ACCRUAL ACCOUNTING CONCEPTS
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Transcript of ACCRUAL ACCOUNTING CONCEPTS
4-1
ACCRUAL ACCOUNTING CONCEPTS
Financial Accounting, Sixth Edition
4
4-2
1. Explain the revenue recognition principle and the expense recognition principle.
2. Differentiate between the cash basis and the accrual basis of accounting.
3. Explain why adjusting entries are needed, and identify the major types of adjusting entries.
4. Prepare adjusting entries for deferrals.
5. Prepare adjusting entries for accruals.
6. Describe the nature and purpose of the adjusted trial balance.
7. Explain the purpose of closing entries.
8. Describe the required steps in the accounting cycle.
Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives
4-3
Types of adjusting entries
Adjusting entries for deferrals
Adjusting entries for accruals
Summary of basic relationships
Timing IssuesTiming IssuesTiming IssuesTiming IssuesThe Basics of The Basics of
Adjusting Adjusting EntriesEntries
The Basics of The Basics of Adjusting Adjusting
EntriesEntries
The Adjusted The Adjusted Trial Balance Trial Balance and Financial and Financial StatementsStatements
The Adjusted The Adjusted Trial Balance Trial Balance and Financial and Financial StatementsStatements
Closing the Closing the BooksBooks
Closing the Closing the BooksBooks
Quality of Quality of EarningsEarningsQuality of Quality of EarningsEarnings
Revenue recognition principle
Expense recognition principle
Accrual versus cash basis of accounting
Preparing the adjusted trial balance
Preparing financial statements
Preparing closing entries
Preparing a post-closing trial balance
Summary of the accounting cycle
Earnings management
Sarbanes-Oxley
Accrual Accounting ConceptsAccrual Accounting ConceptsAccrual Accounting ConceptsAccrual Accounting Concepts
4-4
Generally a month, a quarter, or a year.
Fiscal year vs. calendar year
Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption).
SO 1 Explain the revenue recognition principle SO 1 Explain the revenue recognition principle and the expense recognition principle.and the expense recognition principle.
Jan. Feb. Mar. Apr. Dec.. . . . .
Timing IssuesTiming IssuesTiming IssuesTiming Issues
4-5
Timing IssuesTiming IssuesTiming IssuesTiming Issues
The Revenue Recognition Principle
Companies recognize
revenue in the accounting
period in which it is earned.
In a service enterprise,
revenue is considered to be
earned at the time the
service is performed.
SO 1 Explain the revenue recognition principle SO 1 Explain the revenue recognition principle and the expense recognition principle.and the expense recognition principle.
4-6
Timing IssuesTiming IssuesTiming IssuesTiming Issues
Illustration: Assume Conrad Dry Cleaners cleans
clothing on June 30, but customers do not claim and pay
for their clothes until the first week of July. The journal
entries for June and July would be:
SO 1 Explain the revenue recognition principle SO 1 Explain the revenue recognition principle and the expense recognition principle.and the expense recognition principle.
4-7
Timing IssuesTiming IssuesTiming IssuesTiming Issues
“Let the expenses follow the revenues.”
This is commonly referred to as the “Matching Principle”.
SO 1 Explain the revenue recognition principle SO 1 Explain the revenue recognition principle and the expense recognition principle.and the expense recognition principle.
Illustration 4-1 (Partial)
4-8
Accrual-Basis Accounting
► Transactions recorded in the periods in which the
events occur.
► Revenues are recognized when earned, even if cash
was not received.
► Expenses are recognized when incurred, even if cash
was not paid.
Timing IssuesTiming IssuesTiming IssuesTiming Issues
Accrual versus Cash Basis of Accounting
SO 2 Differentiate between the cash basis SO 2 Differentiate between the cash basis and the accrual basis of accounting.and the accrual basis of accounting.
4-9
Cash-Basis Accounting
► Revenues are recognized only when cash is received.
► Expenses are recognized only when cash is paid.
► Prohibited under generally accepted accounting
principles (GAAP).
Timing IssuesTiming IssuesTiming IssuesTiming Issues
SO 2 Differentiate between the cash basis SO 2 Differentiate between the cash basis and the accrual basis of accounting.and the accrual basis of accounting.
