PRINCIPLE OF

ACCOUNTING2nd Semester DBA

Prepared By: Kamran (Lecturer)

Specialization (Accounting)Kardan Institute of Higher Education

Accounting Period Assumption...Accounting Period Assumption...

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Divides the economic life of a business into artificial time periods.

WHY?

To provide immediate feedback on how the business is doing.

Time Period (Periodicity) Concept

Periodicity: divides the life of a business into short, even time periods, usually one year

Short periods keeps reporting timely and information updated.

Periods of equal length are comparableAn accounting time period that starts on January 1

and ends December 31 is called a calendar year.An accounting time period that is one year long is

called fiscal year.

©Kimberly Lyons3

REVENUE RECOGNITION PRINCIPLE

AND

MATCHING PRINCIPLE

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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...

Expenses should be matched with the

revenues they generate in any specific

accounting period.

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Accrual VS Cash Accounting

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Cash-Basis Accounting

Revenue and expenses are recognized only when cash is received or payments are made.

Mainly used by small businesses.

Not an accurate picture of true profitability.

Cash Basis in not GAAP

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GA

AP

Accrual Basis Accounting

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Subject to the: Revenue Recognition Principle Matching Principle

Accrual AccountingAccrual Accounting

A system of accounting in which revenues and expenses are recorded as they are earned and incurred, not when cash is received or paid.

Provides a more accurate picture of a company’s profitability.

Cash-Basis AccountingVSAccrual basis AccountingExample: Bo Jovian Co. purchases inventory

in December of 2008 for $10,000 and sells the inventory in January of 2009 for $13,000. Bo Jovian has a December 31st year-end.

Compare net income for Bo Jovian for the two years under both accrual and cash basis accounting

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Cash versus Accrual-Basis Net Income

Cash Basis:Cash Basis: 20082008 20092009

RevenuesRevenues $ 0$ 0 $13,000$13,000

- Expenses- Expenses (10,000)(10,000) 00

= Net Income (loss)= Net Income (loss) (10,000)(10,000) $13,000$13,000

Accrual Basis:Accrual Basis: 20082008 20092009

RevenuesRevenues $ 0$ 0 $13,000$13,000

- Expenses- Expenses 00 (10,000)(10,000)

= Net Income (loss)= Net Income (loss) $ 0$ 0 $ 3,000$ 3,000

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Adjusting EntriesAdjusting entries are required at the end of each accounting period for accrual-basis accounting, prior to preparing the financial statements.

To bring balance sheet accounts current.

To reflect proper amounts of revenues and expenses on the Income Statement.

Adjusting Entries Tips

Each adjusting entry always involves at least

One Income Statement Account and

One Balance Sheet Account.

Each adjusting entry always involves at least

One Income Statement Account and

One Balance Sheet Account.

Adjusting entries never involve cash.

Common Adjusting Entries

Prepaid Expenses

Un-earned Revenues

Unrecorded Revenues

Unrecorded Expenses

Prepaid Expenses

Un-earned Revenues

Unrecorded Revenues

Unrecorded Expenses

Payments made in advance for items charged to expense, to show the partial using-up of an asset.

Amounts received before the actual earnings of revenues (the unearned revenues are liabilities).

Revenues earned but not yet recorded by period’s end.

Expenses incurred but not yet recorded by period’s end.

Payments made in advance for items charged to expense, to show the partial using-up of an asset.

Amounts received before the actual earnings of revenues (the unearned revenues are liabilities).

Revenues earned but not yet recorded by period’s end.

Expenses incurred but not yet recorded by period’s end.

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PREPAID EXPENSES Prepaid Expenses are characterized by a previous

transaction which must be adjusted because it is now the end of the period (time period assumption). The transaction is not yet complete at the end of the period. e.g. Shop supplies, Depreciation,

prepaid Rent, prepaid Advertisement, Insurance premium.

Example: Prepaid expenses expense.

Information: You are a tenant renting office space for $2,000 per month. On Jan 1st 2010, you prepay six months of rent or $12,000 to your landlord. The original entry may have been:

1/1/2010 Prepaid Rent 12,000

Cash 12,000

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Adjusting Entries (Prepayments) Suppose it is now Feb 28th 2010, two months later. The previous

entry must be adjusted. The adjusting entry would be:

Note: You had to refer back to the original entry to prepare the correct adjusting entry.

To adjust:

2/28/2010 Rent Expense 4,000

Prepaid Rent 4,000

Shop Supplies (Prepayments) Suppose on Dec,4 Shop supplies were purchased of

amount $4000. These supplies are expected to last for three or four months so it will be treated as Asset and recorded as:

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To adjust:

12/4 Shop Supplies 4,000

Cash 4,000

Shop Supplies

• Suppose during December amount $2000 supplies are consumed. The utilized shop supplies will be treated as expense and need adjustment.

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To adjust:

12/4 Supplies Expense 2,000

Shop Supplies 2,000

The allocation of the cost of a fixed assets to expense in the periods in which services are received from the

asset.

Cost of fixed assets

Balance SheetBalance Sheet

Assets: Plant and equipment

Assets: Plant and equipment

as the services are received

Depreciation

Depreciation Book Value Cost – Accumulated Depreciation Accumulated Depreciation

The sum of depreciation over a number of years is called acc.depreciation.

