNAL Debit Credit Feb. 28 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month Prepaid Insurance Cash Insurance Expense Feb Feb

Amortization How do you apply the matching principle to the cost of a long-lived asset?

Amortization Allocate the cost of an asset to expense over its useful lifeAllocate the cost of an asset to expense over its useful life Amortization is an allocation concept, not a valuation conceptAmortization is an allocation concept, not a valuation concept Note: This is not an attempt to reflect the actual change in value of an asset.

Amortization Example Assume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 yearsAssume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 years Straight-line amortization calculation is:Straight-line amortization calculation is: Cost - Salvage value = $5,000 - $200 = $480/yr Useful Life 10 OR $40/mo

GENERAL JOURNAL Debit Credit Mar. 31 Amortization Expense 40 Accumulated Amortization – 40 Office Equipment To record monthly amortization Accumulated Amortization is acontra assetaccount – an offset (deduction) against the asset account. Accumulated Amortization is a contra asset account – an offset (deduction) against the asset account. Accumulated Amortization-Office Equipment Office Equipment Amortization Expense Amortization Example Mar. 2 5,000 Mar

Balance Sheet Presentation Net book value Office equipment $5,000 Less: Accumulated amortization Net book value 4,960

Unearned Revenues Received on August 2 $1,200 for advertising services expected to be completed by December 31. Unearned Service Revenue Cash Service Revenue GENERAL JOURNAL Debit Credit Aug. 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by December 31 Aug. 2 1,200

Unearned Revenues During August, $400 of the revenue was earned. Unearned Service Revenue Cash Service Revenue GENERAL JOURNAL Debit Credit Aug. 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned Aug. 2 1,200 Aug Bal. 800

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

Accrued Revenues Revenues earned but not yet received in cash or recorded at the end of periodRevenues earned but not yet received in cash or recorded at the end of period

Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31. GENERAL JOURNAL Debit Credit Oct. 31 Accounts Receivable 200 Service Revenue 200 Accounts Receivable Service Revenue Oct

Accrued Expenses Expenses incurred but not yet paid or recorded at the end of periodExpenses incurred but not yet paid or recorded at the end of period

Interest expense is the cost a company incurs to use money. Information needed to calculate interest expense: Face value of note Face value of note Interest rate (always expressed in annual rate) Interest rate (always expressed in annual rate) The length of time note is outstanding The length of time note is outstanding Accrued Interest Expense

Face Value of NoteInterest Time in Terms of One Year Annual Interest Rate $ 5,000 X 12% = $50 Accrued Interest Expense X 1/2 Formula for Calculating Interest

Interest Expense Interest Payable GENERAL JOURNAL Debit Credit Oct. 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month Accrued Interest Expense Oct Oct

Accrued Salaries Expense Assume that the employees receive total salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day.Assume that the employees receive total salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day. Salaries were last paid on October 26 and the next payment of salaries will be November 9. As shown on the calendar on the following slide there are three unpaid work days remain as of October 31.Salaries were last paid on October 26 and the next payment of salaries will be November 9. As shown on the calendar on the following slide there are three unpaid work days remain as of October 31.

Accrued Salaries Expense ( Salaries paid after the service has been performed)

Salaries Expense Salaries Payable GENERAL JOURNAL Debit Credit Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month Accrued Salaries Expense Oct. 31 1,200

Adjusted Trial Balance Adjusted trial balance proves the equity of total debit balances and total credit balances after the adjusting entries have been madeAdjusted trial balance proves the equity 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 balanceFinancial statements can be easily prepared from the adjusted trial balance

Closing the Books Closing entriesClosing 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

TemporaryPermanent Temporary Permanent All revenue accountsAll asset accounts All expense accountsAll liability accounts Dividends account Shareholders’ equity accounts Illustration 4-17

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

Required Steps in the Accounting Cycle Analyse business transactionsAnalyse business transactions Journalize the transactionsJournalize the transactions Post to general ledger accountsPost to general ledger accounts Prepare a trial balancePrepare a trial balance Journalize and post adjusting entries (prepayments and accruals)Journalize and post adjusting entries (prepayments and accruals)

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