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Chapter 4 Accrual Accounting Concepts Financial Accounting: Tools for Business Decision Making, 3rd Ed. What we already know from Chapters 1, 2, and 3 How to prepare Financial Statements Income Statement Statement of Retained Earnings Balance Sheet

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chapter 4

Chapter 4

Accrual Accounting Concepts

Financial Accounting:Tools for Business Decision Making, 3rd Ed.

what we already know from chapters 1 2 and 3
What we already know from Chapters 1, 2, and 3
  • How to prepare Financial Statements
    • Income Statement
    • Statement of Retained Earnings
    • Balance Sheet
  • GAAP Accounting is based on Accrual Accounting:
    • Revenue Recognition and Matching Principles
  • How to record Journal Entries
    • DR Account $XX
    • CR Account $XX
    • written explanation
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.

ch 4 concepts to know
Ch 4 CONCEPTS to Know
  • Timing Issues
    • Revenue Recognition
    • Matching Principles
    • Accrual Accounting
      • “When do we recognize revenues and expenses?”
      • How do accountants do this? Through the use of Adjusting Entries! Yes, adjusting entries.
  • How to prepare Trial Balance
    • Then prepare Financial Statements
    • Followed by Closing Entries
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.
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.

slide8

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

slide9

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 stockholders’ equity account...

and reduce the balances in the temporary accounts to zero.

slide11

Temporary Permanent

All revenues accounts

All asset accounts

All expense accounts

All liability accounts

Dividends

Stockholders’ equity

accounts

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 Assumption
time period assumption13
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.

cash basis
Cash Basis

Revenue recorded only when cash is received.

Expense recorded only when cash is paid.

Cash Basis is not GAAP

accrual basis accounting
Accrual Basis Accounting
  • Revenue recorded only when earned, not when cash is received
  • Expense recorded only when incurred, not when cash paid
  • Generally
  • Accepted
  • Accounting
  • Principles
slide16

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 key
Types of Adjusting Entries KEY
  • 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.
slide19

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
slide20

You can start with the trial balance to find information to adjust prepayments.Remember, accrual accounting is about RECOGNIZING theTIMINGof an event or transaction in the proper period.

slide21

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

slide22

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

slide23

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

slide24

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

slide25

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

slide26

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

slide27

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

slide28

Depreciation

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

slide29

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!

slide30

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

slide31

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

slide33

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.

slide34

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

slide35

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

slide37

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.

slide39

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
slide40

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

slide42

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