Accrual versus Cash Basis of Accounting
4-10
Timing IssuesTiming IssuesTiming IssuesTiming Issues
Illustration: Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2012.
Illustration 4-2 (Partial)
SO 2 Differentiate between the cash basis SO 2 Differentiate between the cash basis and the accrual basis of accounting.and the accrual basis of accounting.
4-11
Adjusting entries are necessary for accounts to reflect “Economic Reality” at the financial statement date.
Adjusting entries make it possible to report correct amounts on
the balance sheet and on the income statement.
A company must make adjusting entries every time it prepares
financial statements.
Includes one income statement account and one balance sheet
account.
The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries
SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries
4-12
Revenues - recorded in the period in which they are
earned.
Expenses - recognized in the period in which they
are incurred.
Adjusting entries - needed to ensure that the
revenue recognition and expense recognition
(Matching) principles are followed.
The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries
SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries
4-13
Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries
Illustration 4-3Categories of adjusting entries
SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries
Deferrals:1. Prepaid expenses: Expenses paid in cash
and recorded as assets before they are used or consumed.
2. Unearned revenues: Cash received and reported as liabilities before revenue is earned.
Accruals:1. Accrued revenues: Revenues earned but
not yet received in cash or recorded.2. Accrued expenses: Expenses incurred
but not yet paid in cash or recorded.
4-14
Trial BalanceTrial Balance –
Each account is
analyzed to
determine
whether it is
complete and up-
to-date. Does it
reflect Economic
Reality?
Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries
SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries
Illustration 4-4
4-15
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
Adjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for Deferrals
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
4-16
Prepaid Expenses
Costs that expire either with the passage of time or
through use.
Adjusting entry results in an increase (a debit) to an
expense account and a decrease (a credit) to an asset
account.
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
4-17
Illustration: Sierra Corporation purchased supplies costing $2,500
on October 5. Sierra recorded the purchase by increasing (debiting)
the asset Supplies. This account shows a balance of $2,500 in the
October 31 trial balance. An inventory count at the close of business
on October 31 reveals that $1,000 of supplies are still on hand.
Supplies 1,500
Supplies Expense 1,500Oct. 31
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Illustration 4-6 (Partial)($2,500 – 1,000 = $1,500)
4-18
Illustration: On October, 4 Sierra Corporation paid $600 for a one-
year fire insurance policy. Coverage began on October 1. Sierra
recorded the payment by increasing (debiting) Prepaid Insurance.
This account shows a balance of $600 in the October 31 trial balance.
Insurance of $50 ($600 ÷ 12) expires each month.
Prepaid Insurance 50
Insurance Expense 50Oct. 31
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Illustration 4-7 (Partial)
4-19
Depreciation
Buildings, equipment, and motor vehicles (long-lived
assets) are recorded as assets, rather than an
expense, in the year acquired.
Companies report a portion of the cost of a long-lived
asset as an expense (depreciation) during each period
of the asset’s useful life.
Depreciation does not attempt to report the actual
change in the value of the asset.
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
4-20
Illustration: For Sierra Corporation, assume that depreciation on
the office equipment is $480 a year, or $40 per month.
Accumulated Depreciation-Equipment 40
Depreciation Expense 40Oct. 31
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Illustration 4-8 (Partial)
4-21
Statement Presentation
Accumulated Depreciation-Equipment is a contra asset
account.
Appears just after the account it offsets (Equipment) on
the balance sheet.
Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Illustration 4-9
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Receipt of cash that is recorded as a liability because the revenue has not been earned.
Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”
rent
airline tickets
Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE
magazine subscriptions
customer deposits
Unearned revenues often occur in regard to:
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
4-23
Unearned Revenues
Adjusting entry to record the revenue that has been
earned and to show the liability that remains.
Adjusting entry results in a decrease (a debit) to a
liability account and an increase (a credit) to a revenue
account.
SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”
4-24 SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”
Illustration: Sierra Corporation received $1,200 on October 2 from
R. Knox for guide services for multi-day trips expected to be
completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. From an evaluation
of the service Sierra performed for Knox during October, the company
determines that it has earned $400 in October.
