accrual accounting concepts chapter 4. time period assumption divides the economic life of a...

Accrual Accounting Concepts

CHAPTER

4

Time Period AssumptionTime Period Assumption

• Divides the economic life of a business into Divides the economic life of a business into artificial time periodsartificial time periods– Interim period (month, quarter)Interim period (month, quarter)

– Year (fiscal, calendar)Year (fiscal, calendar)

• WHY?WHY?– To provide immediate feedback on how the To provide immediate feedback on how the

business is doingbusiness is doing

Revenue Recognition PrincipleRevenue Recognition Principle

• Dictates that Dictates that revenue be recognized in the revenue be recognized in the accounting period in which it is earnedaccounting period in which it is earned

• Revenue is considered earned when the Revenue is considered earned when the service has been provided or when the goods service has been provided or when the goods are deliveredare delivered

Matching PrincipleMatching Principle

• Requires that Requires that expensesexpenses be recorded in the be recorded in the same period in which the same period in which the revenuesrevenues they they helped produce are recordedhelped produce are recorded

Cash BasisCash Basis

• Revenue is recorded only when cash is Revenue is recorded only when cash is receivedreceived

• Expense is recorded only when cash is Expense is recorded only when cash is paidpaid

Accrual Basis AccountingAccrual Basis Accounting

• Adheres to the time period assumption and Adheres to the time period assumption and revenue recognition and matching principlesrevenue recognition and matching principles

• Revenue is recorded when Revenue is recorded when earnedearned, , rather than when cash is receivedrather than when cash is received

• Expense recorded when Expense recorded when incurredincurred, , rather than when cash is paidrather than when cash is paid

• Accrual accounting records events when the Accrual accounting records events when the economic event occurseconomic event occurs

GAAP

Adjusting EntriesAdjusting Entries

• Adjusting entries are made to adjust or Adjusting entries are made to adjust or update accounts at the end of the accounting update accounts at the end of the accounting periodperiod

• Adjusting entries can be categorized asAdjusting entries can be categorized as– PrepaymentsPrepayments

– AccrualsAccruals

Types of Adjusting EntriesTypes of Adjusting Entries

– PrepaymentsPrepayments• Prepaid expensesPrepaid expenses

• Unearned revenuesUnearned revenues

– AccrualsAccruals• Accrued revenuesAccrued revenues

• Accrued expensesAccrued expenses

• Cash has been spent but the item acquired has Cash has been spent but the item acquired has not been used or consumed (not been used or consumed (prepaid expensesprepaid expenses))

• Cash has been collected but the revenue has Cash has been collected but the revenue has not been earned (not been earned (unearned revenuesunearned revenues))

PrepaymentsPrepayments

On January 5 the company paid $2,500 for On January 5 the company paid $2,500 for advertising supplies.advertising supplies.

GENERAL JOURNALGENERAL JOURNAL DebitDebit CreditCredit

Jan. 5 Advertising SuppliesJan. 5 Advertising Supplies 2,500 2,500 Cash Cash 2,5002,500

Purchased advertising suppliesPurchased advertising supplies

Advertising Advertising SuppliesSuppliesCashCash

Jan. 5 2,500Jan. 5 2,500

Advertising Supplies Advertising Supplies ExpenseExpense

SuppliesSupplies

Jan. 5 2,500Jan. 5 2,500

An inventory on January 31 reveals that $1,000 of supplies An inventory on January 31 reveals that $1,000 of supplies remain on hand; therefore, $1,500 of supplies had been used. remain on hand; therefore, $1,500 of supplies had been used. ($2,500 - $1,000) =$ 1,500($2,500 - $1,000) =$ 1,500


Jan. 5 Advertising Supplies ExpenseJan. 5 Advertising Supplies Expense 1,500 1,500 Advertising Supplies Advertising Supplies 1,500 1,500

To record advertising supplies consumedTo record advertising supplies consumed

Advertising Advertising SuppliesSuppliesCashCash

Jan. 5 2,500Jan. 5 2,500

Advertising Advertising Supplies ExpenseSupplies Expense

SuppliesSupplies

Jan. 5 2,500Jan. 5 2,500 Jan. 31 1,500Jan. 31 1,500 Jan. 31 1,500Jan. 31 1,500

Bal. 1,000Bal. 1,000

Prepaid ExpensesPrepaid Expenses

On February 4 the company paid $600 for a 1-year insurance On February 4 the company paid $600 for a 1-year insurance policy; coverage began February 1.policy; coverage began February 1.

