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Objectives of the Chapter
I. Introduce the accrual accounting concept.
II. Introduce the adjusting entries.
Accrual Accounting and the Financial Statements
3
Adjusting the Accounts
4
After studying this chapter, you should be able to:
CHAPTER 6 Accrual Basis of AccountingCHAPTER 6 Accrual Basis of Accounting
1 Explain the time period assumption.
2 Explain the accrual basis of accounting.
3 Explain why adjusting entries are needed.
4 Identify the major types of adjusting entries.
5 Prepare adjusting entries for prepayments.
6 Prepare adjusting entries for accruals.
I. Accrual Accounting
1. The time-period concept, the revenue recognition and the matching principles.
2. Accrual versus cash basis accounting.
Accrual Accounting and the Financial Statements
5
The Time-Period Concept (Periodicity)
Income and financial position of a business are reported periodically, not until the end of life of a business.
Accrual Accounting and the Financial Statements
6
Revenue Recognition Principle (Accrual Basis)
Revenue is recognized when it is earned and realized.
Earned : the entity has substantially accomplished what it must do to be entitled to compensation.
Realized: goods are exchanged for cash or claims.
In general, these conditions are met at time of sale (delivery) or when services are rendered regardless whether cash is collected or not.
Income Measurement And Profit Analysis
7
8
OPERATING CYCLES FOR A SERVICE COMPANY
OPERATING CYCLES FOR A SERVICE COMPANY
Accounts Receivable
Cash
Service Company
Receive Cash
Perform Service
s
Revenue Recognition Principle (Accrual Basis)
The Matching Principle
If revenues are recognized in a period, all related expenses should be recognized in the same period regardless whether expenses are paid or not.
The related expenses include traceable costs (i.e., product costs), period costs, (i.e.,
interest and rent expenses) and estimated/allocation expenses (i.e., depreciation expense and bad debt expense).
Accrual Accounting and the Financial Statements
9
II. Adjusting Entries
Due to the periodicity concept, financial reports are prepared periodically.
Based on revenue recognition principle, adjusting entries are prepared at the end of a period to recognize revenues earned during the period but not yet recorded (i.e., accrued revenues).
Accrual Accounting and the Financial Statements
10
Adjusting Entries (contd.)
Based on the matching principle, the accrued expenses (i.e., expenses incurred but not yet paid/recorded) and estimated expenses (i.e., depreciation expense and bad debt expense) are recorded at the end of a period.
Accrual Accounting and the Financial Statements
11
Types of Adjusting Entries
A. Accruals
B. Deferrals
C. Estimated Expenses
Accrual Accounting and the Financial Statements
12
A. Accruals
Unrecorded revenues or expenses (i.e., revenues earned or expenses inccurred but not yet recorded).
a. Accrued expenses.
b. Accrued revenues.
Accrual Accounting and the Financial Statements
13
Adjusting the Accounts
14
Accrued expenses are expenses incurred but not paid yet.
A liability-expense account relationship exists
Prior to adjustment, liabilities and expenses are understated
The Adjusting Entry results in a debit to an expense account and a credit to a liability account
ACCRUED EXPENSESACCRUED EXPENSES
Accrual Accounting and the Financial Statements
15
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTERESTADJUSTING ENTRIES FOR ACCRUALS
ACCRUED INTEREST
Interest PayableOct. 31 50
Interest ExpenseOct. 31 50
Date Account Titles and Explanation Debit Credit Oct. 31 Interest Expense 50
Interest Payable 50 (To accrue interest on notes payable)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, the portion of the interest to be accrued on a 3-month note payable is calculated to be $50.
Accrual Accounting and the Financial Statements
16
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIESADJUSTING ENTRIES FOR ACCRUALS
ACCRUED SALARIES
Salaries PayableOct. 31 1,200
Date Account Titles and Explanation Debit Credit Oct. 31 Salaries Expense 1,200
Salaries Payable 1,200 (To record accrued salaries)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, accrued salaries are calculated to be $1,200.
Salaries ExpenseOct. 26 4,000 31 1,200 31 5,200
a. Accrued Expenses- An Example
A one-year note payable was issued on 11/1/11 to purchase an equipment. The full amount of the note is $2,400. The annual interest rate is 10% and interests are paid on 4/30/12 and 11/1/12.
11/1/11 Equipment2,400 Note Payable 2,400
Adjusting Entry:
12/31/11 Interest Expense 40
Interest payable 40
Accrual Accounting and the Financial Statements
17
Adjusting the Accounts
18
ADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUESADJUSTING ENTRIES FOR ACCRUALS
ACCRUED REVENUES
Service RevenueOct. 31 10,000 31 400 31 200 31 10,600
Accounts ReceivableOct. 31 200
Date Account Titles and Explanation Debit Credit Oct. 31 Accounts Receivable 200
Service Revenue 200 (To accrue revenue for services provided)
October 31, the agency earned $200 for advertising services that were not billed to clients before October 31.
