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C HAPTER 4 Accrual Accounting and Completing the Accounting Cycle
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C HARACTERISTICS OF THE A CCOUNTING M ODEL Periodic Reporting Accrual-Basis Accounting Adjusting Entries Closing Entries
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P ERIODIC R EPORTING Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be summarized each period.
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Fiscal Year--An accounting period that lasts 12 months. Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely. P ERIODIC R EPORTING
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Fiscal Year--An accounting period that lasts 12 months. Calendar Year—A fiscal year that lasts 12 months and ends on December 31. Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely. P ERIODIC R EPORTING
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Fiscal Year-- For publicly traded companies, the period covered by annual financial statements which are prepared for the public (Annual Report), and the SEC (Form 10K ). P ERIODIC R EPORTING
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Quarter--An accounting period that lasts 3 months. For publicly traded companies quarterly financial reports are prepared and sent to the SEC (Form 10Q). Month--May be a calendar month or a series of periods lasting 4 and 5 weeks. Time Periods are often further divided into Quarters and Months P ERIODIC R EPORTING
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L IFE C YCLE OF A B USINESS E NTITY Accounting Period 1 Accounting Period 2 Accounting Period 3 Balance Sheet Inc Statement, Statement of RE, Cash Flow Statement Inc Statement, Statement of RE, Cash Flow Statement Inc Statement, Statement of RE, Cash Flow Statement
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A CCRUAL A CCOUNTING Accrual-basis accounting is a concept in which revenues and expenses are recorded when earned or incurred, not when cash is received or paid. Revenues and expenses must be assigned to the proper accounting period. “Revenue recognition principle” and the “matching principle” determine the accounting period items are recorded in.
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R EVENUE R ECOGNITION 1. The earning process is “substantially complete.” 2. An exchange has taken place. Revenue is recognized when two criteria are met:
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T HE M ATCHING P RINCIPLE All expenses incurred to generate revenues must be recognized in the same period as the related revenues. Example: The cost of goods sold for an item must be matched with the sales revenue generated in any time period.
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D ETERMINING A CCRUAL I NCOME Recognized Revenues of 2009 - Matched Expenses of 2009 = Net Income for 2009
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S TEPS IN THE A CCOUNTING C YCLE 1.Analyze transactions and business documents. 2.Journalize transactions. 3.Post journal entries to the general ledger. 4.Determine account balances and prepare a trial balance. 5.Journalize and post adjusting entries. 6.Prepare the adjusted trial balance. 7.Prepare financial statements. 8.Journalize and post the closing entries. 9.Balance the accounts and prepare a post- closing trial balance.
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S TEP 5 - A DJUSTING E NTRIES Adjusting entries are required at the end of each accounting period for accrual- basis accounting, prior to preparing the financial statements. The purpose for adjusting entries are to: 1.Bring Balance Sheet accounts current. 2.Reflect proper amounts of revenues and expenses on the Income Statement.
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T IPS R EGARDING A DJUSTING E NTRIES Analytical Process. You must determine what original entry was made (if any) and what the ending balances should be before you know what adjusting entry to make. You cannot memorize adjusting entries. Adjusting entries always include a Balance Sheet account and an Income Statement account. Adjusting entries never involve a CASH account.
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3-S TEP P ROCESS FOR A DJUSTING E NTRIES 1 Identify the original entries that were made, if any. (Original entries were only made for unearned revenues and prepaid expenses.) 2 Determine what the correct balances should be at this point in time. 3 Make the adjustments needed to correct the balances.
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M OST C OMMON A DJUSTING E NTRIES Prepaid Expenses--Expenses that have been recorded (paid) but not yet incurred. Unearned Revenues--Revenues that have been recorded (received) but not yet earned. Accrued Revenues--Revenues that have been earned but not yet recorded. Accrued Expenses--Expenses that have been incurred but not yet recorded.
