of Financial Accounting, 3e CORNERSTONES

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. CHAPTER 3: ACCRUAL ACCOUNTING Cornerstones of Financial Accounting, 3e

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrual versus Cash Basis of Accounting  Under cash-basis accounting, revenue is recorded when cash is received, regardless of when it is actually earned.  Accrual-basis accounting (also called accrual accounting) is an alternative to cash-basis accounting that is required by generally accepted accounting principles. LO-1

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Key Elements of Accrual Accounting  Time Period Assumption  Allows companies to artificially divide their operations into time periods so they can satisfy users’ demands for information. LO-2

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Key Elements of Accrual Accounting  Revenue Recognition Principle  Determines when revenue is recorded and reported.  Under this principle, revenue is recognized, or recorded, in the period in which both of the following conditions are met: 1. The revenue has been earned and 2. the collection of cash is reasonably assured. LO-2

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Key Elements of Accrual Accounting  Revenue Recognition Principle (cont.)  Notice that revenue is recorded when these two conditions are met, regardless of when cash is received. LO-2

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Key Elements of Accrual Accounting  The Expense Recognition (or Matching) Principle  Requires that expenses be recorded and reported in the same period as the revenue that it helped to generate.  An expense is recorded when it is incurred, regardless of when cash is paid. LO-2

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrual Accounting and Adjusting Entries  Adjusting entries are journal entries made at the end of an accounting period to record the completed portion of partially completed transactions.  Adjusting entries are necessary to apply the revenue recognition and matching principles and ensure that a company’s financial statements include the proper amounts. LO-3

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjusting the Accounts  Adjustments are often necessary because timing differences exist between when a revenue or expense is recognized and cash is received or paid.  These timing differences give rise to two categories of adjusting entries—accruals and deferrals. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Types of Adjusting Entries LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjusting the Accounts  The purpose of all adjustments is to make sure revenues and expenses get recorded in the proper time period.  All adjusting entries will affect at least one income statement account and one balance sheet account.  Cash is never affected by adjustments. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Three Step-Process for Making Adjusting Entries  A three-step procedure can be followed for making adjusting journal entries.  Step 1: Identify pairs of income statement and balance sheet accounts that require adjustment.  Step 2: Calculate the amount of the adjustment based on the amount of revenue that was earned or the amount of expense that was incurred during the accounting period.  Step 3: Record the adjusting journal entry. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrued Revenues  If a company has earned revenue but not received the cash, these transactions are called accrued revenues. An example of an accrued revenue is interest earned, but not yet received, on a loan. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrued Revenues (cont.)  As the diagram below indicates, the revenue is earned before cash is received. LO-4 Adjusting entry is necessary

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrued Expenses  Accrued expenses are previously unrecorded expenses that have been incurred but not yet paid in cash.  For accrued expenses, an adjustment is necessary to record the expense and the associated increase in a company’s liabilities, usually a payable. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Accrued Expenses (Cont.) LO-4 Adjusting entry is necessary

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deferred (Unearned) Revenues  Transactions for which a company has received cash but has not yet earned the revenue are called deferred (or unearned) revenues.  The receipt of cash creates a liability for the company to deliver goods or perform services in the future. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deferred (Unearned) Revenues (cont.)  The unearned revenue account delays, or defers, the recognition of revenue by recording the revenue as a liability until it is earned. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deferred (Prepaid) Expenses  Companies often acquire goods and services before they are used.  These prepayments are recorded as assets called deferred (or prepaid) expenses. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Deferred (Prepaid) Expenses (cont.)  The deferral of the expense is necessary because the initial cash payment did not result in an expense, but an asset that results in future benefits. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Depreciation  Because property, plant, and equipment (long- lived assets) help to produce revenue over a number of years, the matching principle requires companies to allocate the cost of these assets as expense to each period in which they are used. This process is called depreciation. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Contra Accounts  Accountants normally use a contra account to reduce the amount of a long-lived asset.  Contra accounts are accounts that have a balance that is opposite of the balance in the related account e.g., Accumulated Depreciation account.  Contra asset account balance is deducted from the balance of the related asset account in the balance sheet, and the resulting difference is known as the book value of the asset. LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of Financial Statement Effects of Adjusting Entries LO-4

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Preparing the Financial Statements  After a company has journalized and posted all of the adjusting entries, it updates the trial balance to reflect the adjustments that have been made.  This trial balance is called an adjusted trial balance.  Similar to the trial balance, the adjusted trial balance lists all of the active accounts and proves the equality of debits and credits. LO-5

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Adjusted Trial Balance LO-5

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Closing the Accounts  The balance sheet accounts- assets, liabilities, and stockholders’ equity- are permanent accounts in that their balances are carried forward from the current accounting period to future accounting periods.  Revenues, expenses, and dividends are used to collect the activities of only one period, so they are considered temporary accounts. LO-6

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Closing the Accounts (cont.)  The final step of the accounting cycle, closing the accounts, is done to:  Transfer the effects of revenues, expenses, and dividends (temporary accounts) to the permanent stockholders’ equity account, Retained Earnings.  Clear the revenue, expenses, and dividends (reduce their balances to zero) for the next accounting period. LO-6

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Closing the Accounts (cont.)  The closing process can be completed in a 4-step procedure:  Step 1: Close revenues to Income Summary.  Step 2: Close expenses to Income Summary. At this point, the balance in the Income Summary account should be equal to net income.  Step 3: Close Income Summary to Retained Earnings.  Step 4: Close Dividends to Retained Earnings. LO-6

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Summary of the Accounting Cycle LO-7

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Appendix: Using a Worksheet to Prepare Financial Statements  Accountants often use an informal schedule called a worksheet to assist them in organizing and preparing the information necessary to perform the end-of-period steps in the accounting cycle—namely the preparation of adjusting entries, financial statements, and closing entries. LO-8

© 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Appendix: Using a Worksheet to Prepare Financial Statements (cont.)  The worksheet is not a financial statement but simply an organizational tool. LO-8