Causes of Depreciation Physical deterioration Obsolescence

Cost - Residual Value

Years of Useful Life Depreciation

Expense per Year=

Depreciation

On January 1, 2003, Bass Co. buys a new boat. Bass Co. pays $24,000 for the boat. The boat has an estimated residual value

of $3,000 and an estimated useful life of 5 years.

Compute depreciation for 2003 using the straight-line method.

Depreciation

Bass Co. will record $4,200 depreciation each year for five years. Total depreciation over the estimated useful life of the

boat is:

Salvage ValueSalvage Value

Depreciation

Adjusting Entries – “Unearned Revenues”Adjusting Entries – “Unearned Revenues”

Receipt of cash that is recorded as a liability because the revenue has not been earned.

Rent

Airline tickets

School tuition fee

Cash ReceiptCash Receipt Revenue EarnedRevenue EarnedBEFOREBEFORE

Advertisement

Unearned revenues often occur in regard to:

Example:Example: On Nov. 1On Nov. 1stst, Phoenix Corp. received $24,000 from , Phoenix Corp. received $24,000 from Arcadia High School for 3 months rent in advance. Show the Arcadia High School for 3 months rent in advance. Show the journal entry to record the receipt on Nov. 1journal entry to record the receipt on Nov. 1stst. .

Unearned rent revenue 24,000

Cash 24,000Nov. 1

Debit Credit

Cash

24,00024,000 24,00024,000

Debit Credit

Unearned Rent Revenue

Adjusting Entries – “Unearned Revenues”

Example: On Nov. 1st, Phoenix Corp. received $24,000 from Arcadia High School for 3 months rent in advance. Show the adjusting journal entry required on Nov. 30th.

Rent revenue 8,000

Unearned rent revenue 8,000Nov. 30

Debit Credit

Rent Revenue

8,0008,000 24,00024,000

Debit Credit

Unearned Rent Revenue

Adjusting Entries – “Unearned Revenues”Adjusting Entries – “Unearned Revenues”

8,0008,000

16,00016,000

Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”

Revenues earned but not yet received in cash or recorded.

Rent

Interest

Services performed

BEFORE

Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:

Example: On January 1st, Phoenix Corp. deposited $100,000 in a bank that return 12% interest per year. Show the journal entry to record the deposit on January 1st.

Cash 100,000

Investments 100,000January 1

Debit Credit

Investments

100,000100,000 100,000100,000

Debit Credit

Cash

Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”

Example: On January 1st, Phoenix Corp. deposited $100,000 in a bank that return 12% interest per year. Show the adjusting journal entry required on January 31st.

Interest revenue 1,000

Interest receivable 1,000January 31

Debit Credit

Interest Receivable

1,0001,000 1,0001,000

Debit Credit

Interest Revenue

Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”Adjusting Entries – “Accrued Revenues”

Adjusting Entries – “Accrued Expenses”Adjusting Entries – “Accrued Expenses”Adjusting Entries – “Accrued Expenses”Adjusting Entries – “Accrued Expenses”

Expenses incurred but not yet paid in cash or recorded.

Rent

Taxes

BEFORE

Accrued expenses often occur in regard to:

Cash Payment Cash PaymentExpense RecordedExpense Recorded

Salaries

Interest

Adjusting entry results in:Adjusting entry results in:

Notes payableNotes payable 200,000

Cash 200,000Feb. 2

Debit Credit

Cash

200,000200,000 200,000200,000

Debit Credit

Notes Payable

Adjusting Entries – “Accrued Expenses”Adjusting Entries – “Accrued Expenses”

Example:Example: On Feb. 2On Feb. 2ndnd, Phoenix Corp. borrowed $200,000 at a rate , Phoenix Corp. borrowed $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the of 9% per year. Interest is due on first of each month. Show the journal entry to record the borrowing on Feb. 2journal entry to record the borrowing on Feb. 2ndnd..

Example:Example: On Feb. 2On Feb. 2ndnd, Phoenix Corp. borrowed $200,000 at a rate , Phoenix Corp. borrowed $200,000 at a rate of 9% per year. Interest is due on first of each month. Show the of 9% per year. Interest is due on first of each month. Show the adjusting journal entryadjusting journal entry required on Feb. 28required on Feb. 28thth..

Interest payable 1,500

Interest expense 1,500Feb. 28

Debit Credit

Interest Expense

1,5001,500 1,5001,500

Debit Credit

Interest Payable

Adjusting Entries – “Accrued Expenses”Adjusting Entries – “Accrued Expenses”

1. Naqeeb paid rent $ 60,000 for 6 months of a buliding on

November 1,2010.He is preparing financial statements on 31st December, prepare adjusting entries.

2. Salman received 20,000 on 31st September 2006 in advance for 4 months as advertisemnent charges, he is maintaining his books of accounts on 31st December. Record adjusting entries for salman.

3. Saleem purchased a building on $50,000. its useful life is 12 years and residual value is $ 2000.Pass the original and adjusting entry at the end of 1st year.

4. You have purchased shop supplies of $15000. At the end of period you have $6000 shop supplies,pass the necessary journal entries.

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