Accrual Accounting Concepts

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Accrual Accounting Concepts
CHAPTER
4
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Time Period Assumption

• Divides the economic life of a business into
  artificial time periods
• Interim period (month, quarter)
• Year (fiscal, calendar)
• WHY?
• To provide immediate feedback on how the business
  is doing

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Revenue Recognition Principle

• Dictates that revenue be recognized in the
  accounting period in which it is earned
• Revenue 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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Cash Basis

• Revenue is recorded only when cash is received
• Expense is recorded only when cash is paid

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Accrual Basis Accounting

• Adheres to the time period assumption and revenue
  recognition and matching principles
• Revenue is recorded when earned,
  rather than when cash is received
• Expense recorded when incurred,
  rather than when cash is paid
• Accrual accounting records events when the
  economic event occurs

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Adjusting Entries

• Adjusting entries are made to adjust or update
  accounts at the end of the accounting period
• Adjusting entries can be categorized as
• Prepayments
• Accruals

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Types of Adjusting Entries

• Prepayments
• Prepaid expenses
• Unearned revenues
• Accruals
• Accrued revenues
• Accrued expenses

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Prepayments

• Cash has been spent but the item acquired has not
  been used or consumed (prepaid expenses)
• Cash has been collected but the revenue has not
  been earned (unearned revenues)

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Supplies
On January 5 the company paid 2,500 for
advertising supplies.
Advertising Supplies
Advertising Supplies Expense
Cash
Jan. 5 2,500
Jan. 5 2,500

GENERAL JOURNAL
Debit Credit Jan. 5 Advertising
Supplies 2,500
Cash 2,500 Purchased
advertising supplies
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Supplies
An inventory on January 31 reveals that 1,000 of
supplies remain on hand therefore, 1,500 of
supplies had been used. (2,500 - 1,000) 1,500
Advertising Supplies Expense
Advertising Supplies
Cash

Jan. 5 2,500
Jan. 31 1,500
Jan. 5 2,500
Jan. 31 1,500
Bal. 1,000
GENERAL JOURNAL
Debit Credit Jan. 5 Advertising
Supplies Expense 1,500
Advertising Supplies 1,500
To record advertising supplies consumed
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Prepaid Expenses
On February 4 the company paid 600 for a 1-year
insurance policy coverage began February 1.
Feb. 4 600
Feb. 4 600
GENERAL JOURNAL
Debit Credit Feb. 4 Prepaid
Insurance 600
Cash

600 Purchased one-year
policy effective February 1
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Prepaid Expenses
On February 28, 50 (600/12 months) of the
insurance had been used or had expired.
Prepaid Insurance
Insurance Expense
Cash
Feb. 4 600
Feb. 4 600
Feb. 28 50
Feb. 28 50
GENERAL JOURNAL
Debit Credit Feb. 28 Insurance Expense
50
Prepaid Insurance
50 Record insurance
expense for the month
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Amortization

• How do you apply the matching principle to the
  cost of a long-lived asset?

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Amortization

• Allocate the cost of an asset to expense over its
  useful life
• Amortization is an allocation concept, not a
  valuation concept

Note This is not an attempt to reflect the
actual change in value of an asset.
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Amortization Example

• Assume a piece of equipment was purchased on
  March 2 for 5,000. Its salvage value is 200 and
  its useful life is 10 years
• Straight-line amortization calculation is
• Cost - Salvage value 5,000 - 200 480/yr
  Useful Life 10
  OR 40/mo

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Amortization Example
Accumulated Amortization-Office Equipment
Amortization Expense
Office Equipment
Mar. 2 5,000
Mar. 31 40
Mar. 31 40
GENERAL JOURNAL
Debit Credit

Mar. 31
Amortization Expense
40 Accumulated
Amortization
40 Office Equipment

To record monthly amortization

Accumulated Amortization is a contra asset
account an offset (deduction) against the asset
account.
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Balance Sheet Presentation
Office equipment 5,000
Less Accumulated amortization 40
Net book value 4,960
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Unearned Revenues
Received on August 2 1,200 for advertising
services expected to be completed by December 31.
Aug. 2 1,200
Aug. 2 1,200
GENERAL JOURNAL
Debit Credit

Aug. 2 Cash

1,200 Unearned
Service Revenue 1,200
Collected money for work to be
performed by December 31
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Unearned Revenues
During August, 400 of the revenue was earned.
Aug. 2 1,200
Aug. 2 1,200
Aug. 31 400
Aug. 31 400
Bal. 800
GENERAL JOURNAL
Debit Credit

Aug. 31 Unearned
Service Revenue 400
Service Revenue
400 To record
revenue earned
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Accruals

• Revenue has been earned, but not collected
  (accrued revenues)
• Expenses were incurred, but not yet paid (accrued
  expenses)

Note Entry has not yet been recorded!
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Accrued Revenues

• Revenues earned but not yet received in cash or
  recorded at the end of period

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Accrued Revenues
Earned 200 for advertising services to clients
in October, but they were not billed until after
October 31.
Oct. 31 200
Oct. 31 200
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 end of period

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Accrued Interest Expense

• Interest expense is the cost a company incurs to
  use money. Information needed to calculate
  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 Expense
Formula for Calculating Interest
X 1/2
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Accrued Interest Expense
Oct. 31 50
Oct. 31 200
GENERAL JOURNAL
Debit Credit

Oct. 31 Interest
Expense 50
Interest Payable
50
Accrue interest expense for the
month
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Accrued Salaries Expense

• Assume that the employees receive total salaries
  of 2,000 for a five-day (Monday to Friday) work
  week, or 400 a day.
• Salaries were last paid on October 26 and the
  next payment of salaries will be November 9. As
  shown on the calendar on the following slide
  there are three unpaid work days remain as of
  October 31.

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Accrued Salaries Expense (Salaries paid after
the service has been performed)
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Accrued Salaries Expense
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
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Adjusted Trial Balance

• Adjusted trial balance proves 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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Closing the Books

• Closing entries
• Transfer the temporary account balances to update
  the retained earnings account
• Reduce the balances in the temporary accounts to
  zero to prepare for the next periods postings

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Illustration 4-17
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Required Steps in the Accounting Cycle

• Analyse business transactions
• Journalize the transactions
• Post to general ledger accounts
• Prepare a trial balance
• Journalize and post adjusting entries
  (prepayments and accruals)

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Required Steps in the Accounting Cycle

• Prepare an adjusted trial balance
• Prepare financial statements
• Journalize and post closing entries
• Prepare a post-closing trial balance