Chapter 4-1. Chapter 4-2 Accrual Accounting Concepts Financial Accounting, Fifth Edition.

Chapter 4-1

Chapter 4-2

Accrual Accounting Concepts

Financial Accounting, Fifth Edition

Chapter 4-3

1. Explain the revenue recognition principle and the matching 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.

9. Understand the causes of differences between net income and cash provided by operating activities.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

Chapter 4-4

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

Matching 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

Chapter 4-5

Generally a month, a quarter, or a year.

Fiscal year vs. calendar year

Timing IssuesTiming IssuesTiming IssuesTiming Issues

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

SO 1 Explain the revenue recognition principle and the matching SO 1 Explain the revenue recognition principle and the matching principle.principle.

Jan. Feb. Mar. Apr. Dec.. . . . .

Chapter 4-6

The time period assumption states that:The time period assumption states that:

a.a. revenue should be recognized in the accounting period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into artificial time periods.

d. the fiscal year should correspond with the calendar year.

Review Review QuestionQuestion



Chapter 4-7


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.


Chapter 4-8


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:


Chapter 4-9


“Let the expenses follow the revenues.”


Chapter 4-10



Chapter 4-11

Accrual-Basis Accounting

Transactions recorded in the periods in which the events occur

Revenues are recognized when earned, rather than when cash is received.

Expenses are recognized when incurred, rather than when paid.


Accrual- vs. Cash-Basis Accounting

SO 2 Differentiate between the cash basis SO 2 Differentiate between the cash basis and and the accrual basis of accounting.the accrual basis of accounting.

Chapter 4-12

Cash-Basis Accounting

Revenues are recognized when cash is received.

Expenses are recognized when cash is paid.

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).


Accrual- vs. Cash-Basis Accounting


Chapter 4-13


Illustration: Suppose that Fresh Colors paints a large building in 2009. In 2009 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 2010.


Illustration 4-2

Chapter 4-14

One of the following statements about the accrual basis of accounting is false. That statement is:

a. Events that change a company’s financial statements are recorded in the periods in which the events occur.

b. Revenue is recognized in the period in which it is earned.

c. The accrual basis of accounting is in accord with generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.




Chapter 4-15

Chapter 4-16

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.

Every adjusting entry will include 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 Explain why adjusting entries are needed, and needed, and identify the major types of identify the major types of adjusting entriesadjusting entries

Chapter 4-17

RevenuesRevenues - recorded in the period in which - recorded in the period in which they are earnedthey are earned.

Expenses Expenses - recognized in the period in which - recognized in the period in which they are incurredthey are incurred.

Adjusting entriesAdjusting entries - needed to ensure that - needed to ensure that the the revenue recognitionrevenue recognition and and matching matching principlesprinciples are followed. are followed.



Chapter 4-18

Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred.

b. revenues are recorded in the period in which they are earned.

c. balance sheet and income statement accounts have correct balances at the end of an accounting period.

d. all of the above.




Chapter 4-19

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

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

Deferrals

3. Accrued Revenues. Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses. Expenses incurred but not yet paid in cash or recorded.

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

Accruals

Illustration 4-3Categories of adjusting entries


Chapter 4-20

Trial BalanceTrial Balance – Each account is analyzed to determine whether it is complete and up-to-date.

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries


Illustration 4-4

Chapter 4-21

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.

Chapter 4-22

Payment of cash, that is recorded as an asset because Payment of cash, that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”

insuranceinsurance

suppliessupplies

advertisingadvertising

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE

rentrent

maintenance on maintenance on equipmentequipment

fixed assets fixed assets (depreciation)(depreciation)

Prepayments often occur in regard to:Prepayments often occur in regard to:


Chapter 4-23

Prepaid Expenses

Costs that expire either with the passage of time or through use.

Adjusting entries (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs in the asset accounts.



Chapter 4-24


Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.


Illustration 4-5

Chapter 4-25

Illustration: Sierra Corporation purchased advertising suppliescosting $2,500 on October 5. Sierra recorded the payment by increasing (debiting) the asset Advertising 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.

Advertising supplies 1,500

Advertising supplies expense

1,500Oct. 31



Illustration 4-6

($2,500 – 1,000 = $1,500)

Chapter 4-26

Chapter 4-27

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 theOctober 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Prepaid insurance 50

Insurance expense 50Oct. 31



Illustration 4-7

Chapter 4-28

Depreciation

Buildings, equipment, and 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 (Matching Principle).


Chapter 4-29

Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.

Accumulated depreciation

40

Depreciation expense 40Oct. 31



Illustration 4-8

Chapter 4-30

Depreciation (Statement Presentation)

Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet.



