The Accounting Cycle Accruals and Deferrals

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PowerPoint Authors:Susan Coomer Galbreath, Ph.D., CPACharles W. Caldwell, D.B.A., CMAJon A. Booker, Ph.D., CPA, CIACynthia J. Rooney, Ph.D., CPA

Copyright © 2012 The McGraw-Hill Companies, Inc.

McGraw-Hill/Irwin

The Accounting CycleThe Accounting CycleAccruals and DeferralsAccruals and Deferrals

Chapter 4

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Adjusting

entries are

needed whenever

revenue or expenses

affect more than oneaccounting

period.

Every adjusting

entry involves achange in either a

revenue or expense and an asset

or liability.

AADJUSTING ENTRIESDJUSTING ENTRIES

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Adjusting EntriesAdjusting Entries

Adjusting Entries are journal entries recorded at the end of an accounting period to adjust income and expense accounts so that they comply with the Accrual Concept of accounting.

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AACCRUAL CONCEPTCCRUAL CONCEPT

Business transactions are

recorded when they occur.

NOT when the related payments are

received or made.

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Accrual Accrual CConceptoncept

Accrual Concept, requires that;

Revenues of the business are recognised in the accounts when earned.

Expenses are recognised when incurred.

NOT when the money is received or paid.

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Accrual Accrual CConcept – oncept – EExamplexample-1-1

An airline company sells its tickets weeks before the flight is due.

BUTIt does not record the payments as

revenue because the event on which the revenue is based has not occurred yet.

Once the service has being provided, we can make the adjusting entry. (i.e. We can record it as received)

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AccrualAccrual C Concept – oncept – EExamplexample-- 2 2

A business records its utility bills as soon as it receives them.

Not when the bills are paid, because the service has already been used.

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AdjustAdjustiing Entrng Entriieses

Adjusting Entries are necessary when accrual basis accounting is used.

Adjusting entries allow businesses to adhere to the Matching Principle.

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TThe MATCHINGhe MATCHING P PRINCIPLERINCIPLE

This principle, requires a company to match expenses with the related revenues in order to report the company`s profitability during the accounting period.

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The MatcThe Matchinghing Pr Principleinciple

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The MatchThe Matchiing Prng Priincnciipleple

A hospital pays £20,000 per month to 5 of its doctors.

Monthly sales are £ 500,000.

£100,000 (£20,000 x 5) worth of monthly salaries should be matched with £500,000 of revenue generated.

Net profit for this month would be:500,000-100,000

-------------------

£ 400,000

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The MatchThe Matchiing Prng Priincnciipleple

The objective is to match the income receivable and the expenditure payable to the appropriate accounting period.

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TTYPESYPES of A of ADJUSTINGDJUSTING E ENTRIESNTRIES

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Type 1: PrepaType 1: Prepaiid d EExpensesxpenses

Prepaid expenses are the type of expenses which are paid in cash and recorded as assets prior to being used.

Prepaid expenses are also known as deferred expenses

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

• Let`s say you prepaid £15,000 for your property insurance on 1st September of the current year.

• Make the appropriate adjustment as of the end of the accounting period. (i.e. 31/12/2012)

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Original Entry: On September 1 the following entry would be recorded when the insurance was prepaid:

Cash 15,000

Prepaid Insurance 15,000

Dec. 31

Debit Credit

Prepaid Insurance

15,00015,000 15,00015,000

Debit Credit

Cash

15,00015,000

AdjustAdjustiing Entrng Entriies for es for “Prepa“Prepaiid Expenses”d Expenses”

DRCR

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AdjustAdjustiing Entrng Entriies for es for “Prepa“Prepaiid Expenses”d Expenses”

Prepaid Insurance is an asset account – it is an amount owned by the company that has economic value.

We will recognise PrepaidInsurance under current assets.

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AnalyzAnalyziing an Adjustng an Adjustiing Entry:ng Entry:

•Each month, a portion of the prepaid insurance expires.

•At the end of the accounting period, the Prepaid Insurance and Insurance Expense accounts must be updated for the insurance that has expired (been used).

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Analyzing an Adjusting Entry:Analyzing an Adjusting Entry:(Example 1)(Example 1)What accounts are involved?

• When something is “used up” it indicates an expense account.

• In this case, we need to debit Insurance Expense for the expired insurance. • Furthermore, the asset, Prepaid Insurance, has decreased so we will credit this asset.

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£15,000 for 12 months = £1,250/month

Policy purchased on Sept 1.