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT
b. Accrued Revenues – An Example
A one year note was received from a credit sale with a face amount of $3,000 and an annual interest rate of 12% on 9/1/12. Interests are received on 3/1/13 and 9/1/13.
9/1/x1 Note Receivable 3,000
Sales Revenue 3,000
Adjusting Entry:
12/31/x1 Interest Receivable 120
Interest Revenue 120
Accrual Accounting and the Financial Statements
19
B. Deferrals
Postponing the recognition of Revenues or expenses
a. Unearned revenues
b. Prepaid expenses
Accrual Accounting and the Financial Statements
20
Adjusting the Accounts
21
Unearned revenues are revenues received and recorded as liabilities before they are earned.
Unearned revenues are subsequently earned by rendering a service to a customer.
A liability-revenue account relationship exists with unearned revenues.
UNEARNED REVENUESUNEARNED REVENUES
Accrual Accounting and the Financial Statements
22
Prior to adjustment, liabilities are overstated and revenues are understated.
The adjusting entry results in a debit to a liability account and a credit to a revenue account.
Examples of unearned revenues include rent, magazine subscriptions, and customer deposits for future services.
UNEARNED REVENUESUNEARNED REVENUES
Accrual Accounting and the Financial Statements
23
ADJUSTING ENTRIES FOR PREPAYMENTS
UNEARNED REVENUESADJUSTING ENTRIES FOR PREPAYMENTS
UNEARNED REVENUES
Service RevenueOct. 31 10,000 31 400
Unearned RevenueOct. 31 400 Oct. 2 1,200
31 800
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.
Date Account Titles and Explanation Debit Credit Oct. 31 Unearned Revenue 400
Service Revenue 400 (To record revenue for services provided)
a. Unearned Revenues
Receiving $2,400 for a one-year advanced rent payment from a tenant on 12/1/11
Accrual Accounting and the Financial Statements
24
(B/S Approach)12/1/11Cash 2,400
Unearned Rent2,400
12/30/11Unearned Rent 200
Rent Revenue200
(I/S Approach)12/1/11Cash 2,400
Rent Revenue2,400
12/30/11Rent Revenue 2,200
Rent Unearned 2,200
Adjusting the Accounts
25
Prepaid expenses are expenses paid in cash and recorded as assets before they are used or consumed.
Prepaid expenses expire with the passage of time or through use and consumption.
An asset-expense account relationship exists with prepaid expenses.
PREPAID EXPENSESPREPAID EXPENSES
Accrual Accounting and the Financial Statements
26
Advertising Supplies ExpenseOct. 31 1,500
Advertising Supplies Oct. 5 2,500 Oct. 31 1,500 31 1,000
Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies Expense 1,500
Advertising Supplies 1,500 (To record supplies used)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.
ADJUSTING ENTRIES FOR PREPAYMENTS
SUPPLIESADJUSTING ENTRIES FOR PREPAYMENTS
SUPPLIES
Accrual Accounting and the Financial Statements
27
ADJUSTING ENTRIES FOR PREPAYMENTS
INSURANCEADJUSTING ENTRIES FOR PREPAYMENTS
INSURANCE
Insurance Expense 63Oct. 31 50
Prepaid Insurance 10 Oct. 4 600 Oct. 31 50 31 550
Date Account Titles and Explanation Debit Credit Oct. 31 Insurance Expense 50
Prepaid Insurance 50 (To record insurance expired)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, an analysis of the policy reveals that $50 of insurance expires each month.
b. Prepaid Expense
Prepaid a 12 month insurance premium of $1,200 on 11/1/11
Accrual Accounting and the Financial Statements
28
(B/S Approach)Prepaid Insur. 1,200
Cash 1,200
12/31/11Insurance Exp. 200 Prepaid Insurance
200
(I/S Approach)Insurance Exp. 1,200
Cash 1,200
12/31/11Prepaid Insur. 1,000
Insurance Exp.1,000
Adjusting the Accounts
29
ALTERNATIVE TREATMENTOF PREPAID EXPENSES AND UNEARNED REVENUES
ALTERNATIVE TREATMENTOF PREPAID EXPENSES AND UNEARNED REVENUES
Some businesses use an alternative treatment for prepaids and unearned revenues.
Instead of debiting an asset at the time an expense is prepaid, the amount is charged to an expense account.
Instead of crediting a liability at the time cash is received in advance of earning it, the amount is credited to a revenue account.
This treatment of prepaid expenses and unearned revenues will ultimately result in the same effect on the financial statements as initial entries to balance sheet accounts and then adjusting entries.
Accrual Accounting and the Financial Statements
30
ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
SUPPLIESALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
SUPPLIES
Advertising Supplies Expense Oct. 5 2,500 Oct. 31 1,000 31 1,500Advertising Supplies
Oct. 31 1,000
Date Account Titles and Explanation Debit Credit Oct. 31 Advertising Supplies 1,000
Advertising Supplies Expense 1,000 (To record supplies inventory)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, an inventory count reveals that $1,000 of $2,500 of supplies are still on hand.
