1. 4-1 ACCRUAL ACCOUNTING CONCEPTS Accounting, Fifth Edition 4

2. 4-2 After studying this chapter, you should be able to: 1. 1.Explain the revenue recognition principle and the expense recognition principle. 2. 2.Differentiate between the cash basis and the accrual basis of accounting. 3. 3.Explain why adjusting entries are needed, and identify the major types of adjusting entries. 4. 4.Prepare adjusting entries for deferrals. 5. 5.Prepare adjusting entries for accruals. 6. 6.Describe the nature and purpose of the adjusted trial balance. 7. 7.Explain the purpose of closing entries. 8. 8.Describe the required steps in the accounting cycle. Learning Objectives

3. 4-3  Generally a month, a quarter, or a year.  Fiscal year vs. calendar year Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption). LO 1 Explain the revenue recognition principle and the expense recognition principle. Jan.Feb.Mar.Apr.Dec...... Timing Issues

4. 4-4 Timing Issues The Revenue Recognition Principle Companies recognize revenue in the accounting period in which the performance obligation is satisfied regardless if cash has been received or not. LO 1 Explain the revenue recognition principle and the expense recognition principle.

5. 4-5 Timing Issues Illustration: Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July. The journal entries for June and July would be: LO 1 Explain the revenue recognition principle and the expense recognition principle.

6. 4-6 Timing Issues “Let the expenses follow the revenues.” LO 1 Explain the revenue recognition principle and the expense recognition principle. Illustration 4-1 (Partial)

7. 4-7 Timing Issues LO 1 Explain the revenue recognition principle and the expense recognition principle. Illustration 4-1 GAAP relationships in revenue and expense recognition

8. 4-8

9. 4-9 Accrual-Basis Accounting ► Transactions recorded in the periods in which the events occur. ► Revenues are recognized when services performed, even if cash was not received. ► Expenses are recognized when incurred, even if cash was not paid. Timing Issues Accrual versus Cash Basis of Accounting LO 2 Differentiate between the cash basis and the accrual basis of accounting.

10. 4-10 Not GAAP Timing Issues LO 2 Differentiate between the cash basis and the accrual basis of accounting. Accrual versus Cash Basis of Accounting Cash-Basis Accounting ► Revenues are recognized only when cash is received. ► Expenses are recognized only when cash is paid. ► Prohibited under generally accepted accounting principles (GAAP).

11. 4-11 Timing Issues Illustration: Suppose that Fresh Colors paints a large building in 2013. In 2013, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2014. Illustration 4-2 (Partial) LO 2 Differentiate between the cash basis and the accrual basis of accounting. 20132014

12. 4-12 Which one of these statements about the accrual basis of accounting is false? a.Companies record events that change their financial statements in the period in which events occur, even if cash was not exchanged. b.Companies recognize revenue in the period in which the performance obligation is satisfied. c.This basis is in accord with generally accepted accounting principles. d.Companies record revenue only when they receive cash, and record expense only when they pay out cash. Review Question Timing Issues LO 2 Differentiate between the cash basis and the accrual basis of accounting.

13. 4-13 Adjusting entries  ensure that the revenue recognition and expense recognition principles are followed.  are required every time a company prepares financial statements.  includes one income statement account and one balance sheet account.  never include cash. The Basics of Adjusting Entries LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

14. 4-14 Adjusting entries are made to ensure that: a. expenses are recognized in the period in which they are incurred. b. revenues are recognized in the period in which the performance obligation is satisfied. c. balance sheet and income statement accounts have correct balances at the end of an accounting period. d. All of the above. Review Question The Basics of Adjusting Entries LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries

15. 4-15 Types of Adjusting Entries LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Adjustments DEFERRALS - Paid (or received) cash before expense (or revenue) recognized. Correction Needed. ACCRUALS - Paid (or received) cash after/later expense (or revenue) recognized. Inclusion needed Prepaid (Deferred) expenses* - paid for before used or consumed Unearned (Deferred) revenues – cash received before services are performed Accrued expenses – costs incurred with cash payment to come later Accrued revenues – services performed with cash payment to come later Type 1Type 2Type 3Type 4 *including depreciation

