Session 4.pdf

8/14/2019 Session 4.pdf

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Learning Goals

Limitations of Trial Balance Rectification Entries

Adjustment Entries

Deferrals and Accruals

Preparing an Adjusted Trial Balance

Preparing Financial Statements

Closing Entries

Preparing a Post-Closing Trial Balance

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Limitations of a Trial Balance

The trial balance may balance even when there are

1. Errors of Omission : A transaction is not journalized, a correct journal entry

is not posted

Rs 1000 paid to Mr X is unrecorded

2. Double Recording or Posting : Credit sales of Rs 5000 recorded in journal or

posted from journal twice

3. Compensating Errors Salary extra debit, Sales extra credit- Rs 100

4. Errors of Principle Repairs to building

5. Recording wrong amounts on the correct sides of right A/cs

Stationery purchased on credit for Rs 175, is recorded as Rs 751 in

journal and posted to stationery and A/P for Rs 751

6. Recording the right amount on the correct side of wrong account:

Rs 1000 cash paid to Shyam is wrongly debited to Shyamal A/c

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Rectification Entries

Stationery purchased for Rs 500 is recorded in the cash book for Rs 50

1. What should have happened ? - Correct Entry

Stationery A/c Dr. 500

Cash A/c......Cr. 500

2. What has happened ? - Entry as passed


Cash A/c......Cr. 50

3. What action will correct the error ? - Rectification Entry


Cash A/c......Cr. 450

So for errors of omission Record it

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Timing, Assumptions and Matching Rule

Let the expenses

follow therevenues.

Going Concern,

Accruals Basis

Matching

Principle

Some transactions span more than one accounting period 6


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Revenue Recognition Principle

1.Persuasive Evidence of an arrangement between buyer and seller

Contract with the buyer : Simple delivery of the product just before the year end,without evidence of a prior order not a revenue

2. Product has been delivered/ service has been rendered

A Ltd received advance payment of Rs50,000 for delivery of goods not yet produced

It should recognize the amount as unearned revenue (CL) till the goods are delivered

3. Price is determined or determinable

4. Collectability is reasonable certain

The buyer has not become insolvent : Has the ability to pay

The buyer is not deliberately escaping payment by fleeing : Has the intention to pay

Uncertainty till embargo imposed on remittance to the sellers country not lifted

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Matching Principle

Addresses the difficulty of assigning revenues and expenses to the

appropriate accounting period so that net income is measuredaccurately

Problem:

Revenues can be earned in a period other than the one in whichcash is received

Expenses can be incurred in a period other than the one inwhich cash is paid

Solution:

The matching rule

Assign revenues to the accounting period in which the goodsare sold or services are rendered

Assign expenses to the accounting period in which they areused to produce income

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Timing Issues : Accrual Vs. Cash Basis of Accounting

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.

Cash Basis: Revenues and Expenses are recorded when cash is exchanged

Accrual Basis: Revenues and Expenses are recorded when they occur

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Adjusting entries needed to ensure that

Transactions that span more than one period are adjusted at the end of

an accounting period Applying Accrual Basis

Revenue recognition & Expense recognition principles are followed

Adjusting entries make it possible to report

correct amounts on the balance sheet and income statement.

A company must make adjusting entries

every time it prepares financial statements at the end of a period

Adjustment Entry must:

Include at least one income statement A/c

Include at least one balance sheet A/c

Do not affect cash flows in current period, never affect Cash A/c

Involves Judgment: Potential for abuse (Ethics)

Adjusting Entries


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Types of Adjusting Entries

Deferrals: Cash Exchanged in Advance of a future Revenue or Expense

1. Prepaid expenses:

Expenses already paid in cash and recorded as assets

before they are used or consumed.

3. Unearned revenues: (Pre-received/ Received in advance)Cash received in advance and reported as liabilities

before revenue is earned.

Accruals: Cash to be Exchanged Later for a current Revenue or Expense

2. Accrued expenses:Expenses incurred

but not yet paid in cash or recorded.