GENERAL JOURNALGENERAL JOURNAL Debit Debit CreditCredit

Feb. 4 Prepaid Insurance 600 Feb. 4 Prepaid Insurance 600 Cash 600 Cash 600

Purchased one-year policy effective February 1Purchased one-year policy effective February 1

Prepaid Prepaid InsuranceInsuranceCashCash

Insurance Insurance ExpenseExpense

Feb. 4 600Feb. 4 600 Feb. 4 600Feb. 4 600

Prepaid ExpensesPrepaid Expenses

On February 28, $50 ($600/12 months) of the insurance On February 28, $50 ($600/12 months) of the insurance had been used or had expired.had been used or had expired.


Feb. 28 Insurance Expense Feb. 28 Insurance Expense 5050 Prepaid Insurance 50 Prepaid Insurance 50 Record insurance expense for the month Record insurance expense for the month

Prepaid Prepaid InsuranceInsuranceCashCash

Insurance Insurance ExpenseExpense

Feb. 4 600Feb. 4 600 Feb. 4 600Feb. 4 600 Feb. 28 50Feb. 28 50 Feb. 28 50Feb. 28 50

AmortizationAmortization

• How do you apply How do you apply the the matching matching principleprinciple to the cost to the cost of a long-lived of a long-lived asset? asset?

AmortizationAmortization

• Allocate the cost of an asset to expense over Allocate the cost of an asset to expense over its useful lifeits useful life

• Amortization is an Amortization is an allocation conceptallocation concept, not a , not a valuation conceptvaluation concept

Note: This is not an attempt to reflect the actual Note: This is not an attempt to reflect the actual change in value of an asset.change in value of an asset.

Amortization ExampleAmortization Example

• Assume a piece of equipment was purchased Assume a piece of equipment was purchased on March 2 for $5,000. Its salvage value is on March 2 for $5,000. Its salvage value is $200 and its useful life is 10 years$200 and its useful life is 10 years

• Straight-line amortization calculation is:Straight-line amortization calculation is:

Cost - Salvage valueCost - Salvage value = $ = $5,000 - $2005,000 - $200 = = $480/yr$480/yr Useful Life Useful Life 10 10

OR OR$40/mo$40/mo


Mar. 31 Amortization Expense 40 Mar. 31 Amortization Expense 40 Accumulated Amortization – 40 Accumulated Amortization – 40

Office Equipment Office Equipment To record monthly amortization To record monthly amortization

Accumulated Amortization is aAccumulated Amortization is a contra assetcontra asset account – an offset account – an offset (deduction) against the asset account.(deduction) against the asset account.

Accumulated Accumulated Amortization-Office Amortization-Office

EquipmentEquipmentOffice EquipmentOffice EquipmentAmortization Amortization

ExpenseExpense

Amortization ExampleAmortization Example

Mar. 2 5,000Mar. 2 5,000 Mar. 31 40Mar. 31 40 Mar. 31 40Mar. 31 40

Balance Sheet PresentationBalance Sheet Presentation

Net book valueNet book value

Office equipmentOffice equipment $5,000$5,000

Less: Accumulated amortizationLess: Accumulated amortization 4040

Net book valueNet book value 4,9604,960

Unearned RevenuesUnearned Revenues

Received on August 2 $1,200 for advertising services Received on August 2 $1,200 for advertising services expected to be completed by December 31.expected to be completed by December 31.

Unearned Service Unearned Service RevenueRevenueCashCash

Service Service RevenueRevenue

GENERAL JOURNALGENERAL JOURNAL Debit Credit Debit Credit

Aug. 2 Cash 1,200 Aug. 2 Cash 1,200 Unearned Service Revenue 1,200 Unearned Service Revenue 1,200 Collected money for work to be performed by Collected money for work to be performed by

December 31 December 31

Aug. 2 1,200Aug. 2 1,200 Aug. 2 1,200Aug. 2 1,200

Unearned RevenuesUnearned Revenues

During August, $400 of the revenue was earned.During August, $400 of the revenue was earned.

Unearned Service Unearned Service RevenueRevenueCashCash



Aug. 31 Unearned Service Revenue 400 Aug. 31 Unearned Service Revenue 400 Service Revenue Service Revenue 400 400

To record revenue earned To record revenue earned

Aug. 2 1,200Aug. 2 1,200 Aug. 2 1,200Aug. 2 1,200 Aug. 31 400Aug. 31 400Aug. 31 400Aug. 31 400

Bal. 800Bal. 800

AccrualsAccruals

• Revenue has been earned, but not Revenue has been earned, but not collected (collected (accrued revenuesaccrued revenues))

• Expenses were incurred, but not yet paid Expenses were incurred, but not yet paid ((accrued expensesaccrued expenses))

Note: Entry has not yet been recorded!Note: Entry has not yet been recorded!