16. 4-16 Trial Balance Trial Balance – Each account is analyzed to determine whether it is complete and up- to-date. Types of Adjusting Entries LO 3 Explain why adjusting entries are needed, and identify the major types of adjusting entries Illustration 4-4

17. 4-17 1 - Adjusting Entries for “Prepaid Expenses” Cash Payment Expense Recorded BEFORE  insurance  supplies  advertising  rent  equipment  buildings Prepayments often occur in regard to: LO 4 Prepare adjusting entries for deferrals. A. Costs that expire either with the passage of time or through use. B. This adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.

18. 4-18 Illustration: Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting) the asset Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand. Supplies 1,500 Supplies Expense1,500Oct. 31 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals. Illustration 4-6 (Partial) + Debit (Dr)Credit (Cr) - A - Supplies 1,500 b a 2,500 _____ C 1,000

19. 4-19 Illustration: On October 4, Sierra Corporation paid $600 for a one- year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in the October 31 trial balance. Insurance of $50 ($600 ÷ 12) expires each month. Prepaid Insurance50 Insurance Expense50Oct. 31 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals. Illustration 4-7 (Partial) + Debit (Dr)Credit (Cr) - A – Prepaid Ins 50 b a 600 _____ C 550

20. 4-20 Practice Problem BE4-4, p202

21. 4-21 Depreciation  Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.  Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life.  Depreciation does not attempt to report the actual change in the value of the asset. 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals.

22. 4-22 Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Accumulated Depreciation-Equipment40 Depreciation Expense40Oct. 31 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals. Illustration 4-8 (Partial)

23. 4-23 Statement Presentation  Accumulated Depreciation- Equipment is a contra asset account.  Appears just after the account it offsets (Equipment) on the balance sheet. 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals. Illustration 4-9

24. 4-24 Practice Problem BE4-5 & 4-6, p202

25. 4-25 1 - Adjusting Entries for “Prepaid Expenses” LO 4 Prepare adjusting entries for deferrals. Summary Illustration 4-10 + Debit (Dr)Credit (Cr) - A - Asset 1,500 b a 2,500 _____ C 1,000 + Debit (Dr)Credit (Cr) - E - Expense b 1,500

26. 4-26 Receipt of cash recorded as a liability before services are performed. 2 - Adjusting Entries for “Unearned Revenues”  rent  airline tickets Cash Receipt Revenue Recorded BEFORE  magazine subscriptions  customer deposits Unearned revenues often occur in regard to: LO 4 Prepare adjusting entries for deferrals. A. Adjusting entry to record the revenue that has been earned and to show the liability that remains. B. This adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.

27. 4-27 LO 4 Prepare adjusting entries for deferrals. 2 - Adjusting Entries for “Unearned Revenues” Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Sierra performed for Knox during October, the company determines that it has earned $400 in October. Service Revenue400 Unearned Service Revenue400Oct. 31 Illustration 4-12 (Partial) - Debit (Dr) Credit (Cr) + L – Unearned Rev b 400 1,200 a _____ 800 C

28. 4-28 Practice Problem BE4-7, p202

29. 4-29 LO 4 Prepare adjusting entries for deferrals. 2 - Adjusting Entries for “Unearned Revenues” Illustration 4-13 Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed ACCOUNTING FOR UNEARNED REVENUES Examples Reason for Adjustment Accounts Before Adjustment Adjusting Entry Rent, magazine subscriptions, customer deposits for future service Liabilities overstated. Revenues understated. Dr. Liabilities Cr. Revenues - Debit (Dr) Credit (Cr) + L – Liability b 400 1,200 a _____ 800 C - Debit (Dr)Credit (Cr) + R - Revenue 400 b

30. 4-30

31. 4-31 Made to record:  Revenues earned and OR  Expenses incurred in the current accounting period that have not been recognized through daily entries. 3 & 4 - Adjusting Entries for Accruals LO 5 Prepare adjusting entries for accruals.

