4-1 ACCRUAL ACCOUNTING CONCEPTS 4 Spring 2016 Accounting, Fifth Edition

4-2 Generally we use a month, a quarter, or a year. Fiscal year vs. calendar year: The business fiscal year might be the same as a calendar year from Jan 1 to Dec 31, or may start at some other date (July 1 to June 30). Recall: We can divide the economic life of a business into artificial time periods (the Periodicity Assumption). Jan.Feb.Mar.Apr.Dec Timing Issues

4-3 Accrual Basis Accounting ► Transactions are recorded in the periods in which the events occur. That means: ► Revenues are recognized (meaning they’re recorded) when earned, even if cash was not immediately received (we debit accounts receivable, cash is received later). ► Expenses are recognized (meaning they’re recorded) when incurred, even if cash was not immediately paid (we credit accounts payable, cash is paid out later). Timing Issues Accrual versus Cash Basis of Accounting

4-4 Cash Basis Accounting - This method of accounting is frequently used but is not allowed (prohibited) under generally accepted accounting principles (GAAP). ► Revenues are recognized only when cash is actually received. ► Expenses are recognized only when cash is actually paid. ► The problem: you can influence when you receive or pay out cash to manipulate the Income Statement Timing Issues Accrual versus Cash Basis of Accounting

4-5 Timing Issues The Revenue Recognition Principle is part of the Accrual Basis of Accounting Companies recognize revenue in the accounting period in which it is earned. Recognized simply means the activity is recorded in the journal. In a service enterprise, revenue is earned and recognized at the time the service is performed. (mow lawn today and record revenue today, even if you don’t get paid until next month).

4-6 Timing Issues Papa Ron’s Lawn Mowing Service mows a lawn (performs the service) on June 30, but… does not get paid until July 11. There are 2 J/Es involved here, one on each date: Accounts Receivable June July July 11 0 Cash July Service Revenue June

4-7 Adjusting entries are needed every time a company wants to prepare their F/S (monthly, quarterly or yearly) to ensure the revenue and expense recognition principles are followed. Adjusting entries Include one I/S account and one B/S account which makes it possible to report correct amounts on the I/S and the B/S. The Basics of Adjusting Entries

4-8 Get Paid $300 in May to mow lawns over the summer (a liability) Cash 300 UnE Rev 300 Mow Lawn In June Earn $100 UnE 100 Rev 100 Adjusting Entries - Deferrals Mow Lawn In July Earn $100 UnE 100 Rev 100 Mow Lawn In August Earn $100 UnE 100 Rev 100 Lawns are all mowed and the $300 has all been earned No entry needed here! Pay $800 in May to pre-pay rent (an asset) For two months Prepaid Rent 800 Cash 800 Stay in Apt. In June Expense $400 Rent Exp. 400 Prepaid Rent 400 Stay in Apt. In July Expense $400 Rent Exp. 400 Prepaid Rent 400 You’ve used up the $800 by staying in the Apt. No entry needed here! 1. Cash Out Now - Expense is “deferred” over time 2. Cash In Now - Revenue is “deferred” over time

4-9 You agree to mow lawns over summer but… you don’t get paid until Sept. No entries yet! Mow Lawn In June Rev 200 A/R 200 Rev 200 Adjusting Entries - Accruals Mow Lawn In July Rev $200 A/R 200 Rev 200 Mow Lawn In August Rev $200 A/R 200 Rev 200 Sept. - Lawns are all mowed and now you collect $600 Cash 600 A/R 600 Stay at an Apt. for 2 $450 a month… pay after the 2 month stay No entries yet! Stay in Apt. In June Expense is $450 Rent Exp. 450 A/P 450 Stay in Apt. In July Expense is $450 Rent Exp. 450 A/P 450 You stayed in the Apt, and now you pay $900 A/P 900 Cash Expense is “accrued” when incurred – Cash Out Later 3. Revenue is “accrued” when earned – Cash In Later

4-10 Original Entries Adjusting Entries 1. Pre-paid Rent 800 Rent Expense 400 Cash 800 Pre-paid Rent 400 ______________________________________________ 2. Cash 300 Unearned Rev 100 Unearned Rev 300 Revenue 100 ______________________________________________ 3. Accts Rec 600 Cash 600 Revenue 600 Accts Rec 600 ______________________________________________ 4. Rent Expense 900 Accts Pay 900 Accts Pay 900 Cash 900_______________________________________________ Original Entries 1 st - Adjusting Entries 2nd

Adjusting Entries for “Prepaid Expenses” Supplies (usage) Pre-paid Insurance (time) Pre-paid Advertising (time) Cash Payment Expense Recorded BEFORE Pre-paid Rent (time) Equipment (long time) Buildings (long time) Prepayments often occur in regard to: These start off as assets! Pay cash and record the expense initially as an asset, it turns into an expense either with the passage of time or through use. The adjusting entry increases (a debit) an expense and a decreases (a credit) an asset. Note: not all accounts use the term “pre-paid” in their title.