Illustration 4-9

Chapter 4-31



SummaryIllustration 4-10

Chapter 4-32

Receipt of cash that is recorded as a liability Receipt of cash that is recorded as a liability because the revenue has not been earned.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”

rentrent

airline ticketsairline tickets

school tuitionschool tuition

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptionsmagazine subscriptions

customer depositscustomer deposits

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:


Chapter 4-33

Unearned Revenues

Company makes an adjusting entry to record the revenue that has been earned and to show the liability that remains.

The adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.



Chapter 4-34 SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.


Illustration 4-11



Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balanceof $1,200 in the October 31 trial balance. From an evaluation of the work 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


Summary


Illustration 4-13

Chapter 4-37

Chapter 4-38

Made to record:

Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been recognized through daily 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.

Chapter 4-39

Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

rentrent

interestinterest

services performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:Adjusting entry results in:


Chapter 4-40

Accrued Revenues

An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.



Chapter 4-41

Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 4-14

Chapter 4-42

Illustration: In October Sierra Corporation earned $200 for advertising services that were not billed to clients before October 31.

Service Revenue 200

Accounts Receivable 200Oct. 31



Illustration 4-15

Chapter 4-43




Chapter 4-44

Expenses incurred but not yet paid in cash or Expenses incurred but not yet paid in cash or recorded.recorded.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”

rentrent

interestinterest

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxestaxes

salariessalaries

Adjusting entry results in:Adjusting entry results in:


Chapter 4-45

Accrued Expenses


(1) It records the obligations, and

(2) It recognizes the expenses.



Chapter 4-46

Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 4-17

Chapter 4-47



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

Illustration 4-18

Chapter 4-48



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).

Salary payable 1,200

Salary expense 1,200Oct. 31

Illustration 4-21

Chapter 4-49

Accrued Expenses


(1) It records the obligations, and

(2) it recognizes the expenses.



Chapter 4-50




Chapter 4-51

Summary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic Relationships


Chapter 4-52

After all adjusting entries are journalized and posted the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance).

Its purpose is to prove the equality of debit balances and credit balances in the ledger.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

SO 6 Describe the nature and purpose of the adjusted trial SO 6 Describe the nature and purpose of the adjusted trial balance.balance.

Chapter 4-53


Chapter 4-54

Which of the following statements is incorrect concerning the adjusted trial balance?

a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.

b. The adjusted trial balance provides the primary basis for the preparation of financial statements.

c. The adjusted trial balance lists the account balances segregated by assets and liabilities.

d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.




Chapter 4-55

Financial Statements are prepared directly from the Adjusted Trial Balance.

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statemen

t

Retained Earnings Statemen

t

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements


Chapter 4-56

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

Chapter 4-57

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsIllustration 4-28

Chapter 4-58

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

Chapter 4-59

In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.



Illustration 4-30

Chapter 4-60


Illustration 4-31

Chapter 4-61


SO 7 Explain the SO 7 Explain the purpose of closing purpose of closing

entries.entries.

Chapter 4-62

The purpose of this 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.


Chapter 4-63

Summary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting Cycle

1. Analyze business transactions

1. 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 balance

4. Prepare a trial balance

3. Post to ledger accounts

3. Post to ledger accounts

5. Journalize and post adjusting entries

5. Journalize and post adjusting entries

SO 8 Describe the required steps in the accounting SO 8 Describe the required steps in the accounting cycle.cycle.

Chapter 4-64

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 SO 8 Describe the required steps in the accounting cycle.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.

Chapter 4-65

Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.

Keep an Eye on CashKeep an Eye on CashKeep an Eye on CashKeep an Eye on Cash

SO 9 SO 9 Understand the causes of differences Understand the causes of differences between net between net income and cash provided by income and cash provided by operating activities.operating activities.

Net income on a cash basis is referred to as “Net cash provided by operating activities.”

The statement of cash flows, reports net cash provided by operating activities.

Chapter 4-66

Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.


Chapter 4-67

The difference for Sierra is $2,840 ($5,700 - $2,860). The following summary shows the causes of this difference of $2,840.


Chapter 4-68

Adjusting Entries – Using a Worksheet Adjusting Entries – Using a Worksheet (Appendix)(Appendix)Adjusting Entries – Using a Worksheet Adjusting Entries – Using a Worksheet (Appendix)(Appendix)

Illustration 4A-1Form and procedure for a worksheet

SO 10 Describe SO 10 Describe the purpose and the purpose and the basic form of the basic form of a worksheet.a worksheet.

Chapter 4-69

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Chapter 4-1. Chapter 4-2 Accrual Accounting Concepts Financial Accounting, Fifth Edition.

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Transcript of Chapter 4-1. Chapter 4-2 Accrual Accounting Concepts Financial Accounting, Fifth Edition.