32. 4-32 Revenues for services performed but not yet received in cash or recorded. 3 - Adjusting Entries for “Accrued Revenues”  rent  interest  services performed Accrued revenues often occur in regard to: BEFORE Cash Receipt Revenue Recorded Adjusting entry results in: LO 5 Prepare adjusting entries for accruals.

33. 4-33 Accrued Revenues This adjusting entry serves two purposes: (1) Shows the receivable that exists, and (2) Records the revenues for services performed. 3 - Adjusting Entries for “Accrued Revenues” LO 5 Prepare adjusting entries for accruals.

34. 4-34 Illustration: In October, Sierra Corporation performed guide services for $200 that were not billed to clients before Oct 31. Service Revenue200 Accounts Receivable200Oct. 31 LO 5 Prepare adjusting entries for accruals. 3 - Adjusting Entries for “Accrued Revenues” Illustration 4-15

35. 4-35 Practice Problem BE4-8(b), p202

36. 4-36 Illustration 4-16 3 - Adjusting Entries for “Accrued Revenues” LO 5 Prepare adjusting entries for accruals. Illustration 4-16 Services performed but not yet received in cash or recorded ACCOUNTING FOR ACCRUED REVENUES Examples Reason for Adjustment Accounts Before Adjustment Adjusting Entry Interest, rent, services performed but not collected Assets understated. Revenues understated. Dr. Assets Cr. Revenues

37. 4-37 Expenses incurred but not yet paid in cash or recorded. 4 - Adjusting Entries for “Accrued Expenses” Accrued expenses often occur in regard to: BEFORE Cash Payment Expense Recorded Adjusting entry results in: LO 5 Prepare adjusting entries for accruals.  taxes  salaries  rent  interest This adjusting entry serves two purposes: (1) Records the obligations, and (2) Recognizes the expenses.

38. 4-38 4 - Adjusting Entries for “Accrued Expenses” LO 5 Prepare adjusting entries for accruals. Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%. Interest Payable50 Interest Expense50Oct. 31 Illustration 4-19 (Partial) Illustration 4-18

39. 4-39 4 - Adjusting Entries for “Accrued Expenses” LO 5 Prepare adjusting entries for accruals. Illustration 4-20 Illustration: 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 $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days).

40. 4-40 4 - Adjusting Entries for “Accrued Expenses” LO 5 Prepare adjusting entries for accruals. Illustration: 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 $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days). Salaries and Wages Payable1,200 Salaries and Wages Expense1,200Oct. 31 Illustration 4-21

41. 4-41 Practice Problem BE4-8(a) & (c), p202

42. 4-42 4 - Adjusting Entries for “Accrued Expenses” LO 5 Prepare adjusting entries for accruals. Illustration 4-17 Illustration 4-22

43. 4-43 Summary of Basic Relationships LO 5 Prepare adjusting entries for accruals. Illustration 4-23 Summary of adjusting entries

44. 4-44 After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance). The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger. The adjusted trial balance is the primary basis for the preparation of the financial statements. The Adjusted Trial Balance LO 6 Describe the nature and purpose of the adjusted trial balance.

45. 4-45 The Adjusted Trial Balance LO 6 Illustration 4-26 Adjusted trial balance

46. 4-46 Which of the following statements is incorrect concerning the adjusted trial balance? a.An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made. b.The adjusted trial balance provides the primary basis for the preparation of financial statements. c.The adjusted trial balance lists the account balances segregated by assets and liabilities. d.The adjusted trial balance is prepared after the adjusting entries have been journalized and posted. Review Question The Adjusted Trial Balance LO 6 Describe the nature and purpose of the adjusted trial balance.

