2. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-1 Chapter Four: The Accounting Cycle: Accruals and Deferrals

3. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-2 At the end of the period, we need to make adjusting entries to get the accounts up to date for the financial statements.

4. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-3 Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. Adjusting Entries

5. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-4  Converting assets to expenses  Accruing unpaid expenses  Converting liabilities to revenue  Accruing uncollected revenues Types of Adjusting Entries

6. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-5 Prior PeriodsCurrent PeriodFuture Periods Transaction Paid cash in advance of incurring expense (creates an asset). Transaction Paid cash in advance of incurring expense (creates an asset). End of Current Period Adjusting Entry  Recognizes portion of asset consumed as expense, and  Reduces balance of asset account. Adjusting Entry  Recognizes portion of asset consumed as expense, and  Reduces balance of asset account. Converting Assets to Expenses

7. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-6 Examples Include: Depreciation Supplies Expiring Insurance Policies Converting Assets to Expenses

8. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-7 Jan. 1Dec. 31 $2,400 Insurance Policy Coverage for 12 Months $200 Monthly Insurance Expense On January 1, Webb Co. purchased a one- year insurance policy for $2,400. Converting Assets to Expenses

9. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-8 Initially, costs that benefit more than one accounting period are recorded as assets. Converting Assets to Expenses

10. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-9 The costs are expensed as they are used to generate revenue. Converting Assets to Expenses

11. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-10 Income Statement Cost of assets used this period to generate revenue. Income Statement Cost of assets used this period to generate revenue. Balance Sheet Cost of assets that benefit future periods. Balance Sheet Cost of assets that benefit future periods. Converting Assets to Expenses

12. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-11 Depreciation is the systematic allocation of the cost of a depreciable asset to expense. Depreciable assets are physical objects that retain their size and shape but lose their economic usefulness over time. The Concept of Depreciation

13. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-12 The portion of an asset’s utility that is used up must be expensed in the period used. Cash (credit) Fixed Asset (debit) On date when initial payment is made... The asset’s usefulness is partially consumed during the period. At end of period... Depreciation Expense (debit) Accumulated Depreciation (credit) The Concept of Depreciation

14. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-13 On May 2, 2006, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Using the straight-line method, calculate the monthly depreciation expense. $2,500 50 = $50 Depreciation expense (per period) = Cost of the asset Estimated useful life Depreciation Is Only an Estimate

15. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-14 JJ’s Lawn Care Service would make the following adjusting entry. Contra-asset Depreciation Is Only an Estimate

16. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-15 JJ’s $15,000 truck is depreciated over 60 months as follows: $15,000  60 months = $250 per month Depreciation Is Only an Estimate

17. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-16 Accumulated depreciation would appear on the balance sheet as follows:

18. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-17 Prior PeriodsCurrent PeriodFuture Periods Transaction Collect cash in advance of earning revenue (creates a liability). Transaction Collect cash in advance of earning revenue (creates a liability). End of Current Period Adjusting Entry  Recognizes portion earned as revenue, and  Reduces balance of liability account. Adjusting Entry  Recognizes portion earned as revenue, and  Reduces balance of liability account. Converting Liabilities to Revenue

19. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-18 Examples Include: Airline Ticket Sales Sports Teams’ Sales of Season Tickets Converting Liabilities to Revenue

20. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-19 Jan. 1Dec. 31 $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. Converting Liabilities to Revenue

21. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-20 Initially, revenues that benefit more than one accounting period are recorded as liabilities. Converting Liabilities to Revenue

22. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-21 Over time, the revenue is recognized as it is earned. Converting Liabilities to Revenue

23. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-22 Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Liability for future periods. Balance Sheet Liability for future periods. Converting Liabilities to Revenue

24. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-23 Prior PeriodsCurrent PeriodFuture Periods Transaction Pay cash in settlement of liability. Transaction Pay cash in settlement of liability. End of Current Period Adjusting Entry  Recognizes expense incurred, and  Records liability for future payment. Adjusting Entry  Recognizes expense incurred, and  Records liability for future payment. Accruing Unpaid Expenses

25. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-24 Examples Include: Interest Wages and Salaries Property Taxes Hey, when do we get paid? Accruing Unpaid Expenses

26. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-25 Monday, May 29 Friday, June 2 $3,000 Wages Expense On May 31, Webb Co. owes wages of $3,000. Payday is Friday, June 2. Wednesday, May 31 Accruing Unpaid Expenses

27. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-26 Initially, an expense and a liability are recorded. Accruing Unpaid Expenses

28. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-27 Income Statement Cost incurred this period to generate revenue. Income Statement Cost incurred this period to generate revenue. Balance Sheet Liability to be paid in a future period. Balance Sheet Liability to be paid in a future period. Accruing Unpaid Expenses

29. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-28 Monday, May 29 Friday, June 2 $5,000 Weekly Wages Let’s look at the entry for June 2. Wednesday, May 31 $2,000 Wages Expense $3,000 Wages Expense Accruing Unpaid Expenses

30. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-29 The liability is extinguished when the debt is paid. Accruing Unpaid Expenses

31. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-30 Prior PeriodsCurrent PeriodFuture Periods Transaction Collect cash in settlement of receivable. Transaction Collect cash in settlement of receivable. End of Current Period Adjusting Entry  Recognizes revenue earned but not yet recorded, and  Records receivable. Adjusting Entry  Recognizes revenue earned but not yet recorded, and  Records receivable. Accruing Uncollected Revenue

32. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-31 Examples Include: Interest Earned Work Completed But Not Yet Billed to Customer Accruing Uncollected Revenue

33. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-32 Saturday, Jan. 15 Tuesday, Feb. 15 $170 Interest Revenue On Jan. 31, the bank owes Webb Co. interest of $170. Interest is paid on the 15 th day of each month. Monday, Jan. 31 Accruing Uncollected Revenue

34. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-33 Initially, the revenue is recognized and a receivable is created. Accruing Uncollected Revenue

35. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-34 Income Statement Revenue earned this period. Income Statement Revenue earned this period. Balance Sheet Receivable to be collected in a future period. Balance Sheet Receivable to be collected in a future period. Accruing Uncollected Revenue

36. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-35 Saturday, Jan. 15 Tuesday, Feb. 15 $320 Monthly Interest $170 Interest Revenue Let’s look at the entry for February 15. Monday, Jan. 31 $150 Interest Revenue Accruing Uncollected Revenue

37. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-36 The receivable is collected in a future period. Accruing Uncollected Revenue

38. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-37 As a corporation earns taxable income, it incurs income taxes expense, and also a liability to governmental tax authorities. Accruing Income Taxes Expense: The Final Adjusting Entry

39. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-38 Costs are matched with revenue in two ways:  Direct association of costs with specific revenue transactions.  Systematic allocation of costs over the “useful life” of the expenditure. Adjusting Entries and Accounting Principles

40. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-39 An item is “material” if knowledge of the item might reasonably influence the decisions of users of financial statements. Supplies Lightbulbs Many companies immediately charge the cost of immaterial items to expense. The Concept of Materiality

41. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-40 Journalize transactions. Post entries to the ledger accounts. Prepare trial balance. Make end-of- year adjustments. Prepare adjusted trial balance. Let’s look at JJ’s Lawn Care Services’ adjusted trial balance. Effects of the Adjusting Entries

42. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-41 All balances are taken from the ledger accounts on May 31 after preparing the two depreciation adjusting entries. Adjusted Trial Balance

43. McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 4-42 End of Chapter Four