Accrual Accounting Concepts

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Chapter 4

• Accrual Accounting Concepts
• Financial AccountingTools for Business Decision
  Making, 3rd Ed.

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What we already know from Chapters 1, 2, and 3

• How to prepare Financial Statements
• Income Statement
• Statement of Retained Earnings
• Balance Sheet
• GAAP Accounting is based on Accrual Accounting
• Revenue Recognition and Matching Principles
• How to record Journal Entries
• DR Account XX
• CR Account XX
• written explanation

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Revenue Recognition Principle...

• dictates that revenue be recognized in the
  accounting period in which it is earned.
• is considered earned
• when the service has been provided or when the
  goods are delivered.

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Matching Principle...

• requires that expenses be recorded in the same
  period in which the revenues they helped produce
  are recorded.

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Ch 4 CONCEPTS to Know

• Timing Issues
• Revenue Recognition
• Matching Principles
• Accrual Accounting
• When do we recognize revenues and expenses?
• How do accountants do this? Through the use of
  Adjusting Entries! Yes, adjusting entries.
• How to prepare Trial Balance
• Then prepare Financial Statements
• Followed by Closing Entries

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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.
• Prepare an adjusting trial balance.

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Adjusted Trial Balance
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.
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SIERRA CORPORATION Adjusted Trial Balance For
the Month Ended October 31, 2004
SIERRA CORPORATION Adjusted Trial Balance For
the Month Ended October 31, 2004
SIERRA CORPORATION Retained Earnings
Statement For the Month Ended October 31, 2004
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Closing the Books
Closing entries transfer the temporary account
balances to the stockholders equity
account... and reduce the balances in the
temporary accounts to zero.
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Time Period Assumption

• Divides the economic life of a business into
  artificial time periods.
• WHY?
• To provide immediate feedback on how the business
  is doing.

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Time Period Assumption...

• Generally a month, a quarter, or a year.

An accounting time period that is one year long
is called fiscal year.
An accounting time period that starts on January
1 and ends December 31 is called a calendar year.
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Cash Basis

Revenue recorded only when cash is
received. Expense recorded only when cash is
paid. Cash Basis is not GAAP
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Accrual Basis Accounting

• Revenue recorded only when earned, not when cash
  is received
• Expense recorded only when incurred, not when
  cash paid
• Generally
• Accepted
• Accounting
• Principles

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Adjusting Entries

• Adjusting entries make the
• revenue recognition
• matching principles
  

HAPPEN!
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Types of Adjusting Entries KEY

• 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.

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Prepayments

• Cash or other asset has been
  spent but the item acquired has not been used or
  consumed
• Cash has been collected before revenue is earned

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You can start with the trial balance to find
information to adjust prepayments.Remember,
accrual accounting is about RECOGNIZING the
TIMING of an event or transaction in the proper
period.
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Sierra Corporation Trial Balance October 31, 2004

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 Rent
Expense
900

28,700 28,700

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Illustration 4-6
Supplies
On October 5 the company paid 2,500 for
advertising supplies.
Supplies Expense
Supplies
Cash

2,500
Oct 5
2,500
Oct 5
GENERAL JOURNAL
Debit Credit Oct 5
Supplies
2,500
Cash
2,500
Purchased advertising supplies
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Illustration 4-6
Supplies
An inventory on October 31 reveals that 1,000 of
supplies remain on hand therefore 1,500 of
supplies have been used. (2,500 - 1,000)
1,500
Supplies Expense
Supplies
Cash

2,500
Oct 5
2,500
Oct 5
GENERAL JOURNAL
Debit Credit Oct 5
Supplies Expense 1,500
Supplies

1,500 To record advertising
supplies consumed
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Supplies Expense
Oct 1,500
Nov 1,800
Dec 1,410
Jan 1,425
Mar 1,435
Apr 1,510
May 1,592
Feb 1,601
June 1,652
July 1,621
Aug 1,427
Sept 1,555
Supplies expense is based on usage... so
different amounts appear each month
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Prepaid Expenses
On October 1 the company paid 600 for a 1-year
insurance policy. Coverage began October 1.
GENERAL JOURNAL
Debit Credit Oct 1
Prepaid Insurance
600
Cash
600
Purchased one-year policy effective October 1
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Oct 50
Nov 50
Dec 50
Jan 50
Mar 50
Apr 50
May 50
Feb 50
June 50
July 50
Aug 50
Sept 50
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Prepaid Expenses
On October 31st, 50 (600/12 months) of the
insurance was used-up or expired.
Prepaid Insurance
Insurance Expense
Cash
600
Oct 1
600
Oct 1
GENERAL JOURNAL
Debit Credit Oct 31
Insurance Expense 50
Prepaid Insurance
50
Record insurance expense for the
month
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Depreciation
How do you apply the Matching Principle to the
cost of a long lived asset ?
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Depreciation
Allocate the cost of an asset to expense over its
useful life Depreciation is an ALLOCATION
CONCEPT- not a VALUATION CONCEPT. Were not
attempting to reflect the actual change in value
of an asset!
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Oct 40
Nov 40
Dec 40
Jan 40
Mar 40
Apr 40
May 40
Feb 40
June 40
July 40
Aug 40
Sept 40
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Accumulated Depreciation-Office Equipment
Depreciation Expense
Office Equipment

GENERAL JOURNAL
Debit Credit

Oct 31
Depreciation Expense
40 Accumulated
Depreciation-Office Equip
40 To record monthly
depreciation

Accumulated depreciation is a contra asset
account - an offset against the fixed asset
account.
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Balance Sheet Presentation
Office equipment 5,000 Less accumulated
depreciation 40 4,960

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Unearned Revenues
Received on Oct. 2 1,200 for advertising
services expected to be completed by Dec 31.
GENERAL JOURNAL
Debit Credit

Oct 2 Cash

1,200
Unearned Service Revenue
1,200 Collected
money for work to be
performed by Dec 31.
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Unearned Revenues
During October 400 of the revenue was earned.
Service Revenue
Unearned Service Revenue
Cash
GENERAL JOURNAL
Debit Credit

Oct 31
Unearned Service Revenue
400 Service
Revenue
400 To record
revenue earned
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Accrual

• Revenue has been earned, but not collected.
• Expenses have been incurred, but not yet paid.

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Accrued Revenues
Revenues earned but not yet received in cash or
recorded at the statement date
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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 Service Revenue
200

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Accrued Expenses
Expenses incurred but not yet paid or recorded at
the statement date.
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• 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

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Accrued Interest
GENERAL JOURNAL
Debit Credit

Oct 31
Interest Expense
50
Interest Payable
50
Accrue interest expense for the month
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Accrued Salaries - Salaries Paid for after the
Service Has Been Performed.
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Accrued Salaries
GENERAL JOURNAL
Debit Credit

Oct 31
Salaries Expense 1,200 Salaries
Payable
1,200 Accrue
salary expense for the month