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CHAPTER. Accrual Accounting Concepts. 4. Time Period Assumption. Divides the economic life of a business into artificial time periods Interim period (month, quarter) Year (fiscal, calendar) WHY? To provide immediate feedback on how the business is doing. Revenue Recognition Principle.

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CHAPTER

Accrual Accounting Concepts

4


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Time Period Assumption

  • Divides the economic life of a business into artificial time periods

    • Interim period (month, quarter)

    • Year (fiscal, calendar)

  • WHY?

    • To provide immediate feedback on how the business is doing


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Revenue Recognition Principle

  • Dictates that revenue be recognized in the accounting period in which it is earned

  • Revenue is considered earned when the service has been provided or when the goods are delivered


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Matching Principle

  • Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded


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Cash Basis

  • Revenue is recorded only when cash is received

  • Expense is recorded only when cash is paid


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GAAP

Accrual Basis Accounting

  • Adheres to the time period assumption and revenue recognition and matching principles

  • Revenue is recorded when earned, rather than when cash is received

  • Expense recorded when incurred, rather than when cash is paid

  • Accrual accounting records events when the economic event occurs


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Adjusting Entries

  • Adjusting entries are made to adjust or update accounts at the end of the accounting period

  • Adjusting entries can be categorized as

    • Prepayments

    • Accruals


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Types of Adjusting Entries

  • Prepayments

    • Prepaid expenses

    • Unearned revenues

  • Accruals

    • Accrued revenues

    • Accrued expenses


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Prepayments

  • Cash has been spent but the item acquired has not been used or consumed (prepaid expenses)

  • Cash has been collected but the revenue has not been earned (unearned revenues)


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Supplies

On January 5 the company paid $2,500 for advertising supplies.

Advertising Supplies

Advertising Supplies Expense

Cash

Jan. 5 2,500

Jan. 5 2,500

GENERAL JOURNALDebitCredit

Jan. 5 Advertising Supplies 2,500 Cash 2,500

Purchased advertising supplies


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Supplies

An inventory on January 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. ($2,500 - $1,000) =$ 1,500

Advertising Supplies Expense

Advertising Supplies

Cash

Jan. 5 2,500

Jan. 31 1,500

Jan. 5 2,500

Jan. 31 1,500

Bal. 1,000

GENERAL JOURNALDebitCredit

Jan. 5 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 To record advertising supplies consumed


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Insurance Expense

Prepaid Insurance

Cash

Prepaid Expenses

On February 4 the company paid $600 for a 1-year insurance policy; coverage began February 1.

Feb. 4 600

Feb. 4 600

GENERAL JOURNALDebit Credit

Feb. 4 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective February 1


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Prepaid Expenses

On February 28, $50 ($600/12 months) of the insurance had been used or had expired.

Insurance Expense

Prepaid Insurance

Cash

Feb. 4 600

Feb. 4 600

Feb. 28 50

Feb. 28 50

GENERAL JOURNALDebit Credit

Feb. 28 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month


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Amortization

  • How do you apply the matching principle to the cost of a long-lived asset?


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Amortization

  • Allocate the cost of an asset to expense over its useful life

  • Amortization is an allocation concept, not a valuation concept

Note: This is not an attempt to reflect the actual change in value of an asset.


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Amortization Example

  • Assume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 years

  • Straight-line amortization calculation is:

    Cost - Salvage value = $5,000 - $200 = $480/yr Useful Life 10 OR $40/mo


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Amortization Example

Accumulated Amortization-Office Equipment

Amortization Expense

Office Equipment

Mar. 2 5,000

Mar. 31 40

Mar. 31 40

GENERAL JOURNALDebit Credit

Mar. 31 Amortization Expense 40 Accumulated Amortization – 40 Office Equipment To record monthly amortization

Accumulated Amortization is acontra assetaccount – an offset (deduction) against the asset account.


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Net book value

Balance Sheet Presentation


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Unearned Service Revenue

Service Revenue

Cash

Unearned Revenues

Received on August 2 $1,200 for advertising services expected to be completed by December 31.

Aug. 2 1,200

Aug. 2 1,200

GENERAL JOURNAL Debit Credit

Aug. 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by December 31


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Unearned Service Revenue

Service Revenue

Cash

Unearned Revenues

During August, $400 of the revenue was earned.

Aug. 2 1,200

Aug. 31 400

Aug. 2 1,200

Aug. 31 400

Bal. 800

GENERAL JOURNALDebitCredit

Aug. 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned


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Accruals

  • Revenue has been earned, but not collected (accrued revenues)

  • Expenses were incurred, but not yet paid (accrued expenses)

Note: Entry has not yet been recorded!


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Accrued Revenues

  • Revenues earned but not yet received in cash or recorded at the end of period


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Accounts Receivable

Service Revenue

Accrued Revenues

Earned $200 for advertising services to clients in October, but they were not billed until after October 31.

Oct. 31 200

Oct. 31 200

GENERAL JOURNALDebitCredit

Oct . 31 Accounts Receivable 200 Service Revenue 200


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Accrued Expenses

  • Expenses incurred but not yet paid or recorded at the end of period


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Accrued Interest Expense

Interest expense is the cost a company incurs to use money. Information needed to calculate interest expense:

  • Face value of note

  • Interest rate (always expressed in annual rate)

  • The length of time note is outstanding


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Face Value of Note

Annual Interest

Rate

Time

in Terms of One Year

Interest

$ 5,000 X

12%

=

$50

Accrued Interest Expense

Formula for Calculating Interest

X 1/2


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Interest Expense

Interest Payable

Accrued Interest Expense

Oct. 31 50

Oct. 31 200

GENERAL JOURNALDebitCredit

Oct. 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month


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Accrued Salaries Expense

  • Assume that the employees receive total salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day.

  • Salaries were last paid on October 26 and the next payment of salaries will be November 9. As shown on the calendar on the following slide there are three unpaid work days remain as of October 31.


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Accrued Salaries Expense

(Salaries paid after the service has been performed)


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Salaries Expense

Salaries Payable

Accrued Salaries Expense

Oct. 31 1,200

Oct. 31 1,200

GENERAL JOURNALDebitCredit

Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month


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Adjusted Trial Balance

  • Adjusted trial balance proves the equity of total debit balances and total credit balances after the adjusting entries have been made

  • Financial statements can be easily prepared from the adjusted trial balance


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Closing the Books

  • Closing entries

    • Transfer the temporary account balances to update the retained earnings account

    • Reduce the balances in the temporary accounts to zero to prepare for the next period’s postings


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TemporaryPermanent

Illustration 4-17

All revenue accounts

All asset accounts

All expense accounts

All liability accounts

Dividends account

Shareholders’ equity

accounts


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Individual Revenues

Individual Expenses

2

1

Income Summary

3

Retained Earnings is a permanent account; the others shown here

are temporary

Retained Earnings

4

Dividends


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Required Steps in the Accounting Cycle

  • Analyse business transactions

  • Journalize the transactions

  • Post to general ledger accounts

  • Prepare a trial balance

  • Journalize and post adjusting entries (prepayments and accruals)


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Required Steps in the Accounting Cycle

  • Prepare an adjusted trial balance

  • Prepare financial statements

  • Journalize and post closing entries

  • Prepare a post-closing trial balance


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