Chapter 4 Accrual Accounting Concepts

1. Chapter 4Accrual Accounting Concepts • Explain the revenue recognition principle and the matching principle. • Differentiate between the cash basis and the accrual basis of accounting. • Explain why adjusting entries are needed and identify the major types of adjusting entries. • Prepare adjusting entries for prepayments.

2. Chapter 4Accrual Accounting Concepts Prepare adjusting entries for accruals. • Describe the nature and purpose of the adjusted trial balance. • Explain the purpose of closing entries. • Describe the required steps in the accounting cycle.

3. 11 1 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.

4. Time Period Assumption... • Generally a month, a quarter, or a year. An accounting time period that is one year long is called a fiscal year. An accounting time period that starts on January 1 and ends December 31 is called a calendar year.

5. 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.

6. Matching Principle... Requires that expensesbe recorded in the same period in which the revenues they helped produce are recorded.

8. Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? • Cost Principle. • Matching Principle • Periodicity Principle • Revenue Recognition Principle

9. Review Which principle dictates that efforts (expenses) be recorded with accomplishments (revenues)? • Cost Principle. • Matching Principle • Periodicity Principle • Revenue Recognition Principle

10. Review When would revenue be recorded for the following scenario . . . Ad agency is hired for a project in May, does the work in June and is paid in July? June

11. Review When would expenses be recorded for this companion scenario ? The Ad agency on this project incurs $1,500 of expenses in May, $3,000 in June, and none in July? The answer is June! Matching says the expenses should follow the revenue.

12. Review When would revenue be recorded for the following scenario . . . Sell plane ticket on September 1 for a flight on October 15? The answer is October – when the service is provided!

13. Review When would expenses be recorded for the following scenario . . . The airline pays pilot salaries on October 7th for the week ended September 30th? The answer is September – the pilots provided labor services for September flights during that month.

14. 11 2 GAAP Cash Basis Revenue recorded only when cash is received. Expense recorded only when cash is paid.

15. Accrual Basis Accounting • Adheres to the: • Revenue Recognition Principle Revenue recorded only when earned, not when cash is received • Matching Principle Expense recorded only when incurred, not when cash paid

16. Accrual Basis adheres to... • Generally • Accepted • Accounting • Principles

18. Types of Adjusting Entries • 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.

19. Prepayments • PREPAID EXPENSES - Costs that expire either with the passage of time or through use. • UNEARNED REVENUES- money has been received before the goods or services are provided.

20. You can start with the trial balance to find information to adjust prepayments.

21. Sierra Corporation Trial Balance October 31, 2007 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

22. Prepaid Expenses Amount equals cost of goods or services used up or expired If not adjusted, expenses would be understated and assets overstated

23. Supplies On October 5 the company paid $2,500 for advertising supplies. Advertising Supplies Expense Advertising Supplies Cash Oct 5 2,500 Oct 5 2,500 GENERAL JOURNAL Debit Credit Oct 5 Supplies 2,500 Cash 2,500 Purchased advertising supplies

24. Oct 31 1,500 Oct 31 1,500 Bal. 1,000 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 Advertising Supplies Expense Advertising Supplies Cash Oct 5 2,500 Oct 5 2,500 GENERAL JOURNAL Debit Credit Oct 5 Supplies Expense 1,500 Supplies 1,500 To record advertising supplies consumed

25. Supplies Expense Oct $1,500 Nov $1,800 Dec $1,410 Jan $1,425 Feb $1,601 Mar $1,435 Apr $1,510 May $1,592 June $1,652 July $1,621 Aug $1,427 Sept $1,555 Supplies expense is based on usage... so different amounts appear each month

26. Insurance Expense Prepaid Insurance Cash Oct 1 600 Oct 1 600 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

27. Insurance Policy 1 Year $ 600 Oct $50 Nov $50 Dec $50 Jan $50 Feb $50 Mar $50 Apr $50 May $50 June $50 July $50 Aug $50 Sept $50

28. Oct 31 50 Oct 31 50 550 Prepaid Expenses On October 31st, $50 ($600/12 months) of the insurance was used-up or expired. Insurance Expense Prepaid Insurance Cash Oct 1 600 Oct 1 600 GENERAL JOURNAL Debit Credit Oct 31 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month

29. Depreciation How do you apply the Matching Principle to the cost of a long lived asset ?

30. Depreciation Allocates the cost of an asset to expense over its useful life – MATCHING PRINCIPLE Is an estimate Depreciation is ALLOCATION of cost- not VALUATION(Current Replacement Cost) We’re not attempting to reflect the actual change in value of an asset!

31. Office Equipment Depreciation= $480/year Oct $40 Nov $40 Dec $40 Jan $40 Feb $40 Mar $40 Apr $40 May $40 June $40 July $40 Aug $40 Sept $40

32. Oct 2 5,000 Oct 31 40 Oct 31 40 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.

33. Book Value or Carrying Value Balance Sheet Presentation Office equipment $ 5,000 Less : accumulated depreciation 40 $4,960

34. 11 5 Unearned Service Revenue Service Revenue Cash Oct 2 1,200 Oct 2 1,200 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.

35. Oct. 31 400 Oct. 31 400 Oct 2 1,200 Oct 2 1,200 Bal 800 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