4. Accrued revenues:

Revenues earned

but not yet received in cash or recorded

Recognition of Expense is Deferred

Recognition of Revenue is Deferred

Revenue arisen, not yet recorded

Expenses arisen, not yet recorded

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Four Types of Adjustments

Assets Liabilities

Expense1. Recorded costs are

allocated betweentwo or more

accounting periods

2. Expenses areincurred but not yetrecorded

Revenue4. Revenues are

earned but not yetrecorded

3. Recorded unearnedrevenues areallocated between

two or moreaccounting periods

INCOMESTATEM

ENT

Note: Each

adjusting entry

involves one

balance sheet

account & one

income statement

account

(Accrued Expenses)

(Deferred Expenses)

(Accrued Revenues)(Deferred Revenues)

BALANCE SHEETCash exchanged

BEFORE recognition

Cash to be exchanged

AFTER recognitionAccrual recognition of

a revenue or expense

that has arisen but is

unrecorded (Type 2, 4)

Deferral postponement of

recognition of an expense

already paid or of revenue

received in advance (Type 1, 3) 12


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DEFERRALS(Type 1 and 3 : of the Book)

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Adjustment Entries Deferrals: Prepaid Expense (Type 1)

Prepaid Expense : Expenses paid in advance that have not yet expired

Cash Payment Before Expense are recorded (Supplies, Prepaid Rent, Plant)

Recorded costs to be allocated between two or more accounting periods

At the time of Payment : Service or benefit is yet to be received

Debited to an Asset a/c

At the end of Accounting Period: A certain portion Expires (with passage oftime or Use)

Expired portion to be transferred to an Expense A/c

Adjusting entry to record the EXPENSE that has been incurred and to theASSET that remains. Results in

an increase to an expense account (Dr.) and a decrease to an asset account (Cr.)

Adjustment Entry

Recognition of Expense is Deferred

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July 3 3,200

Adjustment Entry (Type 1) : Prepaid Rent Adjustment

By July 31, half of the prepaid rent has expired and should be treated

as an expense

Rent Expense

Adjustment July 31: Prepaid rent of $1,600 has expired for July.

Adjust account by allocating the amount to the Rent Expense account.

1,600 July 31 July 31 1,600

Bal. 1,600

The account now reflects theprepaid August amount

The account now reflects theJuly rent expense amount

Prepaid Rent

On July 3, Creative Design, Inc paid two months rent in advance for $3,200.

The amount was recorded in the Prepaid Rent account.

Dr. Cr.July 31 Rent Expense 1,600

Prepaid Rent 1,600

Dr. Cr.July 3 Prepaid Rent 3,200

Cash 3,200

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Plant, Depreciation Expense, Accumulated Depreciation

Purchase of a long term asset is a deferral of an expense

The cost of the asset must be allocated over its estimated useful life.

The amount allocated to any one period is called depreciation.

Depreciation expense

Incurred during an accounting period to produce revenue, must be estimated

Based on: Cost of the asset, its estimated useful life (number of methods)

Depreciation expense does not reduce the asset account directly, but is recordedin a Contra Account, called Accumulated Depreciation

A separate account, shown as a deduction from the related asset account

Contra account is used to

Recognize that depreciation is an estimate, Preserves original cost of the asset

In combination with the asset account, it shows

How much of the asset has been allocated as an expense

The balance left to be depreciated

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For ABC 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 Entry (Type 1): Deferred Expense (Asset, Depreciation)

Depreciation is the process of allocating cost of an asset to expense over its useful life

- Depreciation doesnt attempt to report actual change in the value of the asset

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Mr. A (Tenant) Mr. B (Landlord)

Advance payment today

Mr. A records

Prepaid Expense (A)

Cash (A) (Cr.)

Mr. B records

Cash (A) (Dr.)

Unearned Revenue (L)

Mr. A records:

Rent Expense (E) (Dr.),Prepaid Rent (A) (Cr.)

Mr. B records

Unearned Revenue (L) (Dr.),

Rent Revenue ( R ) (Cr.)