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On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry? E XAMPLE : P REPAID E XPENSES
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On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry? E XAMPLE : P REPAID E XPENSES Original Entry 3,600 3,600 Correct Balances1,800 1,800 Prepaid RentCash Rent Expense
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On July 1, 2008 XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008 to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry? E XAMPLE : P REPAID E XPENSES Original Entry 3,600 3,600 Correct Balances1,800 1,800 Prepaid RentCash Rent Expense Adjusting Entry 1,800 1,800 Adjusting Entry: 12/31 Rent Expense1,800 Prepaid Rent 1,800
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On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach? P REPAID E XPENSES
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On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach? P REPAID E XPENSES Original Entry 3,600 3,600 Correct Balances1,800 1,800 Prepaid Rent Cash Rent Expense
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On July 1, 2008, XYZ Company pays $3,600 for one year’s rent in advance, covering July 1, 2008, to June 30, 2009. On December 31, 2008, an adjustment will be needed. What is the adjusting entry using the expense approach? P REPAID E XPENSES Original Entry 3,600 3,600 Correct Balances1,800 1,800 Prepaid Rent Cash Rent Expense Adjusting Entry 1,800 1,800 Adjusting Entry: 12/31 Prepaid Rent 1,800 Rent Expense 1,800
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On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it? E XAMPLE : U NEARNED R EVENUE
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On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it? E XAMPLE : U NEARNED R EVENUE Original Entry 5,000 5,000 Correct Balances 2,500 2,500 Unearned Rev Cash Show Rev
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On July 1 XYZ Company receives $5,000 for season tickets to a trade show they will put on every month for the next 12 months. On December 31 an adjustment will be needed. What is it? E XAMPLE : U NEARNED R EVENUE Original Entry 5,000 5,000 Correct Balances 2,500 2,500 Unearned Rev Cash Show Rev Adjusting Entry 2,500 2,500 Adjusting Entry: 12/31 Unearned Rev 2,500 Show Rev 2,500
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E XAMPLE : A CCRUED R EVENUE The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice nor receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry?
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E XAMPLE : A CCRUED R EVENUE The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice nor receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry? Original Entrynonenone Correct Balances500500 Rent Receivable Rent Revenue
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E XAMPLE : A CCRUED R EVENUE The XYZ Company earns a rent revenue of $500 in 2008 but did not send out an invoice or receive the payment until January 3, 2009. An adjustment will be needed. What is the adjusting entry? Original Entrynonenone Correct Balances500500 Rent Receivable Rent Revenue Adjusting Entry: 12/31Rent Receivable 500 Rent Revenue 500
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The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry? E XAMPLE : A CCRUED E XPENSE
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The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry? E XAMPLE : A CCRUED E XPENSE Original Entrynonenone Correct Balances1,0001,000 Property Tax Expense Property Tax Payable
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The XYZ Company is assessed property taxes of $1,000 for 2008, but will not make this payment until January 5, 2009. An adjustment will be needed. What is the adjusting entry? E XAMPLE : A CCRUED E XPENSE Original Entrynonenone Correct Balances1,0001,000 Property Tax Expense Property Tax Payable Adjusting Entry: 12/31 Property Tax Expense 1,000 Property Tax Payable 1,000
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Which of the following is not a True statement? a)Accumulated depreciation is a contra- asset. b)Depreciation expense is a contra-expense. c)Accumulated depreciation has a normal credit balance. d)Depreciation expense has a normal debit balance. Accrued E XPENSE
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There are 9 steps in the Accounting Cycle. List them in order. (Hint: Three of them contain the words “Trial Balance”) 1.__________________________ 2.__________________________ 3.__________________________ 4.__________________________ 5.__________________________ 6.__________________________ 7.__________________________ 8.__________________________ 9.__________________________
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S TEPS IN THE A CCOUNTING C YCLE 1.Analyze transactions and business documents. 2.Journalize transactions. 3.Post journal entries to the general ledger. 4.Determine account balances and prepare a trial balance. 5.Journalize and post adjusting entries. 6.Prepare the adjusted trial balance. 7.Prepare financial statements. 8.Journalize and post the closing entries. 9.Balance the accounts and prepare a post- closing trial balance.
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Prepare Financial Statements Record Trans- actions Prepare Trial Balance Make Adjusting Entries After all transactions have been recorded, a trial balance prepared, and adjusting entries made... the financial statements can be prepared. Step 7 Preparing Financial Statements
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S TEP 8 T HE C LOSING P ROCESS Nominal Accounts (temporary accounts) are closed to a zero balance at the end of each accounting period. Real Accounts (permanent accounts) are not closed to a zero balance at the end of the accounting period. These accounts are carried forward to the next period. Closing Entries reduce all nominal accounts to a zero balance.
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Examples Real Accounts Assets Liabilities Owners’ Equity (Balance Sheet Accounts)
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Real Accounts Assets Liabilities Owners’ Equity (Balance Sheet Accounts) Nominal Accounts Revenues Expenses Dividends (Income Statement Accounts) Examples
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C LOSING E NTRIES Dec 31 Sales Revenue....................... 1,500 Rent Revenue........................ 100 Cost of Goods Sold............1,100 Salaries Expense............... 200 Other Expenses................. 150 Retained Earnings............. 150 The Goal: Move all Revenue and Expense items (Net Income) into Retained Earnings. This is not the actual entry!
