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CHAPTER 4 Accrual Accounting Concepts Time Period Assumption Divides the economic life of a business into artificial time periods – Interim period (month, quarter) – Year (fiscal, calendar) WHY? – To provide immediate feedback on how the business is doing 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 – Most sales happen immediately, pay for the item and leave, sometimes others will pay in advance or after the job, when it is paid is not relevant to determine revenue. Matching Principle Requires that expenses be recorded in the same period in which the revenues they helped produce are recorded Cash Basis Revenue is recorded only when cash is received Expense is recorded only when cash is paid Accrual Basis Accounting Adheres to the time period assumption, revenue recognition and matching principles Revenue is recorded when earned, rather than when cash is received Expense recorded when incurred, rather than when cash is paid Accrual accounting records events when the economic event occurs Adjusting Entries Adjusting entries are made to adjust or update accounts at the end of the accounting period Adjusting entries can be categorized as – Prepayments – Accruals Types of Adjusting Entries – Prepayments Prepaid expenses Unearned revenues – Accruals Accrued revenues Accrued expenses Prepayments Cash has been spent but the item acquired has not been used or consumed (prepaid expenses) Cash has been collected but the revenue has not been earned (unearned revenues) Supplies On January 5 the company paid $2,500 for advertising supplies. Advertising Advertising Supplies Cash Supplies Expense Jan. 5 2,500 Jan. 5 2,500 GENERAL JOURNAL Debit Credit Jan. 5 Advertising Supplies 2,500 Cash 2,500 Purchased advertising supplies Supplies An inventory on January 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. ($2,500 - $1,000) =$ 1,500 Advertising Advertising Cash Supplies Supplies Expense Jan. 5 2,500 Jan. 5 2,500 Jan. 31 1,500 Jan. 31 1,500 Bal. 1,000 GENERAL JOURNAL Debit Credit Jan. 5 Advertising Supplies Expense 1,500 Advertising Supplies 1,500 To record advertising supplies consumed Prepaid Expenses On February 4 the company paid $600 for a 1-year insurance policy; coverage began February 1. Prepaid Insurance Cash Insurance Expense Feb. 4 600 Feb. 4 600 GENERAL JOURNAL Debit Credit Feb. 4 Prepaid Insurance 600 Cash 600 Purchased one-year policy effective February 1 Prepaid Expenses On February 28, $50 ($600/12 months) of the insurance had been used or had expired. Prepaid Insurance Cash Insurance Expense Feb. 4 600 Feb. 4 600 Feb. 28 50 Feb. 28 50 GENERAL JOURNAL Debit Credit Feb. 28 Insurance Expense 50 Prepaid Insurance 50 Record insurance expense for the month Amortization How do you apply the matching principle to the cost of a long- lived asset? Amortization Allocate the cost of an asset to expense over its useful life Amortization is an allocation concept, not a valuation concept Note: This is not an attempt to reflect the actual change in value of an asset. Amortization Example Assume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 years Straight-line amortization calculation is: Cost - Salvage value = $5,000 - $200 = $480/yr Useful Life 10 OR $40/mo Amortization Example Accumulated Amortization-Office Amortization Office Equipment Equipment Expense Mar. 2 5,000 Mar. 31 40 Mar. 31 40 GENERAL JOURNAL Debit Credit Mar. 31 Amortization Expense 40 Accumulated Amortization – 40 Office Equipment To record monthly amortization Accumulated Amortization is a contra asset account – an offset (deduction) against the asset account. Balance Sheet Presentation Office equipment $5,000 Less: Accumulated 40 amortization Net book value 4,960 Net book value Unearned Revenues Received on August 2 $1,200 for advertising services expected to be completed by December 31. Unearned Service Service Cash Revenue Revenue Aug. 2 1,200 Aug. 2 1,200 GENERAL JOURNAL Debit Credit Aug. 2 Cash 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by December 31 Unearned Revenues During August, $400 of the revenue was earned. Unearned Service Service Cash Revenue Revenue Aug. 2 1,200 Aug. 31 400 Aug. 2 1,200 Aug. 31 400 Bal. 800 GENERAL JOURNAL Debit Credit Aug. 31 Unearned Service Revenue 400 Service Revenue 400 To record revenue earned Accruals Revenue has been earned, but not collected (accrued revenues) Expenses were incurred, but not yet paid (accrued expenses) Note: Entry has not yet been recorded! Accrued Revenues Revenues earned but not yet received in cash or recorded at the end of period – Happens when you finish the work that earns the revenue, but either you have not yet billed or have not yet received payment Accrued Revenues Earned $200 for advertising services to clients in October, but they were not billed until after October 31. Accounts Service Receivable Revenue Oct. 31 200 Oct. 31 200 GENERAL JOURNAL Debit Credit Oct . 31 Accounts Receivable 200 Service Revenue 200 Accrued Expenses Expenses incurred but not yet paid or recorded at the end of period – Lots of times this will include accounting fees, Hydro, Interest, Wages, etc. Accrued Interest Expense Interest expense is the cost a company incurs to use money. Information needed to calculate interest expense: • Face value of note • Interest rate (always expressed in annual rate) • The length of time note is outstanding Accrued Interest Expense Formula for Calculating Interest Face Value Annual Time of Note Interest in Terms of Interest Rate One Year $ 5,000 X 12% X 1/2 = $50 Accrued Interest Expense Interest Expense Interest Payable Oct. 31 50 Oct. 31 200 GENERAL JOURNAL Debit Credit Oct. 31 Interest Expense 50 Interest Payable 50 Accrue interest expense for the month Accrued Salaries Expense Assume that the employees receive total salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day. Salaries were last paid on October 26 and the next payment of salaries will be November 9. As shown on the calendar on the following slide there are three unpaid work days remain as of October 31. Accrued Salaries Expense (Salaries paid after the service has been performed) Accrued Salaries Expense Salaries Expense Salaries Payable Oct. 31 1,200 Oct. 31 1,200 GENERAL JOURNAL Debit Credit Oct. 31 Salaries Expense 1,200 Salaries Payable 1,200 Accrue salary expense for the month Adjusted Trial Balance Adjusted trial balance proves the equity of total debit balances and total credit balances after the adjusting entries have been made Financial statements can be easily prepared from the adjusted trial balance Closing the Books Closing entries – Transfer the temporary account balances to update the retained earnings account – Reduce the balances in the temporary accounts to zero to prepare for the next period’s postings Illustration 4-17 Temporary Permanent All revenue accounts All asset accounts All expense accounts All liability accounts Shareholders’ equity Dividends account accounts Individual Expenses Individual Revenues 2 Income Summary 1 3 Retained Earnings is a permanent Retained Earnings account; the others shown here are temporary 4 Dividends Required Steps in the Accounting Cycle • Analyse business transactions • Journalize the transactions • Post to general ledger accounts • Prepare a trial balance • Journalize and post adjusting entries (prepayments and accruals) Required Steps in the Accounting Cycle • Prepare an adjusted trial balance • Prepare financial statements • Journalize and post closing entries • Prepare a post-closing trial balance Questions? As back track, if you would like to Do a cash flow statement try question P1-6A Will take up next week.
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