4-12 Usage Adjustment: Sierra purchased supplies costing $2,500 on October 5 recording the purchase by increasing (debiting) the asset Supplies and crediting cash (not shown here). The balance of $2,500 on the October 31 trial balance needs to be adjusted because an inventory count at the close of business on October 31 reveals that only $1,000 of supplies are still on hand. This means $1,500 has been used up (2,500 – 1,000 = 1,500) Supplies (the asset)1,500 Supplies Expense1,500Oct Adjusting Entries for “Prepaid Expenses”

4-13 Over Time Adjustment: October, 1 Sierra pre-paid a $600 expense for a one-year fire insurance policy with cash. Sierra recorded the payment by increasing (debiting) the asset Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. However, insurance of $50 ($600 ÷ 12) expires each month. So…. on Oct 31, the account needs a $50 adjustment! Prepaid Insurance (the asset)50 Insurance Expense50Oct Adjusting Entries for “Prepaid Expenses”

4-14 Depreciation of Long-Lived Assets Buildings, equipment, and vehicles (long-lived assets – meaning used over years) are initially recorded as assets, rather than expenses, in the year acquired. Companies report a portion of the cost of the asset as an expense (called depreciation expense) during each period of the asset’s useful life. With each passing year the total amount of depreciation is kept in an account called accumulated depreciation. Note: Depreciation does not attempt to report the actual change in the market value of the asset. 1. Adjusting Entries for “Prepaid Expenses”

4-15 Over A Long Time Adjustment: Oct 2 paid $5,000 cash (credit) for Equipment (debit). Assume the depreciation on $5,000 is $40 per month ($480 a yearl). Each month the I/S will have a $40 expense. The B/S will accumulate the monthly expenses by adding $40 to the Accumulated Depreciation account each month until it reaches the total of $5,000 (the equipment is fully depreciated). Accumulated Depreciation-Equip. (B/S) 40 Depreciation Expense (I/S) 40Oct Adjusting Entries for “Prepaid Expenses”

4-16 Accumulated Depreciation on the Balance Sheet Accumulated Depreciation-Equipment is a contra asset account. It shows up as a credit and thus subtracted from the related asset which has a debit balance (see example below). It appears on the B/S just after the account it offsets (Equipment). The $4,960 (see below) is referred to as the book value of the equipment. Book value is not the same as its market value (what it would sell for on the current open market). Look at slide 31 to see how this would appear on the Balance Sheet. 1. Adjusting Entries for “Prepaid Expenses” Book Value =

Adjusting Entries for “Unearned Revenues” rent airline tickets mowing lawns Cash Receipt Revenue Recorded BEFORE magazine subscriptions customer deposits shoveling snow Unearned revenues often occur in regard to: These start off as liabilities (obligations). The original receipt of cash (debit) is recorded along with a liability (credit) because the revenue has not been earned yet. The adjusting entry records any revenue that has been earned and shows any liability that might remain. The adjusting entry shows a decrease (a debit) to a liability and an increase (a credit) to a revenue.

Adjusting Entries for “Unearned Revenues” Sierra Corporation received (debited) $1,200 cash in advance on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Thus, “unearned service revenue” would have been credited for $1,200. If Sierra determines that it has earned $400 (of the $1,200) in October, the adjusting entry to change unearned service revenue to (earned) service revenue is: Service Revenue400 Unearned Service Revenue400Oct. 31

Adjusting Entries for “Accrued Revenues” rent interest services performed (mowing lawns, shoveling snow) BEFORE Accrued revenues often occur in regard to: Cash Receipt Revenue Recorded These start off with receivables! The revenues have been earned and need to be recorded, but the cash hasn’t been received yet. This adjusting entry results in a debit to accounts receivable and a credit to some type of revenue.