Prepaid Expense and Unearned Revenue

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Service Tomorrow


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Adjustment Entries Deferred or Unearned Revenue (Type 3)

Unearned Revenue (Pre-received/ Received in advance)

Cash Receipt Before Revenue earned or recognized

(Airline Tickets, Magazine Subscription, Rent, Customer deposits)

Recorded unearned revenue to be allocated between two or more

accounting periods

At the time of cash receipt: Service (goods) yet to be rendered (delivered)

Credited to a Liability A/c

At the end of the accounting period: Service Rendered (or Goods delivered)

Amount Earned is transferred to a Revenue A/c

Adjusting entry to record the REVENUE that has been earned and to show

the LIABILITY that remains. Results in :

a decrease to a liability account (Dr.) and an increase to a revenue account (Cr.)

Recognition of Revenue is Deferred

Adjustment Entry

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Unearned Revenue

When payment was received during the accounting period

Recognition of revenue was postponed and LIABILITY recorded

If adjustment entry is not passed at the end of the accounting period,

even though the REVENUE has been Earned LIABIITIES will be overstated

REVENUES will be understated

Stockholders equity will be Understated

Net income will be Understated

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Adjustment July 31: Recognize $800 of the unearned revenue as earned in July.

$800 of the advance payment has been earned in July

Unearned Design Revenue Design Revenue

July 31 800

The account now reflects abalance that is unearned revenue

The account now reflects the totalrevenue applicable to July

July 19 1,400

On July 19, Creative Designs, Inc. received $1,400 as an advance payment for brochures to

be prepared for a client. By the end of the month, $800 of the brochures were completed

and accepted by the client.

When the payment was originally received, it was recorded as a liability.

Bal. 600

July 10 2,800

July 15 9,600July 31 800

Assets = Liabilities + Stockholders Equity

July 31 Unearned Design Revenue 800

Design Revenue 800

Dr. Cr.

July 19 Cash 1400

Unearned Design Revenue 1400

Dr. Cr.

Adjustment Entries (Type 3) Unearned Revenue

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ACCRUALS(Type 2 and 4 : of the Book)

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Adjustment Entries Accrued Expense (Type 2)

Accrued Expenses or Outstanding Expenses

Expenses Incurred during the period, but not yet recorded no cash paid yet

(Rent, Interest, Wages, Taxes, Utilities)

At the end of the Accounting Period: Amount that has been incurred is

Recognized as an Expense, and

Recorded as a Liability.

Adjustment Entry results in

Increases an expense account (Dr.) and

Increases a liability account (Cr.)

Expenses arisen, not yet recorded

Adjustment Entry

As the expense accumulates,

it is said to accrue

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Accrued Revenue or Receivables

Revenue earned during the period, but not yet recorded: no cash receipts

yet(Rent, Interest, Service performed, Revenues earned on operations)

At the end of the Accounting Period: Amount that has been Earned is

Recognized as an REVENUE, and

Recorded as an ASSET (Accounts Receivable) amount due to thecompany for services performed (or goods delivered)

Adjustment Entry results in

Increases an asset account (debits) and

Increases a revenue account (credits)

Revenue arisen, not yet recorded

Adjustment Entries Accrued Revenue (Type 4)

Adjustment Entry

As the revenue accumulates,

it is said to accrue

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Adjustment July 31: Recognize $400 as revenue earned in July

The fee has been earned by the end of the month, but has not been recorded

Accounts Receivable

Adjustment Entries Accrued Revenue (Type 4)

Design Revenues

July 31 400

The account now reflects allreceivables for July

The account now reflects the totalrevenue applicable to July

July 31 Accounts Receivable 400

Design Revenue 400

July 15 9,600

In July, Creative Designs agreed to design a website for Marsh Tire Company with the

first section operational by July 31. The fee for this section is $400.