Accrual Accounting and the Financial Statements
31
ALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
UNEARNED REVENUESALTERNATIVE ADJUSTMENTS FOR PREPAYMENTS
UNEARNED REVENUES
Service RevenueOct. 31 800 Oct. 2 1,200
31 400
Date Account Titles and Explanation Debit Credit Oct. 31 Service Revenue 800
Unearned Revenue 800 (To record unearned revenue)
JOURNAL ENTRYJOURNAL ENTRY
POSTINGPOSTING
ADJUSTMENTADJUSTMENT October 31, analysis reveals that, of $1,200 in fees, $400 has been earned in October.
Unearned RevenueOct. 31 800
Accounting Estimates
• Some assets are not fully used up in a single fiscal period.– A truck may last five years, but its value as a
resource declines with time and usage.
Accounting Estimates
• Some assets are not fully used up in a single fiscal period.– A truck may last five years, but its value as a
resource declines with time and usage.
• Assets that benefit more than one year are called long-term or “fixed” assets.
Adjusting the Accounts
34
Depreciation is the allocation of the cost of an asset to expense over its useful life in a rational and systematic manner.
The purchase of equipment or a building is viewed as a long-term prepayment of services and, therefore, is allocated in the same manner as other prepaid expenses.
DEPRECIATIONDEPRECIATION
Accrual Accounting and the Financial Statements
35
DEPRECIATIONDEPRECIATION
Depreciation is an estimate rather than a factual measurement of the cost that has expired.
In recording depreciation, Depreciation Expense is debited and a contra asset account, Accumulated Depreciation, is credited
Depreciation Expense
XXX
Accumulated Depreciation
XXX
Accrual Accounting and the Financial Statements
36
In the balance sheet, Accumulated Depreciation is offset against the asset account.
The difference between the cost of any depreciable asset and its related accumulated depreciation is referred to as the book value of the asset.
DEPRECIATIONDEPRECIATION
Accounting Estimates
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
Cash (credit)
Cash (credit)
Fixed Asset (debit)
Fixed Asset (debit)
Journal entry when
payment is made.
Accounting Estimates
Cash (credit)
Cash (credit)
Fixed Asset (debit)
Fixed Asset (debit)
Journal entry when
payment is made.
The asset’s usefulness is
partially consumed during the
period.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
Accounting Estimates
Accumulated Depreciation
(credit)
Accumulated Depreciation
(credit)
Depreciation Expense (debit)
Depreciation Expense (debit)Cash
(credit)
Cash (credit)
Fixed Asset (debit)
Fixed Asset (debit)
Journal entry when
payment is made.
The asset’s usefulness is
partially consumed during the
period.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
AJE at end of period
Accounting Estimates
Accumulated Depreciation
(credit)
Accumulated Depreciation
(credit)
Depreciation Expense (debit)
Depreciation Expense (debit)
This is called a contra-asset account and has a credit balance.
This is called a contra-asset account and has a credit balance.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
AJE at end of period
Accounting Estimates
Accumulated Depreciation
(credit)
Accumulated Depreciation
(credit)
Depreciation Expense (debit)
Depreciation Expense (debit)
This is called a contra-asset account and has a credit balance.
This is called a contra-asset account and has a credit balance.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
AJE at end of period
Balance Sheet Presentation Asset (at cost) $40,000Less: Accumulated Depr. 5,000Book Value $35,000
Balance Sheet Presentation Asset (at cost) $40,000Less: Accumulated Depr. 5,000Book Value $35,000
Accounting Estimates
Accumulated Depreciation
(credit)
Accumulated Depreciation
(credit)
Depreciation Expense (debit)
Depreciation Expense (debit)
This is called a contra-asset account and has a credit balance.
This is called a contra-asset account and has a credit balance.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
AJE at end of period
Accounting Estimates
Accumulated Depreciation
(credit)
Accumulated Depreciation
(credit)
Depreciation Expense (debit)
Depreciation Expense (debit)
This is called a contra-asset account and has a credit balance.
This is called a contra-asset account and has a credit balance.
The portion of an asset’s utility that is used up must be expensed in the period used.
The portion of an asset’s utility that is used up must be expensed in the period used.
AJE at end of period
Balance Sheet Presentation Asset (at cost) $40,000Less: Accumulated Depr. 5,000Book Value $35,000
Balance Sheet Presentation Asset (at cost) $40,000Less: Accumulated Depr. 5,000Book Value $35,000
Definition of Book Value
Asset cost - Accumulated Depreciation
Accounting Estimates
Book Value = $35,000
Truck
Bal. 40,000
Accumulated Dep’n - Truck
5,000 Bal.
Accounting Estimates
GENERAL JOURNALPage: 1
Date Description PR Debit Credit
Accounting EstimatesExample
On 12/31/97, Putnam Plumbing, recorded $2,000 of Depreciation Expense on a
$10,000 truck.
Prepare the proper adjusting journal entry.
Prepare the proper adjusting journal entry.