4-20 In October, Sierra earned $200 for performing guide services but was not immediately paid. Sierra sent out the bills for these services a few days later. So, at the end of Oct. an adjusting entry is needed to record the Earned Revenue and the A/R (the money that’s owed to them): Service Revenue200 Accounts Receivable 200 Oct Adjusting Entries for “Accrued Revenues” What if someone owed you Interest Receivable XXX Interest that you’ve earned? Interest Revenue XXX

Adjusting Entries for “Accrued Expenses” BEFORE Accrued expenses often occur in regard to: Cash Payment Expense Recorded taxes salaries rent interest These start off with payables! These expenses have been incurred and need to be recorded, but the cash hasn’t been paid yet. The adjusting entry results in a debit to an expense and a credit to a liability (e.g., accounts payable).

Adjusting Entries for “Accrued Expenses” Sierra signed a 3 month note payable of $5,000 on Oct.1. The note requires Sierra to pay interest at an annual rate of 12%. First we multiply $5,000 by 12%. Then multiply by the fraction of the year being calculated (if 1 month, multiply by 1/12; if 2 months use 2/12; and so on) Interest Payable 50 Interest Expense 50 Oct. 31

Adjusting Entries for “Accrued Expenses” Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9 (every two weeks). The employees earn $400 a day ($2,000 for a 5 day work week. This means accrued salaries at October 31 are $1,200 ($400 × 3 days). See the next slide for the adjusting journal entry.

Adjusting Entries for “Accrued Expenses” Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $400 per day or $2,000 for a five-day work week. Thus, accrued salaries at October 31 (for Oct. 29th, 30th & 31st) are $1,200 ($400 x 3 days). Salaries Payable1,200 Salaries Expense1,200Oct. 31

4-25 The Trial Balance “Before” Adjustments (this is from Chapter 3)

4-26 Summary of all the Adjusting Journal Entries

4-27 After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts: The “Adjusted” Trial Balance. The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger and is the primary basis for preparing the Financial Statements! The Adjusted Trial Balance

4-28 The Trial Balance The Adjusted Trial Balance SO 6 The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger and is the primary basis for the F/S preparation.

4-29 F/S are prepared directly from the Adjusted Trial Balance - in this Order! F/S are prepared directly from the Adjusted Trial Balance - in this Order! Balance Sheet A = L & E Income Statement Rev - Exp Retained Earnings Statement Any Div? Preparing Financial Statements

4-30 Preparing Financial Statements

4-31 Preparing Financial Statements

4-32 At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account - Retained Earnings. At the beginning of the next period these balances start over with zero balances. Closing entries should not be confused with adjusting entries. Closing the Books Common Stock Retained Earnings These 3 all get transferred to Retained Earnings

Service Revenue 10,600 Retained Earnings 10,600 Sierra’s _________________________________ Retained Earnings Beg Bal 0 2. Retained Earnings 7,740 10,600 Salaries Expense 5,200 7,740 Supplies Expense 1, Rent Expense 900 _______________ Insurance Expense 50 $ 2,360 Interest Expense 50 Depreciation Expense 40 Example: look at slide 25! _________________________________ The Sal/Exp is credited to transfer the balance to R/E 3. Retained Earnings 500 Sal/Exp is now 0 and starts Dividends 500 over in the next period Sierra’s Closing Entries

4-34 The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period. But remember the adjusted trial balance is the the primary basis for the F/S preparation Preparing a Post-Closing Trial Balance All temporary accounts will have zero balances. These 3 have been reduced to Zero by being closed out to Retained Earnings! Common Stock Retained Earnings

4-35 of the Accounting Cycle Summary of the Accounting Cycle 1. Analyze business transactions 2. Journalize the transactions 6. Prepare an adjusted trial balance 7. Prepare financial statements 8. Journalize and post closing entries 9. Prepare a post-closing trial balance 4. Prepare a trial balance 3. Post to ledger accounts 5.Journalize and post adjusting entries: Deferrals/Accruals 5.Journalize and post adjusting entries: Deferrals/Accruals

4-36 Simple Summary For A Sole Proprietor = + Assets & Expenses go up with Debits Liabilities, Owners Equity & Revenues all go up with Credits DEAD = Debits increase Expenses & Assets CLEaR = Credits increase Liabilities, Equity and Revenues Owner’s Equity

4-37 Once again, the Debit Credit Summary = + Assets, Expenses & Dividends all go up with Debits Liabilities, Owners Equity (Common Stock & Retained Earnings) & Revenues all go up with Credits DEAD = Debits increase Expenses, Assets, and Dividends CLEaR = Credits increase Liabilities, Equity (Common Stock & Retained Earnings) and Revenues