Accrued RevenuesAccrued Revenues

• Revenues earned but not yet received in Revenues earned but not yet received in cash or recorded at the end of periodcash or recorded at the end of period

Accrued RevenuesAccrued Revenues

Earned $200 for advertising services to clients in Earned $200 for advertising services to clients in October, but they were not billed until after October 31.October, but they were not billed until after October 31.


Oct . 31 Accounts Receivable 200Oct . 31 Accounts Receivable 200 Service Revenue 200 Service Revenue 200

Accounts Accounts ReceivableReceivable


Oct. 31 200Oct. 31 200 Oct. 31 200Oct. 31 200

Accrued ExpensesAccrued Expenses

• Expenses incurred but not yet paid or Expenses incurred but not yet paid or recorded at the end of periodrecorded at the end of period

Interest expense is the cost a company Interest expense is the cost a company incurs to use money. Information needed to incurs to use money. Information needed to calculate interest expense:calculate interest expense:• Face value of noteFace value of note

• Interest rate (always expressed in annual rate)Interest rate (always expressed in annual rate)• The length of time note is outstandingThe length of time note is outstanding

Accrued Interest ExpenseAccrued Interest Expense

Face Value of Note Interest

Timein Terms of

One Year

Annual Interest

Rate

$ 5,000 X$ 5,000 X 12%12% == $50$50


X 1/2X 1/2

Formula for Calculating InterestFormula for Calculating Interest

Interest ExpenseInterest Expense Interest PayableInterest Payable


Oct. 31 Interest Expense 50 Oct. 31 Interest Expense 50 Interest Payable 50 Interest Payable 50

Accrue interest expense for the month Accrue interest expense for the month


Oct. 31 50Oct. 31 50 Oct. 31 200Oct. 31 200

Accrued Salaries ExpenseAccrued Salaries Expense

• Assume that the employees receive total Assume that the employees receive total salaries of $2,000 for a five-day (Monday to salaries of $2,000 for a five-day (Monday to Friday) work week, or $400 a day.Friday) work week, or $400 a day.

• Salaries were last paid on October 26 and the Salaries were last paid on October 26 and the next payment of salaries will be November 9. next payment of salaries will be November 9. As shown on the calendar on the following As shown on the calendar on the following slide there are three unpaid work days remain slide there are three unpaid work days remain as of October 31.as of October 31.


((Salaries paid after the service has been performed)Salaries paid after the service has been performed)

Salaries ExpenseSalaries Expense Salaries PayableSalaries Payable


Oct. 31 Salaries Expense Oct. 31 Salaries Expense 1,200 1,200 Salaries Payable 1,200 Salaries Payable 1,200

Accrue salary expense for the month Accrue salary expense for the month


Oct. 31 1,200Oct. 31 1,200 Oct. 31 1,200Oct. 31 1,200

Adjusted Trial BalanceAdjusted Trial Balance

• Adjusted trial balanceAdjusted trial balance proves the equity of proves the equity of total debit balances and total credit balances total debit balances and total credit balances after the adjusting entries have been madeafter the adjusting entries have been made

• Financial statements can be easily prepared Financial statements can be easily prepared from the adjusted trial balancefrom the adjusted trial balance

Closing the BooksClosing the Books

• Closing entriesClosing entries– Transfer the temporary account balances to Transfer the temporary account balances to

update the retained earnings accountupdate the retained earnings account

– Reduce the balances in the temporary Reduce the balances in the temporary accounts to zero to accounts to zero to prepare for the next prepare for the next period’s postingsperiod’s postings

TemporaryTemporary PermanentPermanent

All revenue accounts All asset accounts

All expense accounts All liability accounts

Dividends accountShareholders’ equity

accounts

Illustration 4-17

Retained Earnings is a permanent account; the others shown hereare temporary

Individual Expenses

Retained Earnings

Income Summary

Individual Revenues

Dividends

1

3

4

2

Required Steps in the Accounting CycleRequired Steps in the Accounting Cycle

• Analyse business transactionsAnalyse business transactions

• Journalize the transactionsJournalize the transactions

• Post to general ledger accountsPost to general ledger accounts

• Prepare a trial balancePrepare a trial balance

• Journalize and post adjusting entries Journalize and post adjusting entries

(prepayments and accruals)(prepayments and accruals)

Required Steps in the Accounting CycleRequired Steps in the Accounting Cycle

• Prepare an adjusted trial balancePrepare an adjusted trial balance

• Prepare financial statementsPrepare financial statements

• Journalize and post closing entriesJournalize and post closing entries

• Prepare a post-closing trial balancePrepare a post-closing trial balance

accrual accounting concepts chapter 4. time period assumption divides the economic life of a...

Documents

cash basis revenue

purchased advertising

advertising supplies

prepaid expenses cash

paid slide

gaap slide

time period assumption

advertising supplies2