Service Revenue 400
Unearned Service Revenue 400Oct. 31
Illustration 4-12 (Partial)
4-25
Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not been recognized through daily (routine) entries.
Adjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for Accruals
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
4-26
Accrued Revenues
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues earned.
Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
4-27
Illustration: In October, Sierra Corporation earned $200 for
guide services that were not billed to clients before October 31.
Service Revenue 200
Accounts Receivable 200Oct. 31
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”
Illustration 4-15
4-28
Accrued Expenses
An adjusting entry serves two purposes:
(1) Records the obligations, and
(2) Recognizes the expenses.
Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
4-29
Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%.
Interest Payable 50
Interest Expense 50Oct. 31
Illustration 4-19 (Partial)
Illustration 4-18
4-30
Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
Illustration 4-20
Illustration: Sierra Corporation last paid salaries on October 26;
the next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 × 3 days).
4-31
Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
Illustration: Sierra Corporation last paid salaries on October 26;
the next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 x 3 days).
Salaries Payable 1,200
Salaries Expense 1,200Oct. 31
Illustration 4-21
4-32
Summary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic Relationships
SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.
4-33
After all adjusting entries are journalized and posted the
company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
The adjusted trial balance’s purpose is to prove the
equality of debit balances and credit balances in the
ledger.
The adjusted trial balance is the primary basis for the
preparation of the financial statements.
The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance
SO 6 Describe the nature and purpose of the adjusted trial balance.SO 6 Describe the nature and purpose of the adjusted trial balance.
4-34
The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance
SO 6SO 6
4-35
Financial statements are prepared directly from the Adjusted Trial Balance.
Financial statements are prepared directly from the Adjusted Trial Balance.
Balance Sheet
Income Statement
Retained Earnings
Statement
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
SO 6 Describe the nature and purpose of the adjusted trial balance.SO 6 Describe the nature and purpose of the adjusted trial balance.
4-36
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
Illustration 4-27
4-37
Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements
Illustration 4-28
4-38
At the end of the accounting period, companies transfer the
temporary account balances to the permanent
stockholders’ equity account—Retained Earnings.
Closing the BooksClosing the BooksClosing the BooksClosing the Books
SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.
Illustration 4-29
4-39
In addition to updating Retained Earnings to its correct
ending balance, closing entries produce a zero balance in
each temporary account.
Closing the BooksClosing the BooksClosing the BooksClosing the Books
SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.
Illustration 4-30
4-40
There are 4 Closing Entries1. Close all revenue accounts to income
summary.2. Close all expense accounts to income
summary.3. Close income summary to R.E.4. Close dividends to R.E.
That’s all there is to it!
Closing the BooksClosing the BooksClosing the BooksClosing the Books
4-41
Closing the BooksClosing the BooksClosing the BooksClosing the Books
Illustration 4-31
2012
4-42
The purpose of the post-closing trial balance is to prove
the equality of the permanent account balances that the
company carries forward into the next accounting period.
Preparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial Balance
All temporary accounts will have zero balances.
SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.
4-43
Summary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting Cycle
1. Analyze business transactions1. Analyze business transactions
2. Journalize the transactions
2. Journalize the transactions
6. Prepare an adjusted trial balance
6. Prepare an adjusted trial balance
7. Prepare financial statements
7. Prepare financial statements
8. Journalize and post closing entries
8. Journalize and post closing entries
9. Prepare a post-closing trial balance
9. Prepare a post-closing trial balance
4. Prepare a trial balance4. Prepare a trial balance
3. Post to ledger accounts3. Post to ledger accounts
5. Journalize and post adjusting entries:Deferrals/Accruals
5. Journalize and post adjusting entries:Deferrals/Accruals
SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.
Illustration 4-33Required steps in theaccounting cycle
4-44
Quality of Earnings – company provides full and transparent
information.
Earnings Management - the planned timing of revenues,
expenses, gains, and losses to smooth out bumps in net income. Companies may manage earnings by:
Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings
SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.
one-time items to prop up earnings numbers.
inflate revenue numbers in the short-run.
improper adjusting entries.
As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.