Financial Accounting: Tools for Business Decision Making, 4th Ed. Kimmel, Weygandt, Kieso CHAPTER 4 Prepared by Ellen L. Sweatt Georgia Perimeter College 1 Chapter 4 ACCRUAL ACCOUNTING CONCEPTS 2 Chapter 4 Accrual Accounting Concepts 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. 3 Chapter 4 Accrual Accounting Concepts 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. 4 1 11 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. 5 Time Period Assumption... Generally a month, a quarter, or a year. An accounting time period that is one year long is called a fiscal year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year. 6 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. 7 Matching Principle... Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded. 8 9 Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? a. Cost Principle. b.Matching Principle c. Periodicity Principle d.Revenue Recognition Principle 10 Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? a. Cost Principle. b.Matching Principle c. Periodicity Principle d.Revenue Recognition Principle 11 Review When would revenue be recorded for the following scenario . . . Ad agency is hired for a project in May, does the work in June and is paid in July? June 12 Review When would expenses be recorded for this companion scenario ? The Ad agency on this project incurs $1,500 of expenses in May, $3,000 in June, and none in July? The answer is June! Matching says the expenses should follow the revenue. 13 Review When would revenue be recorded for the following scenario . . . Sell plane ticket on September 1 for a flight on October 15? The answer is October – when the service is provided! 14 Review When would expenses be recorded for the following scenario . . . The airline pays pilot salaries on October 7th for the week ended September 30th? The answer is September – the pilots provided labor services for September flights during that month. 15 2 11 Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid. 16 Accrual Basis Accounting Adheres to the: • Revenue Recognition Principle Revenue recorded only when earned, not when cash is received • Matching Principle Expense recorded only when incurred, not when cash paid 17 Accrual Basis adheres to... •Generally •Accepted •Accounting •Principles 18 19 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. 20 Prepayments •PREPAID EXPENSES - Costs that expire either with the passage of time or through use. •UNEARNED REVENUES- money has been received before the goods or services are provided. 21 You can start with the trial balance to find information to adjust prepayments. 22 Sierra Corporation Trial Balance October 31, 2007 Cash Advertising Supplies Prepaid Insurance Office Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Dividends Service Revenue Salaries Expense Rent Expense Debit Credit $15,200 2,500 600 5,000 $ 5,000 2,500 1,200 10,000 500 10,000 4,000 900 $28,700 $28,700 Prepaid Expenses Amount equals cost of goods or services used up or expired If not adjusted, expenses would be understated and assets overstated 24 Supplies On October 5 the company paid $2,500 for advertising supplies. Advertising Cash Oct 5 2,500 Advertising Supplies Oct 5 Supplies Expense 2,500 GENERAL JOURNAL Oct 5 Supplies Cash Purchased advertising supplies Debit Credit 2,500 2,500 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 Advertising Advertising Supplies Cash Expense Supplies Oct 5 2,500 Oct 5 2,500 Oct 31 1,500 Oct 31 1,500 Bal. 1,000 GENERAL JOURNAL Oct 5 Supplies Expense Supplies To record advertising supplies consumed Debit Credit 1,500 1,500 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 27 Prepaid Expenses On October 1 the company paid $600 for a 1-year insurance policy. Coverage began October 1. Cash Oct 1 Insurance Expense Prepaid Insurance 600 Oct 1 600 GENERAL JOURNAL Debit Credit Oct 1 Prepaid Insurance Cash 600 Purchased one-year policy effective October 1 600 Insurance Policy Oct $50 Nov $50 Dec $50 Jan $50 Feb $50 Mar $50 Apr $50 May $50 June $50 July $50 Aug $50 Sept $50 1 Year $ 600 29 Prepaid Expenses On October 31st, $50 ($600/12 months) of the insurance was used-up or expired. Prepaid Insurance Cash Oct 1 600 Oct 1 600 Oct 31 50 Insurance Expense Oct 31 50 550 GENERAL JOURNAL Oct 31 Insurance Expense Prepaid Insurance Record insurance expense for the month Debit Credit 50 50 Depreciation How do you apply the Matching Principle to the cost of a long lived asset ? 