Chapter 4-1homepage.westmont.edu/charmon/Westmont/003slides4.pdf · 2010-01-26 · Chapter 4-5 The...

Chapter 4-1

Chapter 4-2

Accrual Accounting Concepts

Financial Accounting, Fifth Edition

Chapter 4-3

1. Explain the revenue recognition principle and the matching principle.

2. Differentiate between the cash basis and the accrual basis of accounting.

3. Explain why adjusting entries are needed, and identify the majortypes of adjusting entries.

4. Prepare adjusting entries for deferrals.5. Prepare adjusting entries for accruals.6. Describe the nature and purpose of the adjusted trial balance.7. Explain the purpose of closing entries.8. Describe the required steps in the accounting cycle.9. Understand the causes of differences between net income and

cash provided by operating activities.

Study ObjectivesStudy ObjectivesStudy Objectives

Chapter 4-4

Generally a month, a quarter, or a year.Fiscal year vs. calendar year

Timing IssuesTiming IssuesTiming Issues

Accountants divide the economic life of a business into artificial time periods (Time Period Assumption).

SO 1 Explain the revenue recognition principle and the matchingSO 1 Explain the revenue recognition principle and the matching principle.principle.

Jan. Feb. Mar. Apr. Dec.. . . . .

Chapter 4-5

The time period assumption states that:The time period assumption states that:a.a. revenue should be recognized in the accounting

period in which it is earned.

b. expenses should be matched with revenues.

c. the economic life of a business can be divided into artificial time periods.

d. the fiscal year should correspond with the calendar year.

Review QuestionReview Question



Chapter 4-6


Revenue Recognition PrincipleCompanies recognize revenue in the accounting period in which it is earned.

In a service enterprise, revenue is considered to be earned at the time the service is performed.


Chapter 4-7


Illustration: Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim and pay for their clothes until the first week of July.The journal entries for June and July would be:


Chapter 4-8


“Let the expenses follow the revenues.”


Chapter 4-9

Accrual-Basis AccountingTransactions recorded in the periods in which the events occur

Revenues are recognized when earned, rather than when cash is received.

Expenses are recognized when incurred, rather than when paid.


Accrual- vs. Cash-Basis Accounting

SO 2 Differentiate between the cash basis and SO 2 Differentiate between the cash basis and the accrual basis of accounting.the accrual basis of accounting.

Chapter 4-10

Cash-Basis AccountingRevenues are recognized when cash is received.

Expenses are recognized when cash is paid.

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).


Accrual- vs. Cash-Basis Accounting


Chapter 4-11


Illustration: Suppose that Fresh Colors paints a large building in 2009. In 2009 it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2010.


Illustration 4-2

Chapter 4-12

One of the following statements about the accrual basis of accounting is false. That statement is:

a. Events that change a company’s financial statements are recorded in the periods in which the events occur.

b. Revenue is recognized in the period in which it is earned.

c. The accrual basis of accounting is in accord with generally accepted accounting principles.

d. Revenue is recorded only when cash is received, and expenses are recorded only when cash is paid.




Chapter 4-13

Chapter 4-14

Adjusting entries

make it possible to report correct amounts on the balance sheet and on the income statement.

made every time financial statements are prepared.

include one income statement account and one balance sheet account.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries

SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries

Chapter 4-15

Revenues - recorded in the period in which they are earned.

Expenses - recognized in the period in which they are incurred.

Adjusting entries - needed to ensure that the revenue recognition and matching principles are followed.



Chapter 4-16

Adjusting entries are made to ensure that:a. expenses are recognized in the period in which

they are incurred.b. revenues are recorded in the period in which

they are earned.c. balance sheet and income statement accounts

have correct balances at the end of an accounting period.

d. all of the above.




Chapter 4-17

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

1. Prepaid Expenses.Expenses paid in cash and recorded as assets before they are used or consumed.

Deferrals3. Accrued Revenues.

Revenues earned but not yet received in cash or recorded.

4. Accrued Expenses.Expenses incurred but not yet paid in cash or recorded.

2. Unearned Revenues.Cash received and recorded as liabilities before revenue is earned.

Accruals

Illustration 4-3Categories of adjusting entries


Chapter 4-18

Trial BalanceTrial Balance –Each account is analyzed to determine whether it is complete and up-to-date.

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries


Illustration 4-4

Chapter 4-19

Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

Adjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for Deferrals

SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.

Chapter 4-20

Payment of cash, that is recorded as an asset because Payment of cash, that is recorded as an asset because service or benefit will be received in the future.service or benefit will be received in the future.

Adjusting Entries for “Prepaid Expenses”Adjusting Entries for Adjusting Entries for ““Prepaid ExpensesPrepaid Expenses””

insuranceinsurancesuppliessuppliesadvertisingadvertising

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE

rentrentmaintenance on equipmentmaintenance on equipmentfixed assets (depreciation)fixed assets (depreciation)

Prepayments often occur in regard to:Prepayments often occur in regard to:


Chapter 4-21


Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.


Illustration 4-5

Chapter 4-22

Illustration: Sierra Corporation purchased advertising suppliescosting $2,500 on October 5. Sierra recorded the payment by increasing (debiting) the asset Advertising Supplies. This account shows a balance of $2,500 in the October 31 trial balance. An inventory count at the close of business on October 31 reveals that $1,000 of supplies are still on hand.

Oct. 31



Illustration 4-6

($2,500 – 1,000 = $1,500)

Chapter 4-23

Illustration: On October 4 Sierra Corporation paid $600 for a one-year fire insurance policy. Coverage began on October 1. Sierra recorded the payment by increasing (debiting) Prepaid Insurance. This account shows a balance of $600 in theOctober 31 trial balance. Insurance of $50 ($600 / 12) expires each month.

