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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 l.jpg

Accrual Accounting

and

Completing the Accounting Cycle

Chapter 4


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Characteristics of theAccounting Model

  • Periodic Reporting

  • Accrual-Basis Accounting

  • Adjusting Entries

  • Closing Entries


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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.


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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.


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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.


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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 ).


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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.


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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


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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.


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Revenue Recognition

Revenue is recognized when two criteria are met:

  • The earning process is “substantially complete.”

  • An exchange has taken place.


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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.


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Determining Accrual Income

Recognized Revenues of 2009

- Matched Expenses of 2009

= Net Income for 2009


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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.


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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.


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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.


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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.


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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.


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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?


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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


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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


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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?


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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


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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


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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?


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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


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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


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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?


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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?


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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


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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?


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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


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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


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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.


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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”)

  • __________________________

  • __________________________

  • __________________________

  • __________________________

  • __________________________

  • __________________________

  • __________________________

  • __________________________

  • __________________________


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Steps in the Accounting Cycle order.

  • 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.


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Record Trans-actions order.

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.


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Step 8 order. The 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.


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Examples order.

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)


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Examples order.

Real Accounts

Assets

Liabilities

Owners’ Equity

(Balance Sheet Accounts)

Nominal Accounts

Revenues

Expenses

Dividends

(Income Statement Accounts)


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This is not the actual entry! order.

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


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Closing order. Entries

Closing the books ALWAYS requires

4

closing entries


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Closing order. 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


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The Closing Process order.

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.


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The Closing Process order.

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


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The Closing Process order.

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


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The Closing Process order.

Closing Entry 3.

Close Income Summary.

Dr. Cr.

Income Summary…............. 1,400

Retained Earnings.….... 1,400


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The Closing Process order.

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.


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The Closing Process order.

Closing Entry 4.

Close Dividends (if any).

Dr. Cr.

Retained Earnings…............ 500

Dividends………….….... 500


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About Dividends order.

  • 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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Example: Dividends order.

Declaration of Dividends:

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

Dividends Payable.... 500


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Example: Dividends order.

Declaration of Dividends:

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

Dividends Payable.... 500

Payment of Dividends:

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

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


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Example: Dividends order.

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


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The Closing Process order.

Retained Earnings

Net Inc.

Div.

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

ddd

Dividends

ddd

Bal. ddd


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The Closing Process order.

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.


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Step 8 order. . 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.


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Post Closing Trial Balance order.

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


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Steps in the Accounting Cycle order.

  • 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.


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Cash-Basis Accounting order.

  • 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 order.

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 order.

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 order.

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


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GAAP order.

Cash Basis is not GAAP


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Appendix -- Worksheets order.

  • 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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Adjusting Entries – Using a Worksheet order. (Appendix)

  • Illustration 4A-1

  • Form and procedure for a worksheet


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The End order.


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