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Chapter 3

Chapter 3. Adjusting the Accounts. Objectives of the Chapter. I. Introduce the accrual accounting concept. II. Introduce the adjusting entries. I. Accrual Accounting. 1. The time-period concept, the revenue recognition and the matching principles. 2. Accrual versus cash basis accounting.

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Chapter 3

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  1. Chapter 3 Adjusting the Accounts

  2. Objectives of the Chapter I. Introduce the accrual accounting concept. II. Introduce the adjusting entries. Accrual Accounting and the Financial Statements

  3. 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

  4. 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

  5. Revenue Recognition Principle (SFAS No. 5) (-An 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

  6. 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), periodcosts, (i.e., interest and rent expenses) and estimated/allocation expenses (i.e., depreciation expense and bad debt expense). Accrual Accounting and the Financial Statements

  7. Accrual vs. Cash Basis Accounting • Accrual-basis accounting: Revenues are recognized based on revenue recognition principle (i.e., recognized when realized and earned regardless whether cash is collected or not). Expenses are recognized based on matching principle. Note: revenue and expense recognize before cash settlement. Accrual Accounting and the Financial Statements

  8. Accrual vs. Cash Basis Accounting (contd.) • Cash-basis accounting: The accountant does not record a transaction until cash is received or paid. Cash-basis accounting is NOT acceptable for financial reporting. 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 occurred but not yet recorded). a. Accrued expenses. b. Accrued revenues. Accrual Accounting and the Financial Statements

  13. a. Accrued Expenses- An Example • A one-year note payable was issued on 11/1/x1 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/x2 and 11/1/x2. 11/1/x1 Equipment 2,400 Note Payable 2,400 Adjusting Entry: 12/31/x1 Interest Expense 40 Interest payable 40 Accrual Accounting and the Financial Statements

  14. 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/x1. Interests are received on 3/1/x2 and 9/1/x2. 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

  15. B. Deferrals • Postponing the recognition of Revenues or expenses a. Unearned revenues b. Prepaid expenses Accrual Accounting and the Financial Statements

  16. a. Unearned Revenues • Receiving $2,400 for a one-year advanced rent payment from a tenant on 12/1/x1 (I/S Approach) 12/1/x1 Cash 2,400 Rent Revenue 2,400 12/30/x1 Rent Revenue 2,200 Rent Unearned 2,200 (B/S Approach) 12/1/x1 Cash 2,400 Unearned Rent 2,400 12/30/x1 Unearned Rent 200 Rent Revenue 200 Accrual Accounting and the Financial Statements

  17. b. Prepaid Expense • Prepaid a 12 month insurance premium of $1,200 on 11/1/x1 (I/S Approach) Insurance Exp. 1,200 Cash 1,200 12/31/x1 Prepaid Insur. 1,000 Insurance Exp. 1,000 (B/S Approach) Prepaid Insur. 1,200 Cash 1,200 12/31/x1 Insurance Exp. 200 Prepaid Insurance 200 Accrual Accounting and the Financial Statements

  18. C. Estimated Expenses (based on the matching principle) Depreciation Expense 12/31 Depreciation Expense XXX Accumulated Depreciation XXX Bad Debt Expense 12/31 Bad Debt Expense XXX Allowance for B/D XXX Income Tax Expense 12/31 Income Tax Expense XXX Income Tax Payable XXX Accrual Accounting and the Financial Statements

  19. Example (from Financial Accounting by Harrison and Horngren): Information for Adjustments at 4/30/ 19x1 (a) Prepaid rent expired, $1,000. (b) Supplies on hand, $400 (balance of supplies equals $700 before adjustment). (c) Depreciation on furniture, $275. (d) Accrued salary expense, $950. (e) Accrued service revenue, $250. (f) Amount of unearned service revenue that has been earned, $150. (g) Accrued income tax expense, $540. Accrual Accounting and the Financial Statements 19

  20. Adjusting Entries (a) Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense. (b) Supplies Expense 300 Supplies 300 To record supplies used. (c) Depreciation Exp. - Furniture 275 Accumulated Depr. - Furniture 275 To record depreciation on furniture. (d) Salary Expense 950 Salary Payable 950 To accrue salary expense. Accrual Accounting and the Financial Statements 20

  21. Exhibit 3-9 Panel B (contd.) (e) Accounts Receivable 250 Service Revenue 250 To accrue service revenue. (f) Unearned Service Revenue 150 Service Revenue 150 To record unearned revenue that has been earned. (g) Income Tax Expense 540 Income Tax Payable 540 To accrue income tax expense. Accrual Accounting and the Financial Statements 21

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