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Chapter 4. Chapter 4 Accrual Accounting Concepts. After studying Chapter 4, you should be able to: Explain the revenue recognition principle and the matching principle. Differentiate between the cash basis and the accrual basis of accounting.

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Chapter 4

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Chapter 4

Chapter 4


Chapter 4 accrual accounting concepts

Chapter 4Accrual Accounting Concepts

After studying Chapter 4, you should be able to:

  • Explain the revenue recognition principle and the matching principle.

  • Differentiate between the cash basis and the accrual basis of accounting.

  • Explain why adjusting entries are needed and identify the major types of adjusting entries.

  • Prepare adjusting entries for prepayments.


Chapter 4 accrual accounting concepts1

Chapter 4Accrual Accounting Concepts

After studying Chapter 4, you should be able to:

  • Prepare adjusting entries for accruals.

  • Describe the nature and purpose of the adjusted trial balance.

  • Explain the purpose of closing entries.

  • Describe the required steps in the accounting cycle.


Time period assumption

Time Period Assumption...

Divides the economic life of a business into artificial time periods

WHY?

to provide immediate feedback on how the business is doing.


Time period assumption1

Time Period Assumption...

  • Generally a month, a quarter, or a year.

An accounting time period that is one year long is called fiscal year.

An accounting time period that starts on January 1 and ends December 31 is called a calendar year.


Revenue recognition principle

Revenue Recognition Principle...

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

  • is considered earned

    • when the service has been provided or

    • when the goods are delivered.


Matching principle

Matching Principle...

requires that expensesbe recorded in the same period in which the revenues they helped produce are recorded. (or in the period to which they relate)


Cash basis

Cash Basis

Revenue recorded only when cash is received.

Expense recorded only when cash is paid.


Cash basis in not gaap

GAAP

Cash Basis in not GAAP


Accrual basis accounting

Accrual Basis Accounting

  • Adheres to the:

  • Revenue Recognition Principle

  • Matching Principle


Accrual basis accounting1

Accrual Basis Accounting

  • Revenue recorded only when earned, not when cash is received

  • Expense recorded only when incurred, not when cash paid


Accrual basis adheres to

Accrual Basis adheres to...

  • Generally

  • Accepted

  • Accounting

  • Principles


Chapter 4

Year 1 Year 2

Activity

Purchased paint, painted building ,

paid employees

Received payment for work

done in year one

Accrual

basis

Revenue $80,000

Expense 50,000

Net Income $30,000

Revenue $ 0

Expense 0

Net Income $ 0

Cash

basis

Revenue $ 0

Expense 50,000

Net Loss ( $50,000)

Revenue $80,000

Expense 0

Net Income $80,000


Adjusting entries

Adjusting Entries

Adjusting entries make the:

  • revenue recognition &

  • matching principles

HAPPEN!


Types of adjusting entries

Types of Adjusting Entries

  • Prepayments:

    • Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.

    • Unearned Revenues: Cash received and recorded as liabilities before revenue is earned.

  • Accruals:

    • Accrued revenues: Revenues earned but not yet received in cash or recorded.

    • Accrued expenses: Expenses incurred but not yet paid in cash or recorded.


Chapter 4

Prepayments

  • Cash or other asset has been spent but the item acquired has not been used or consumed

  • Cash has been collected before revenue is earned


You can start with the trial balance to find information to adjust prepayments

You can start with the trial balance to find information to adjust prepayments.


Chapter 4

Sierra Corporation

Trial Balance

October 31, 2004

Debit Credit

Cash $15,200

Advertising Supplies 2,500

Prepaid Insurance 600

Office Equipment 5,000

Notes Payable $ 5,000

Accounts Payable 2,500

Unearned Service Revenue 1,200

Common Stock 10,000

Dividends 500

Service Revenue 10,000

Salaries Expense 4,000

Rent Expense 900

$28,700 $28,700


Chapter 4

Illustration 4-6

Supplies

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

Supplies Expense

Cash

Supplies

Oct 5

2,500

Oct 5

2,500

GENERAL JOURNAL Debit Credit

Oct 5 Supplies 2,500 Cash 2,500

Purchased advertising supplies


Chapter 4

Oct 31

1,500

Oct 31

1,500

Illustration 4-6

Supplies

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

Supplies Expense

Cash

Supplies

Oct 5

2,500

Oct 5

2,500

GENERAL JOURNAL Debit Credit

Oct 5 Supplies Expense 1,500 Supplies 1,500

To record advertising supplies consumed


Chapter 4

Supplies Expense

Oct $1,500

Nov $1,800

Dec $1,410

Jan $1,425

Feb $1,601

Mar $1,435

Apr $1,510

May $1,592

June $1,652

July $1,621

Aug $1,427

Sept $1,555

Supplies expense is based on usage... so different amounts appear each month


Chapter 4

Insurance Expense

Prepaid Insurance

Cash

Oct 1

600

Oct 1

600

Prepaid Expenses

On October 1 the company paid $600 for a 1-year insurance policy. Coverage began October 1.