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Closing the books ALWAYS requires 4 closing entries C LOSING E NTRIES
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Closing Entry 1. Close all revenue accounts by debiting them. Dr. Cr. Sales Revenue............ 13,000 Rent Revenue………... 2,000 Income Summary... 15,000 C LOSING E NTRIES
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Revenues Bal. xxx Income Summary Revenues The Closing Processxxx Since the revenue account is a nominal account, it is closed at the end of the period to Income Summary. xxx
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Closing Entry 2. Close all expense accounts by crediting them. Dr. Cr. Income Summary…............. 13,600 Cost of Goods Sold….... 12,800 Insurance Expense........ 500 Supplies Expense.......... 300 The Closing Process
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Expenses Bal. YYY YYY The expense accounts are credited in order to close the account at the end of the period. xxx Rev. Exp. Income Summary YYY The Closing Process
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Closing Entry 3. Close Income Summary. Dr. Cr. Income Summary…............. 1,400 Retained Earnings.….... 1,400 The Closing Process
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Retained Earnings Net Income The Income Summary account is closed with a debit orcredit depending on its balance. The Income Summary account is closed with a debit or credit depending on its balance. xxx Rev. Exp. Income Summary Net Income YYY The Closing Process
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Closing Entry 4. Close Dividends (if any). Dr. Cr. Retained Earnings…............ 500 Dividends………….….... 500 The Closing Process
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A BOUT D IVIDENDS Dividends are not expenses. They are distributions to stockholders of part of the corporation’s earnings. Dividends reduce Retained Earnings. For example: If a company earns $1,400 of Net Income, paying dividends to shareholders does not change Income.
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Declaration of Dividends: Dividends......................500 Dividends Payable....500 E XAMPLE : D IVIDENDS
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Declaration of Dividends: Dividends......................500 Dividends Payable....500 Payment of Dividends: Dividends Payable.........500 Cash........................500 E XAMPLE : D IVIDENDS
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Declaration of Dividends: Dividends......................500 Dividends Payable....500 Payment of Dividends: Dividends Payable.........500 Cash........................500 Closing Entry for Dividends: Retained Earnings.........500 Dividends.................500 E XAMPLE : D IVIDENDS
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The dividends account, which is also nominal, is credited to close out the balance. Net Inc. Div. Retained Earnings ddd Dividends Bal. ddd ddd The Closing Process
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Retained Earnings Beg. Bal. BBB Rev. Exp. Div. End. Bal. EEE Retained Earnings is a real account and always carries a balance. Net Income for the period is added by these two entries. The Closing Process
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S TEP 8. P OST -C LOSING T RIAL B ALANCE Provides a listing of all real account balances at the end of the closing balance. The Trial Balance assures that total debits equal total credits prior to the beginning of the new accounting period. Revenues and expenses will not appear because they have no balances. Only real accounts will have a balance at this time.
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Jim Brewster, Inc. Post-Closing Trial Balance as of December 31, 2008 DebitsCredits Cash $ 8,200 Accounts Receivable 4,000 Inventory 3,000 Supplies 1,000 Accounts Payable$ 5,000 Capital Stock 10,000 Retained Earnings _____ _ 1,200 Totals $16,200 $16,200 Post Closing Trial Balance Example
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S TEPS IN THE A CCOUNTING C YCLE 1.Analyze transactions and business documents. 2.Journalize transactions. 3.Post journal entries to the general ledger. 4.Determine account balances and prepare a trial balance. 5.Journalize and post adjusting entries. 6.Prepare the adjusted trial balance. 7.Prepare financial statements. 8.Journalize and post the closing entries. 9.Balance the accounts and prepare a post- closing trial balance.
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C ASH -B ASIS A CCOUNTING Revenue and expenses are recognized only when cash is received or payments are made. Mainly used by small businesses. Not an accurate picture of true profitability.
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Example: Accrual vs. Cash-Basis Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31.
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Example: Accrual vs. Cash-Basis Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31. Brewster Enterprises Reported Income for 20XX Cash-Basis Accounting Cash Receipts$41,000 Cash Disbursement 28,000 Income$13,000
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Example: Accrual vs. Cash-Basis Brewster Enterprises billed their client for $48,000 during the year. On December 31 they had received $41,000, with the remaining $7,000 to be received in the next year. Total expenses during the year amounted to $31,000 with $3,000 of these costs not yet paid for at December 31. Brewster Enterprises Reported Income for 20XX Cash-Basis Accounting Accrual Basis Accounting Cash Receipts$41,000 Revenues Earned $48,000 Cash Disbursement 28,000 Expenses Incurred 31,000 Income$13,000 Income $17,000
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C ASH B ASIS IS NOT GAAP GAAP
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A PPENDIX -- W ORKSHEETS May be useful for you to review to clarify the Adjusting Entry process and the surrounding Trial Balances. Worksheets are used to simplify the process of preparing financial statements. Worksheets are also used to analyze end-of-period adjustments. Most accountants use a spreadsheet to prepare the worksheet electronically. Trial balances are used to test whether total debits equal total credits.
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A DJUSTING E NTRIES – U SING A W ORKSHEET (A PPENDIX ) Illustration 4A-1 Form and procedure for a worksheet
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T HE E ND
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