Months that have expired between purchase and fiscal year-end 4 months (Sept, Oct, Nov, Dec)

Amount of adjustment =(£1,250/month X 4 months) £ 5,000

(£15,000/12 )

Analyzing an Adjusting Entry:Analyzing an Adjusting Entry:

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Let’s record the adjusting entry;

Prepaid Insurance £5,000

Insurance Expense £5,000 Dec. 31

Debit Credit

Prepaid Insurance

15,00015,0005,0005,000

Debit Credit

Insurance Expense

£1£100,000,000

DRCR

5,0005,000

£5,000£5,000

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The Concept of DepreciationThe Concept of Depreciation (Example 2)(Example 2)

Depreciation is the systematic allocation of the cost of a depreciable asset to expense.

Depreciation is the systematic allocation of the cost of a depreciable asset to expense.

Cash (credit)

Cash (credit)

Fixed Asset (debit)

Fixed Asset (debit)

On date when initial payment is made . . .

The asset’s usefulness is

partially consumed during the

period.At end of period . . .

Depreciation Expense (debit)

Depreciation Expense (debit)

Accumulated Depreciation

(credit)

Accumulated Depreciation

(credit)

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On May 2, 2011, JJ’s Lawn Care Service purchased a lawn mower with a useful

life of 50 months for $2,500 cash.

Using the straight-line method, calculate the monthly depreciation

expense.

$2,50050

=$50$50

Depreciationexpense (per

period)=

Cost of the assetEstimated useful life

Depreciation Is Only an Depreciation Is Only an EstimateEstimate

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JJ’s Lawn Care Service would make the following adjusting entry.

JJ’s Lawn Care Service would make the following adjusting entry.

GENERAL JOURNAL

Date Account Titles and ExplanationPRDebit Credit

May 31 Depreciation Expense: Equipment 50

Accumulated Depreciation: Equipment 50

To record one month's depreciation.

Contra-asset Contra-asset


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JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and

make the journal entry.

JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and

make the journal entry.

GENERAL JOURNAL

Date Account Titles and ExplanationPRDebit Credit

May 31 Depreciation Expense: Truck 250

Accumulated Depreciation: Truck 250

To record one month's depreciation.

$15,00060 months = $250 per month$15,00060 months = $250 per month


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Accumulated depreciation would appear on the balance sheet as

follows:

Accumulated depreciation would appear on the balance sheet as

follows:


Cost - Accumulated Depreciation = Book ValueCost - Accumulated Depreciation = Book Value

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JJ's Lawn Care Service Adjusted Trial Balance

May 31, 2011Cash 3,925$ Accounts receivable 75 Tools & equipment 2,650 Accum. depreciation: tools & eq. 50$ Truck 15,000 Accum. depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Dividends 200 Sales revenue 750 Gasoline expense 50 Depreciation exp.: tools & eq. 50 Depreciation exp.: truck 250 Total 22,200$ 22,200$

All balances are taken from

the ledger accounts on May 31 after

preparing the two

depreciation adjusting entries.

Adjusted Trial BalanceAdjusted Trial Balance

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TTypeype 2: U 2: Unearnednearned R Revenuesevenues

Unearned Revenues are payments for future services to be performed or goods to be delivered.

At the end of each accounting period, adjusting entries must be made to recognize the portion of unearned revenues that have been earned during the period.

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Adjusting Entries for Adjusting Entries for ““UUnearned nearned RRevenues”evenues”

Suppose that you are the owner of an Insurance company and on November 30th a customer pays £1,800 for an insurance policy to protect her delivery vehicles for six months.

Make the appropriate adjustment as of the end of the accounting period. (i.e. 31/12/2012)

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Initially, the insurance company records this transaction by;

increasing an asset account (cash) with a debit

increasing a liability account (unearned revenue) with a credit.

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Adjusting Entry:

Unearned Insurance £ 1,800

Cash £1,800Nov. 30

Debit Credit

Cash

1,8001,800 1,8001,800

Debit Credit

Unearned Insurance

££ 1,8001,800


DRCR

££ 1,8001,800

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After one month on 31 December 2012, the insurance company makes an adjusting entry;

To decrease (debit) unearned revenue

To increase (credit) revenue by an amount equal to one sixth of the initial payment.

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Adjusting Entry:

Vehicle Insurance Revenue

£ 300

Unearned Insurance

300

Dec. 31

Debit Credit

Vehicle Insurance Revenue

1,800

Debit Credit

Unearned Insurance

$300$300


DRCR

£ 300

$1,500$1,500

300300

(£1,800 / 6months)= 300 per

month

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If we do not include adjusting entries to show the earning of previously unearned revenues ;

We overstate total liabilities and understate total revenues and net income.