47. 4-47 Financial statements are prepared directly from the Adjusted Trial Balance. Balance Sheet Income Statement Retained Earnings Statement Preparing Financial Statements LO 6 Describe the nature and purpose of the adjusted trial balance.

48. 4-48 Preparing Financial Statements Illustration 4-27

49. 4-49 Preparing Financial Statements Illustration 4-28

50. 4-50 Quality of Earnings – company provides full and transparent information. Earnings Management - the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Companies may manage earnings by: Quality of Earnings  one-time items to prop up earnings numbers.  inflate revenue numbers in the short-run.  improper adjusting entries. As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting. LO 6 Describe the nature and purpose of the adjusted trial balance.

51. 4-51 At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings. Closing the Books LO 7 Explain the purpose of closing entries. Illustration 4-29 Personal example: If someone asked you how much you had in your bank account on Dec 31st, would you answer be any different if that same person asked you on January 1st? Personal example: If someone asked you how much you had in your bank account on Dec 31 st would your answer be any different if you were asked again on January 1 st ? Personal example: If someone asked you how much you made in 2014, what would your response be? What if they asked you how much you made in 2015, what would your answer be?

52. 4-52 1) Close the Revenue accounts into the Income Summary. 2) Close the Expense accounts in the Income Summary. 3) Close the Income Summary accounts to the Capital Account as either a net income or net loss. 4) Close the Dividends account into the Capital account. Closing Steps

53. 4-53 Income Summary Salaries ExpensesConsulting Revenues $ 18,100 $ 25,000 Retained Earnings $ 7,000 Examine the accounts presented. 3-53 Closing Steps

54. 4-54 $ 25,000 Close revenues with a debit to the revenue account and a credit to Income Summary. Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 25,000 3-54 Closing Steps - R

55. 4-55 $ 25,000 Close expense accounts with a credit to expenses and a debit to Income Summary. $ 25,000 $ 18,100 Salaries ExpensesConsulting Revenues Income Summary $ 18,100 3-55 Closing Steps - E

56. 4-56 $ 18,100 $ 25,000 $ 18,100 $ 25,000 $ 18,100 Determine the balance in the Income Summary account. Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries Salaries ExpensesConsulting Revenues Income Summary $ 6,900 3-56 Closing Steps - I

57. 4-57 $ 18,100 $ 25,000 $ 18,100 $ 7,000 Close the Income Summary to Retained Earnings. $ 6,900 Salaries Expenses Income Summary Retained Earnings $ 6,900 3-57 Closing Steps - I

58. 4-58 Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries Recording Closing EntriesRecording Closing EntriesRecording Closing EntriesRecording Closing Entries The dividends account is closed to Retained Earnings. Dividends $ 2,000 $ 7,000 6,900 11,900 Retained Earnings $ 2,000 3-58 Closing Steps - D Determine the ending balance in Retained Earnings.

59. 4-59 The dividends account is closed to Retained Earnings. Dividends $ 2,000 Determine the ending balance in Retained Earnings. $ 2,000 $ 11,900 $ 7,000 6,900 Retained Earnings 3-59 Closing Steps - D

60. 4-60 Closing the Books Illustration 4-31 2014

61. 4-61 Practice Problem E4-18, p. 209

62. 4-62 Preparing a Post-Closing Trial Balance LO 7 Explain the purpose of closing entries. Trial Balance prepared after the closing entries have been posted. Trial Balance prepared after the closing entries have been posted. The purpose is to insure that all nominal or temporary accounts have been closed. The purpose is to insure that all nominal or temporary accounts have been closed. The only accounts on this trial balance should be assets, liabilities, and equity accounts. The only accounts on this trial balance should be assets, liabilities, and equity accounts.

63. 4-63 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 LO 8 Describe the required steps in the accounting cycle. Illustration 4-33 Required steps in the accounting cycle