GENERAL JOURNAL Debit Credit

Oct 1 Prepaid Insurance 600 Cash 600

Purchased one-year policy effective October 1


Chapter 4

Insurance Policy

1 Year $ 600

Oct $50

Nov $50

Dec $50

Jan $50

Feb $50

Mar $50

Apr $50

May $50

June $50

July $50

Aug $50

Sept $50


Chapter 4

Oct 31

50

Oct 31

50

Prepaid Expenses

On October 31st, $50 ($600/12 months) of the insurance was used-up or expired.

Insurance Expense

Prepaid Insurance

Cash

Oct 1

600

Oct 1

600

GENERAL JOURNAL Debit Credit

Oct 31 Insurance Expense 50

Prepaid Insurance 50

Record insurance expense for the month


Chapter 4

Depreciation

How do you apply the Matching Principle to the cost of a long lived asset ?


Chapter 4

Depreciation

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

Depreciation is an ALLOCATIONCONCEPT- not a VALUATION CONCEPT.

We’re not attempting to reflect the actual change in value of an asset!


Chapter 4

Office Equipment

Depreciation= $480/year

Oct $40

Nov $40

Dec $40

Jan $40

Feb $40

Mar $40

Apr $40

May $40

June $40

July $40

Aug $40

Sept $40


Chapter 4

Oct 2

5,000

Oct 31

40

Oct 31

40

Accumulated Depreciation-Office Equipment

Depreciation Expense

Office Equipment

GENERAL JOURNAL Debit Credit

Oct 31 Depreciation Expense 40

Accumulated Depreciation-Office Equip 40

To record monthly depreciation

Accumulated depreciation is a contra asset account - an offset against the fixed asset account.


Balance sheet presentation

Book Value or

Carrying Value

Balance Sheet Presentation

Office equipment$ 5,000

Less : accumulated depreciation 40

$4,960


Chapter 4

Unearned Service Revenue

Service Revenue

Cash

Oct 2

1,200

Oct 2

1,200

Unearned Revenues

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

GENERAL JOURNAL Debit Credit

Oct 2 Cash 1,200

Unearned Service Revenue 1,200

Collected money for work to be performed by Dec 31.


Chapter 4

Oct. 31 400

Oct. 31 400

Oct 2

1,200

Oct 2

1,200

Unearned Revenues

During October $400 of the revenue was earned.

Service Revenue

Unearned Service Revenue

Cash

GENERAL JOURNAL Debit Credit

Oct 31 Unearned Service Revenue 400

Service Revenue 400

To record revenue earned


Chapter 4

Accrual

  • Revenue has been earned, but not collected.

  • Expenses have been incurred, but not yet paid.


Accrued revenues

Accrued Revenues

Revenues earned but not yet received in cash or recorded at the statement date


Chapter 4

Accrued Revenues

Accounts Receivable

Service Revenue

Oct 31

200

Oct 31

200

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

GENERAL JOURNAL Debit Credit

Oct 31 Accounts Receivable 200

Service Revenue 200


Accrued expenses

Accrued Expenses

Expenses incurred but not yet paid or recorded at the statement date.


Chapter 4

Formula for Computing Interest

Face Value of Note

Annual Interest

Rate

Time

in term of One Year

Interest

$ 5,000 X

12%

=

$50

1/12

  • Interest expense is the cost a company incurs to use money:

  • Information needed to compute interest expense:

  • face value of note

  • interest rate (always expressed in annual rate)

  • the length of time note is outstanding


Chapter 4

Interest Expense

Interest Payable

Oct 31 50

Oct 31 50

Accrued Interest

GENERAL JOURNAL Debit Credit

Oct 31 Interest Expense 50 Interest Payable 50

Accrue interest expense for the month


Chapter 4

Accrued Salaries - Salaries Paid for after the Service Has Been Performed.


Chapter 4

Salaries Expense

Salaries Payable

Oct 31 1,200

Oct 31 1,200

Accrued Salaries

GENERAL JOURNAL Debit Credit

Oct 31 Salaries Expense 1,200

Salaries Payable 1,200

Accrue salary expense for the month


Adjusted trial balance

Adjusted Trial Balance

The adjusted trial balance is used to prove 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.


Chapter 4

SIERRA CORPORATION

Adjusted Trial Balance

For the Month Ended October 31, 2004

SIERRA CORPORATION

Adjusted Trial Balance

For the Month Ended October 31, 2004

SIERRA CORPORATION

Retained Earnings Statement

For the Month Ended October 31, 2004


Chapter 4

SIERRA CORPORATION

Balance Sheet

October 31, 2004

SIERRA CORPORATION

Adjusted Trial Balance

For the Month Ended October 31, 2004

Balance as Oct. 31 from

Retained Earnings Statement


Closing the books

Closing the Books

Closing entries transfer the temporary account balances to the retained earnings account in stockholders’ equity ...

and reduce the balances in the temporary accounts to zero.


Chapter 4

Temporary Permanent

All revenues accounts

All asset accounts

All expense accounts

All liability accounts

Dividends

Stockholders’ equity

accounts


Chapter 4

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


The accounting cycle

The Accounting Cycle


Required steps in the accounting cycle

Required Steps in the Accounting Cycle

  • Analyze business transactions.

  • Journalize the transactions.

  • Post to ledger accounts.

  • Prepare a trial balance.

  • Journalize and post adjusting entries--prepayments and accruals.

  • Prepare an adjusting trial balance.


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