Financial Accounting:
Tools for Business Decision Making
Chapter 4
Accrual Accounting Concepts
After studying Chapter 4, you should be able to:
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.
4
Chapter 4
Accrual Accounting Concepts
After studying Chapter 4, you should be able to:
Prepare adjusting entries for accruals.
Describe the nature and purpose of the adjusted trial
balance.
Explain the purpose of closing entries.
Revenue Recognition
Principle...
dictates that revenue be recognized in the
accounting period in which it is earned.
is considered earned when the service has
6
Time Period Assumption...
Divides the economic life of a
business into artificial time
periods
WHY?
Matching Principle...
requires that
expenses
be recorded
in the same period in which the
8
Cash Basis
10
Cash Basis in not GAAP
G
A
Accrual Basis Accounting
Adheres to the:
•
Revenue Recognition Principle
12
Accrual Basis Accounting
•
Revenue recorded only when earned
not when cash is received
•
Expense recorded only when
Accrual Basis adheres to...
•
G
enerally
•
A
ccepted
Year 1 Year 2
Purchased paint, painted building , paid employees
Received payment for work done in year one
Activity
Accrual
basis
Cash
basis
Revenue $80,000
Expense 50,000
Net Income $30,000
Revenue $ 0
Expense 50,000
Net Loss ( $50,000)
Revenue $80,000
Expense 0
Net Income $80,000
Revenue $ 0
Expense 0
Net Income $ 0
Adjusting Entries
Adjusting entries make the:
revenue recognition &
matching principles
16
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.
Prepayments
•
Cash or other asset has been
spent but the item acquired has
not been used or consumed
•
Cash has been collected before
You can start with the
trial
Sierra Corporation
Trial Balance
October 31, 1998
Debit Credit
Cash $15,200
Advertising Supplies 2,500
Prepaid Insurance 600
Office Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Prepaid Expenses
On October 4 the company paid $600 for a
1-year insurance policy. Coverage began
October 1.
GENERAL JOURNAL Debit Credit Oct 4 Prepaid Insurance 600
Cash 600 Purchased one-year policy effective October 1
Insurance Policy
1 Year $ 600
Oct
$50
Mar
$50
Apr
$50
May
$50
Feb
$50
Nov
$50
Dec
$50
Jan
$50
June
$50
July
$50
Aug
$50
Sept
$50
Prepaid Expenses
On October 31st, $50
($600/12months) of the insurance was
used-up or expired.
GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50
Prepaid Insurance 50
Record Insurance expense for the month
On October 5 the company paid
$2,500 for advertising supplies.
GENERAL JOURNAL Debit Credit Oct 5 Supplies 2,500 Cash 2,500
An inventory on October 31 reveals that $1,000
of supplies remain on hand;therefore $1,500 of
supplies had been used. ($2,500- $1,000) =$
1,500
GENERAL JOURNAL Debit Credit Oct 5 Supplies Expense 1,500 Supplies
1,500
To record advertising supplies consumed
Oct
$1500
Mar
$1435
Apr
$1510
May
$1592
Feb
$1601
Nov
$1800
Dec
$1410
Jan
$1425
June
$1652
July
$1621
Aug
$1427
Sept
$1555
Supplies expense is based on usage... so
26
How do you apply the
Matching
Principle
to the cost of a long lived
asset ?
Allocate the cost of an asset to expense
over its useful life
Depreciation is an
Estimated Value
-
not an
actual
change in the
Value
of
the asset.
Office Equipment
Depreciation= $480/year
Oct
$40
Mar
$40
Apr
$40
May
$40
Feb
$40
Nov
$40
Dec
$40
Jan
$40
June
$40
July
$40
Aug
$40
Sept
$40
GENERAL JOURNAL Debit Credit
Oct 31 Depreciation Expense 40
Accumulated Depreciation-Office Equip 40 To record monthly depreciation
Accumulated depreciation is a
Accumulated
Depreciation-Office Equipment
40 Oct 31Office Equipment
5000 Oct 2Depreciation
Expense
30
Office equipment
$ 5,000
Less : accumulated depreciation
40
$4,960
Balance Sheet Presentation
Unearned Revenues
Received on Oct. 2 $1,200 for advertising
services expected to be completed by
12/31.
Unearned Service
Insurance
Cash
1,200 Oct 2 1,200 Oct 2Service
Revenue
GENERAL JOURNAL Debit Credit
Oct 2 Cash 1,200
Unearned Revenues
During October $400 of the revenue was
earned.
Unearned Service
Insurance
Cash
1,200 Oct 2Service
Revenue
1,200 Oct 2GENERAL JOURNAL Debit Credit
Oct 31 Unearned Service Revenue 400
Service Revenue 400 To record revenue earned
Accrual
•
Revenue has been earned, but not collected
34
Accrued Revenues
Accrued Revenues
Earned $200 for advertising services to
clients in October, but they were not
billed until after October 31st.
GENERAL JOURNAL Debit Credit
Oct 31 Accounts Receivable 200
Accounts
Receivable
200 Oct 31
Service
Revenue
36
Accrued Expenses
Formula for Computing Interest
Face Value
of Note Interest Time
in term of One Year Annual
Interest Rate
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
Interest Expense Interest Payable
Oct 31 50 Oct 31 50
GENERAL JOURNAL Debit Credit
Oct 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month
Salaries Expense Salaries Payable
Oct 31 1,200 Oct 31 1,200
GENERAL JOURNAL Debit Credit
Oct 31 Salaries Expense 1,200
Salaries Payable 1,200 Accrue salary expense for the month
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 can be easily prepared
from the adjusted trial balance.
44
Closing the Books
Closing entries transfer the temporary
account balances to the stockholders’
equity account...
Temporary
Permanent
All revenues accounts
All asset accounts
All expense accounts
All liability accounts
Dividends
Stockholders’ equity
Retained Earnings is a permanent
account; the others shown here
are temporary
Individual Expenses
Retained Earnings Income Summary
Individual Revenues
Dividends
1
3
48
Required Steps in the
Accounting Cycle
Analyze business transactions.
Journalize the transactions.
Post to ledger accounts.
Prepare a trial balance.
Journalize and post adjusting
entries--prepayments and accruals.
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