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Accrual Accounting and Completing the Accounting Cycle. Chapter 4. Characteristics of the Accounting Model. Periodic Reporting Accrual-Basis Accounting Adjusting Entries Closing Entries. Periodic Reporting.

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chapter 4

Accrual Accounting

and

Completing the Accounting Cycle

Chapter 4

characteristics of the accounting model
Characteristics of theAccounting Model
  • Periodic Reporting
  • Accrual-Basis Accounting
  • Adjusting Entries
  • Closing Entries
periodic reporting
Periodic Reporting

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.

slide4

Periodic Reporting

Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely.

Fiscal Year--An accounting period that lasts 12 months.

slide5

Periodic Reporting

Time Period Concept--The life of a business is divided into distinct and short time periods so the accounting information can be timely.

Fiscal Year--An accounting period that lasts 12 months.

Calendar Year—A fiscal year that lasts 12 months and ends on December 31.

slide6

Periodic Reporting

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 ).

slide7

Periodic Reporting

Time Periods are often further divided into Quarters and Months

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.

life cycle of a business entity
Life Cycle of a Business Entity

Accounting Period

1

Accounting Period

2

Accounting Period

3

Inc Statement, Statement of RE,

Cash Flow Statement

Inc Statement, Statement of RE,

Cash Flow Statement

Inc Statement, Statement of RE,

Cash Flow Statement

Balance Sheet

Balance Sheet

Balance Sheet

accrual accounting
Accrual Accounting
  • 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.
revenue recognition
Revenue Recognition

Revenue is recognized when two criteria are met:

  • The earning process is “substantially complete.”
  • An exchange has taken place.
the matching principle
The Matching Principle

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.

determining accrual income
Determining Accrual Income

Recognized Revenues of 2009

- Matched Expenses of 2009

= Net Income for 2009

steps in the accounting cycle
Steps in the Accounting Cycle
  • Analyze transactions and business documents.
  • Journalize transactions.
  • Post journal entries to the general ledger.
  • Determine account balances and prepare a trial balance.
  • Journalize and post adjusting entries.
  • Prepare the adjusted trial balance.
  • Prepare financial statements.
  • Journalize and post the closing entries.
  • Balance the accounts and prepare a post-closing trial balance.
step 5 adjusting entries
Step 5 - Adjusting Entries

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:

  • Bring Balance Sheet accounts current.
  • Reflect proper amounts of revenues and expenses on the Income Statement.
tips regarding adjusting entries
Tips Regarding Adjusting Entries
  • 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.
3 step process for adjusting entries
3-Step Process forAdjusting Entries
  • Identify the original entries that were made, if any. (Original entries were only made for unearned revenues and prepaid expenses.)
  • Determine what the correct balances should be at this point in time.
  • Make the adjustments needed to correct the balances.
most common adjusting entries
Most Common Adjusting Entries
  • 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.
example prepaid expenses
Example: Prepaid Expenses

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?

example prepaid expenses19
Example: Prepaid Expenses

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?

Rent Expense

Prepaid Rent

Cash

Original Entry 3,600 3,600

Correct Balances1,800 1,800

example prepaid expenses20
Example: Prepaid Expenses

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?

Rent Expense

Prepaid Rent

Cash

Original Entry 3,600 3,600

Correct Balances1,800 1,800

Adjusting Entry 1,800 1,800

Adjusting Entry: 12/31 Rent Expense 1,800

Prepaid Rent 1,800

prepaid expenses
Prepaid Expenses

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?

prepaid expenses22
Prepaid Expenses

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?

Prepaid Rent

Cash

Rent Expense

Original Entry 3,600 3,600

Correct Balances1,800 1,800

prepaid expenses23
Prepaid Expenses

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?

Prepaid Rent

Cash

Rent Expense

Original Entry 3,600 3,600

Correct Balances1,800 1,800

  • Adjusting Entry 1,800 1,800

Adjusting Entry: 12/31 Prepaid Rent 1,800

Rent Expense 1,800

example unearned revenue
Example: Unearned Revenue

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?

example unearned revenue25
Example: Unearned Revenue

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?

Cash

Show Rev

Unearned Rev

Original Entry 5,000 5,000

Correct Balances 2,500 2,500

example unearned revenue26
Example: Unearned Revenue

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?

Cash

Show Rev

Unearned Rev

Original Entry 5,000 5,000

Correct Balances 2,500 2,500

  • Adjusting Entry 2,500 2,500

Adjusting Entry: 12/31 Unearned Rev 2,500

Show Rev 2,500

example accrued revenue
Example: Accrued Revenue

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?

example accrued revenue28

RentReceivable

Rent Revenue

Original Entry none none

Correct Balances 500 500

Example: Accrued Revenue

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?

example accrued revenue29

RentReceivable

Rent Revenue

Original Entry none none

Correct Balances 500 500

Example: Accrued Revenue

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?

Adjusting Entry:

12/31 Rent Receivable 500

Rent Revenue 500

example accrued expense
Example: Accrued Expense

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?

example accrued expense31
Example: Accrued Expense

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?

Property Tax

Expense

Property Tax Payable

Original Entry none none

Correct Balances 1,000 1,000

example accrued expense32
Example: Accrued Expense

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?