31 Depreciation Allocates the cost of an asset to expense over its useful life – MATCHING PRINCIPLE Is an estimate Depreciation is ALLOCATION of costnot VALUATION(Current Replacement Cost) We’re not attempting to reflect the actual change in value of an asset! 32 Office Equipment Oct $40 Nov $40 Dec $40 Jan $40 Feb $40 Mar $40 Apr $40 May $40 June $40 July $40 Aug $40 Sept $40 Depreciation= $480/year 33 Office Equipment Accumulated DepreciationOffice Equipment Oct 2 5,000 Oct 31 40 GENERAL JOURNAL Oct 31 Depreciation Expense Depreciation Expense Oct 31 40 Debit Credit 40 Accumulated Depreciation-Office Equip 40 To record monthly depreciation Accumulated depreciation is a contra asset account - an offset against the fixed asset account. 34 Balance Sheet Presentation Office equipment Less : accumulated depreciation $ 5,000 40 $4,960 Book Value or Carrying Value 35 5 Unearned Revenues 11 Received on Oct. 2 $1,200 for advertising services expected to be completed by Dec 31. Unearned Service Service Revenue Revenue Cash Oct 2 1,200 Oct 2 1,200 GENERAL JOURNAL Debit Oct 2 1,200 Cash Unearned Service Revenue Collected money for work to be performed by Dec 31. Credit 1,200 Unearned Revenues During October $400 of the revenue was earned. Unearned Service Revenue Cash Oct 2 1,200 Oct. 31 400 Oct 2 1,200 Bal 800 GENERAL JOURNAL Oct 31 Unearned Service Revenue Service Revenue To record revenue earned Service Revenue Oct. 31 400 Debit Credit 400 400 5 11 Accruals •Revenue has been earned, but not collected. •Expenses have been incurred, but not yet paid. 38 Accrued Revenues Revenues earned but not yet received in cash or recorded at the statement date. 39 Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31st. Accounts Receivable Oct 31 200 GENERAL JOURNAL Oct 31 Accounts Receivable Service Revenue Service Revenue Oct 31 Debit 200 Credit 200 200 Accrued Expenses Expenses incurred but not yet paid or recorded at the statement date. 41 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 Formula for Computing Interest Face Value of Note $ 5,000 X Annual Interest Rate 12% Time in term of One Year * 1/12 Interest = $50 Accrued Interest Interest Expense Oct 31 50 Interest Payable Oct 31 GENERAL JOURNAL Oct 31 Interest Expense Interest Payable Accrue interest expense for the month Debit 50 Credit 50 50 Accrued Salaries - Salaries Paid for after the Service Has Been Performed. Accrued Salaries Salaries Expense Oct 31 1,200 Salaries Payable Oct 31 1,200 GENERAL JOURNAL Oct 31 Salaries Expense Salaries Payable Accrue salary expense for the month Debit Credit 1,200 1,200 6 11 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 (except Cash Flow Statement) can be easily prepared from the adjusted trial balance. 46 47 7 11 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. 50 Temporary Permanent All revenues accounts All asset accounts All expense accounts All liability accounts Dividends Stockholders’ equity accounts Close Temporary Accounts Only Zero balance after closing entries! Do not close! 52 The Closing Process 8 11 The Accounting Cycle 57 Required Steps in the Accounting Cycle 58 Review Which is not a temporary account? a.Salaries expense b.Service revenue c.Accounts Receivable d.Dividends 59 Review Which is not a temporary account? a.Salaries expense b.Service revenue c.Accounts Receivable d.Dividends 60 Review Which account will have a zero balance after closing entries? a.Service Revenue b.Advertising Supplies c.Prepaid Insurance d.Accumulated Depreciation 61 Review Which account will have a zero balance after closing entries? a.Service Revenue b.Advertising Supplies c.Prepaid Insurance d.Accumulated Depreciation 62 Review Which types of accounts will appear in the post-closing trial balance? a.Temporary accounts b.Accounts shown in the income statement c.Permanent accounts d.All of the above 63 Review Which types of accounts will appear in the post-closing trial balance? a.Temporary accounts b.Accounts shown in the income statement c.Permanent accounts d.All of the above 64 Copyright © 2007 John Wiley & Sons, Inc. 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