Oct. 31



Illustration 4-7

Chapter 4-24

Depreciation

Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.

Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life (Matching Principle).


Chapter 4-25

Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.

Oct. 31



Illustration 4-8

Chapter 4-26

Depreciation (Statement Presentation)Accumulated Depreciation is a contra asset account.

Appears just after the account it offsets (Equipment) on the balance sheet.



Illustration 4-9

Chapter 4-27



SummaryIllustration 4-10

Chapter 4-28

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

Adjusting Entries for “Unearned Revenues”Adjusting Entries for Adjusting Entries for ““Unearned RevenuesUnearned Revenues””

rentrentairline ticketsairline ticketsschool tuitionschool tuition

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptionsmagazine subscriptionscustomer depositscustomer deposits

Unearned revenues often occur in regard to:Unearned revenues often occur in regard to:


Chapter 4-29 SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.


Illustration 4-11



Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for advertising services expected to be completed by December 31. Unearned Service Revenue shows a balanceof $1,200 in the October 31 trial balance. From an evaluation of the work Sierra performed for Knox during October, the company determines that it has earned $400 in October.

Oct. 31

Illustration 4-12


Summary


Illustration 4-13

Chapter 4-32

Chapter 4-33

Made to record:

Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been recognized through daily entries.

Adjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for Accruals

SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.

Chapter 4-34

Revenues earned but not yet received in cash or Revenues earned but not yet received in cash or recorded.recorded.

Adjusting Entries for “Accrued Revenues”Adjusting Entries for Adjusting Entries for ““Accrued RevenuesAccrued Revenues””

rentrentinterestinterestservices performedservices performed

BEFORE

Accrued revenues often occur in regard to:Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:Adjusting entry results in:


Chapter 4-35

Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 4-14

Chapter 4-36

Illustration: In October Sierra Corporation earned $200 for advertising services that were not billed to clients before October 31.

Oct. 31



Illustration 4-15

Chapter 4-37




Chapter 4-38

Expenses incurred but not yet paid in cash or Expenses incurred but not yet paid in cash or recorded.recorded.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for Adjusting Entries for ““Accrued ExpensesAccrued Expenses””

rentrentinterestinterest

BEFORE

Accrued expenses often occur in regard to:Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxestaxessalariessalaries

Adjusting entry results in:Adjusting entry results in:


Chapter 4-39

Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 4-17

Chapter 4-40



Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%.

Oct. 31

Illustration 4-19

Illustration 4-18

Chapter 4-41



Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days).

Oct. 31

Illustration 4-21

Chapter 4-42




Chapter 4-43

Adjusted Trial Balance

Prepared after all adjusting entries are journalized and posted.

Purpose is to prove the equality of debit balances and credit balances in the ledger.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

SO 6 Describe the nature and purpose of the adjusted trial balaSO 6 Describe the nature and purpose of the adjusted trial balance.nce.

Chapter 4-44


Chapter 4-45

Which of the following statements is incorrect concerning the adjusted trial balance?

a. An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.

b. The adjusted trial balance provides the primary basis for the preparation of financial statements.

c. The adjusted trial balance lists the account balances segregated by assets and liabilities.

d. The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.




Chapter 4-46

Financial Statements are prepared directly from the Adjusted Trial Balance.

Financial Statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statement

Retained Earnings

Statement

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements


Chapter 4-47

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

Chapter 4-48

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsIllustration 4-28

Chapter 4-49

At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account—Retained Earnings.

Closing the BooksClosing the BooksClosing the Books

SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.

Illustration 4-29

Chapter 4-50

In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.



Illustration 4-30

Chapter 4-51


Illustration 4-31

Chapter 4-52


SO 7 Explain the purpose SO 7 Explain the purpose of closing entries.of closing entries.

Chapter 4-53

The purpose of this trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period.

Preparing a Post-Closing Trial BalancePreparing a PostPreparing a Post--Closing Trial BalanceClosing Trial Balance

All temporary accounts will have zero balances.


Chapter 4-54

Summary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting Cycle

1. Analyze business transactions1. Analyze business transactions

2. Journalize the transactions

2. Journalize the transactions

6. Prepare an adjusted trial balance

6. Prepare an adjusted trial balance

7. Prepare financial statements

7. Prepare financial statements

8. Journalize and post closing entries

8. Journalize and post closing entries

9. Prepare a post-closing trial balance

9. Prepare a post-closing trial balance

4. Prepare a trial balance4. Prepare a trial balance

3. Post to ledger accounts3. Post to ledger accounts

5. Journalize and post adjusting entries

5. Journalize and post adjusting entries

SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.

Chapter 4-55

Quality of Earnings – company provides full and transparent information.

Earnings Management - the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. Companies may manage earnings by:

Quality of EarningsQuality of EarningsQuality of Earnings

SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.

one-time items to prop up earnings numbers.inflate revenue numbers in the short-runimproper adjusting entries

As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.

Chapter 4-56

Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.

Keep an Eye on CashKeep an Eye on CashKeep an Eye on Cash

SO 9 SO 9 Understand the causes of differences between net Understand the causes of differences between net income and cash provided by operating activities.income and cash provided by operating activities.

Net income on a cash basis is referred to as “Net cash provided by operating activities.”

The statement of cash flows, reports net cash provided by operating activities.

Chapter 4-57

Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.

Keep an Eye on CashKeep an Eye on CashKeep an Eye on Cash

Chapter 4-58

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