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TTypeype 3: 3: AAccrued Rccrued Revenuesevenues

An asset class for goods or services that have been sold or completed but that have not yet been billed and/or paid for.

Accrued revenue is income that has been incurred but not received

Accrued revenue is also called accrued assets.

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Adjusting Entries for Adjusting Entries for ““AAccrued ccrued RRevenues”evenues”

ABC Ltd. sold £1,000 of products to a customer who is not required to pay for 60 days.

The sale is recorded by ABC Ltd. on the income statement as revenue and on the balance sheet as a current asset

Even though no money will be received until later. (The sale process is occurred)

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Initial Entry:

Revenue £ 1,000

Receivables (Current Asset) £ 1,000Dec. 31

Debit Credit

Receivables

1,0001,000 1,0001,000

Debit Credit

Revenue

1,0001,000

Adjustıng Entries for “accrued revenues”Adjustıng Entries for “accrued revenues”

DRCR

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Adjusting Entries for “accrued revenues”Adjusting Entries for “accrued revenues”

The concept of accrued revenue is needed in order to properly match revenues with expenses.

The absence of accrued revenue would tend to show excessively low initial revenue levels. Thus, low profits for a business

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For example; Muffin Ltd. rented its office to Cookie

Ltd. for £500 a month.

Muffin Ltd. has not received December rent of £500 from Cookie Ltd.

What figure of rent receivable should be shown as income for Muffin Ltd. for the year ended 31/12/2012

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Adjusting Entry: The adjusting entry at the end of December is to debit rent receivable and credit rental revenue by £500.

Rental Revenue £500

Rent Receivable (Current Asset) £500Dec. 31

Debit Credit

Rent Receivable

500500 500500

Debit Credit

Rental Revenue

500500


DRCR

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After one month, on January 2013 Muffin Ltd. received the rental income of £500 form Cookie Ltd.

What would be the double entry?

To increase (debit) as cash is received.

To decrease (credit) as rent is paid by Cookie Ltd.

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Adjusting Entry: The adjusting entry on January 2013 is to debit Cash / Bank and credit Receivable`s account for £500.

£500

Cash or Bank £500Jan. 31

Debit Credit

Rent Receivable

500500

Debit Credit

Cash / Bank

--


DRCR Rent Receivable

500500

--

500500

500500

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TTypeype 4: 4: AAccrued Expenses ccrued Expenses

Accrued Expense is an expense incurred but not yet paid.

A journal entry is created to record the expense, as well as an offsetting liability (which is usually classified as a current liability in the balance sheet).

The absence of a journal entry result in reported profits being too high in that period. (as expense will not be reported in the FS)

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Adjusting Entries for Adjusting Entries for ““AAccrued Expenses”ccrued Expenses”

Examples of expenses that are commonly accrued include:

Interest on loans, for which no lender invoice has yet been received

Goods received and consumed or sold, for which no supplier invoice has yet been received

Services received, for which no supplier invoice has yet been received

Wages incurred, for which payment to employees has not yet been made

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For example; Green Ltd. enters into a rental agreement to

use the trucks of Car & Cars Ltd.The term states that Green Ltd. will pay

monthly rentals of £2,000 at the end of each month.

The lease started on July 1st, 2012. On July 31, the rent for the month has not yet been paid and no record for rent expense was made.

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What would be the necessary adjusting entry for rent expense?

In this case, Green Ltd. has already incurred (consumed/used) the expense. Even if it has not yet been paid, it should be recorded as an expense.

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Adjusting Entry: The adjusting entry at the end of July is to debit rent expense and credit rent payable for £2,000.

Rent Payable £ 2,000

Rent Expense £ 2,000July. 31

Debit Credit

Rent Expense

2,0002,000 2,0002,000

Debit Credit

Rent Payable

2,0002,000


DRCR

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Expense recognition principle, requires expenses to be recognized when incurred regardless of when paid.

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SUMMARYSUMMARY

Prepaid expenses

Depreciation

Accrued revenues

Debit Expense

Credit Asset (Prepaid)

Debit Depreciation Expense

Credit Accumulated Depreciation

Debit Receivable

Credit Revenue

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SUMMARYSUMMARY

Accrued expenses

Unearned revenues

Debit Expense

Credit Liability

Debit Liability (Unearned)

Credit Revenue

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End of Chapter 4End of Chapter 4

The Accounting Cycle Accruals and Deferrals

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