Bal. 5,000

July 22 5,000 July 10 2,800July 16 9,600

July 31 400

July 31 800

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Adjusting Entries - Accruals

Without Adjustment for Accrued Expenses - Expenses and Liabilities willbe understated: NI, Shareholders Equity will be Overstated

Without Adjustment for Accrued Revenues Revenues and Assets will beunderstated: NI, Shareholders Equity will be Understated

Balance Sheet and Income Statement would be incorrect

Mr Xs Accrued Expenses (A/P) would be Mr. Ys Accrued Revenue (A/R)28


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Preparing an Adjusted Trial Balance

After all adjusting entries are recorded (journalized) and posted

the Ledger Account balances are recalculated

After that another Trial balance is prepared from the ledger accounts(Adjusted Trial Balance)

The adjusted trial balances 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.

Some accounts will have the same balance they had on the trial balance

Others will be different because adjusting entries changed the balances


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Preparing Financial Statements : Sequence

Income Statement

Revenue accounts Expense accounts

Net income

Balance Sheet

AssetsAsset accounts

LiabilitiesLiability accounts

Stockholders EquityCommon stockRetained earnings

Statement of Retained Earnings

Beginning retained earnings

+ Net Income

DividendsEnding retained earnings

Adjusted Tr ial Balance

Asset accountsLiability accounts

Common StockRetained EarningsDividendsRevenue accountsExpense accounts

1

2

3

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Check the preparation

in Page 153 of text

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Closing the Books

Temporary accounts Permanent accounts

(or nominal accounts) (or real accounts)

All Revenue accounts,

All Expense accounts,

Dividends accounts

All Assets accounts,

All Liabilities accounts,

All Shareholders Equity accountsi.e. all Balance sheet accounts

Are closed at the end of each period Are not closed at the end of each

period

Begin each period with a zerobalance

Carry their end-of-period balances tonext period

At the end of the accounting period, companies transfer the temporary account

balances to : Retained Earnings (stockholders equity account- permanent)

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Closing Entries

CLOSING ENTRY: Required at the end of any period for which financial

statements are prepared

Summarizes a periods revenues and expenses by transferring balances tothe Income Summary account

Updates Retained Earnings to its correct ending balance

Produces a zero balance in each temporary account

Set the stage for the next period by clearing revenue, expense, and

dividends accounts of their balances

Does not appear on financial statements

Only used in the closing process

Its balance equals the net income or loss reported on the income statement

Income Summary

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The Closing Process

Expense Accounts Revenue Accounts

Income Summary

Retained EarningsDividends

xxxxxx

xx

xx

Step 1: Close

revenue accounts

xxxxxx

Step 2: Close

expense accounts

xx

Step 3: Close

Income Summary

xxStep 4:

Close

Dividends

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Closing the Books

2012

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Closing the Books


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Preparing a Post-Closing Trial Balance

Trial balance is prepared again after the closing entries

All temporary accounts will have zero balances.

It would show balances of ONLY Permanent (Balance Sheet)accounts

The purpose of the post-closing trial balance is

To check that total debits equal total credits in the ledger afterclosing entries have been posted

To prove the equality of the permanent account balances that thecompany carries forward into the next accounting period

Hence prove equality of the two sides of balance sheet

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Determining Cash Flows from Accrual-Based Information

Each revenue and expense account has one or more related accounts onthe balance sheet,

joined through adjusting entries

Balance Sheet Income Statement

Supplies Supplies Expense

Wages Payable Wages Expense

Unearned Revenue Earned Revenue

Prepaid Insurance Insurance Expense

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Determining Cash Flows from Accrual-Based Information

310

310

June 30 670

Cash Prepaid Insurance Insurance Expense

120May 31 480 120

Prepaid Expense

Ending Balance (on 30 June)

+ Expense for the Period (during June)

Beginning Balance ( on May 31)

Cash Payments for Expenses during June

Prepaid Expense

$ 670

+ 120

480

$ 310

The beginning

balance is

deductedbecause it was

paid in a prior

period

Actual cash paid for

insurance in June

SE 11 (p165)

E12 (p168)


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E12 (p168)

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Thank You

Session 4.pdf

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Transcript of Session 4.pdf