Property Tax

Expense

Property Tax Payable

Original Entry none none

Correct Balances 1,000 1,000

Adjusting Entry: 12/31 Property Tax Expense 1,000

Property Tax Payable 1,000

slide33

AccruedExpense

  • Which of the following is not a True statement?
    • Accumulated depreciation is a contra-asset.
    • Depreciation expense is a contra-expense.
    • Accumulated depreciation has a normal credit balance.
    • Depreciation expense has a normal debit balance.
slide34

There are 9 steps in the Accounting Cycle. List them in order.

(Hint: Three of them contain the words “Trial Balance”)

  • __________________________
  • __________________________
  • __________________________
  • __________________________
  • __________________________
  • __________________________
  • __________________________
  • __________________________
  • __________________________
steps in the accounting cycle35
Steps in the Accounting Cycle
  • Analyze transactions and business documents.
  • Journalize transactions.
  • Post journal entries to the general ledger.
  • Determine account balances and prepare a trial balance.
  • Journalize and post adjusting entries.
  • Prepare the adjusted trial balance.
  • Prepare financial statements.
  • Journalize and post the closing entries.
  • Balance the accounts and prepare a post-closing trial balance.
slide36

Record Trans-actions

Prepare Trial Balance

Make Adjusting Entries

Prepare Financial Statements

Step 7

Preparing Financial Statements

  • After all transactions have been recorded, a trial balance prepared, and adjusting entries made . . . the financial statements can be prepared.
step 8 the closing process
Step 8The Closing Process
  • 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.
slide38

Examples

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)

slide39

Examples

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)

Nominal Accounts

Revenues

Expenses

Dividends

(Income Statement Accounts)

closing entries

This is not the actual entry!

Closing Entries

The Goal: Move all Revenue and Expense items (Net Income) into Retained Earnings.

Dec 31 Sales Revenue....................... 1,500

Rent Revenue........................ 100

Cost of Goods Sold............ 1,100

Salaries Expense............... 200

Other Expenses................. 150

Retained Earnings............. 150

closing entries41
Closing Entries

Closing the books ALWAYS requires

4

closing entries

closing entries42
Closing Entries

Closing Entry 1.

Close all revenue accounts by debiting them.

Dr. Cr.

Sales Revenue............ 13,000

Rent Revenue………... 2,000

Income Summary... 15,000

slide43

The Closing Process

Income Summary

Revenues

xxx

Bal. xxx

xxx

Revenues

Since the revenue account is a nominal account, it is closed at the end of the period to Income Summary.

slide44

The Closing Process

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

slide45

The Closing Process

Income Summary

xxx

Rev.

Exp.

YYY

Expenses

The expense accounts are credited in order to close the account at the end of the period.

Bal. YYY

YYY

slide46

The Closing Process

Closing Entry 3.

Close Income Summary.

Dr. Cr.

Income Summary…............. 1,400

Retained Earnings.….... 1,400

slide47

The Closing Process

Income Summary

Retained Earnings

xxx

Rev.

Exp.

YYY

Net Income

Net Income

The Income Summary account is closed with a debit orcredit depending on its balance.

slide48

The Closing Process

Closing Entry 4.

Close Dividends (if any).

Dr. Cr.

Retained Earnings…............ 500

Dividends………….….... 500

about dividends
About Dividends
  • 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.

slide50

Example: Dividends

Declaration of Dividends:

Dividends...................... 500

Dividends Payable.... 500

slide51

Example: Dividends

Declaration of Dividends:

Dividends...................... 500

Dividends Payable.... 500

Payment of Dividends:

Dividends Payable......... 500

Cash........................ 500

slide52

Example: Dividends

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

slide53

The Closing Process

Retained Earnings

Net Inc.

Div.

The dividends account, which is also nominal, is credited to close out the balance.

ddd

Dividends

ddd

Bal. ddd

slide54

The Closing Process

Retained Earnings

Retained Earnings is a real account and always carries a balance.

Beg. Bal. BBB

Rev.

Exp.

Div.

End. Bal. EEE

Net Income for the period is added by these two entries.

step 8 post closing trial balance
Step 8. Post-Closing Trial Balance
  • 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.
slide56

Post Closing Trial Balance

Example

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

steps in the accounting cycle57
Steps in the Accounting Cycle
  • Analyze transactions and business documents.
  • Journalize transactions.
  • Post journal entries to the general ledger.
  • Determine account balances and prepare a trial balance.
  • Journalize and post adjusting entries.
  • Prepare the adjusted trial balance.
  • Prepare financial statements.
  • Journalize and post the closing entries.
  • Balance the accounts and prepare a post-closing trial balance.
cash basis accounting
Cash-Basis Accounting
  • 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.
slide59

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.

slide60

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

slide61

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 AccountingAccrual Basis Accounting

Cash Receipts $41,000 Revenues Earned $48,000

Cash Disbursement 28,000Expenses Incurred 31,000

Income $13,000 Income $17,000

appendix worksheets
Appendix -- Worksheets
  • 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.
adjusting entries using a worksheet appendix
Adjusting Entries – Using a Worksheet (Appendix)
  • Illustration 4A-1
  • Form and procedure for a worksheet
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