Chapter 3 Outline: The Accounting Cycle - Accrual Accounting PDF

**Chapter 3 Outline** *The Accounting Cycle---End of Period* **PART A: Accrual Basis of Accounting** **Revenue Recognition Principle:** The recognition of revenue involves consideration of two factors (simplistic view): 1. Provide a good or service 2. Collection is probable (being realized o...

**Chapter 3 Outline** *The Accounting Cycle---End of Period* **PART A: Accrual Basis of Accounting** **Revenue Recognition Principle:** The recognition of revenue involves consideration of two factors (simplistic view): 1. Provide a good or service 2. Collection is probable (being realized or realizable) For this class we will assume "providing the good or service" to be the most important consideration with "being realized or realizable" being the second most important. **Determining when to Record Revenue** -record in the period in which a good or service was provided -a cash inflow is not necessarily "revenue" -revenue recognition is NOT driven by cash receipt...being earned is most important -deferred revenue is a LIABILITY it is NOT REVENUE **Practice---Revenue Recognition:** ---- \$ ---- A. Target sells a \$1,000 TV to a customer on September 15th. Customer writes a check to purchase the TV. How much revenue should Target recognize in September? Complete the transaction analysis for case A. ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** 9/15 **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- Record the transaction: 9/15 ------ -- -- -- Post the transaction -- -- -- -- -- -- -- -- -- -- Complete the following for the month of **September**. ---- \$ ---- B. A magazine company receives a total of \$12,000 on September 16th from subscribers for a one year subscription. The subscriptions begin in October. How much revenue should the magazine recognize in September? Complete the transaction analysis for case B. ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** 9/16 **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- Record the transaction: 9/16 ------ -- -- -- Post the transaction -- -- -- -- -- -- -- -- -- -- **Accrual Basis Compared with Cash Basis Accounting** Accrual Basis Accounting revenue recognition "principle" is based on when revenues are EARNED not based on when cash is received. Cash Basis Accounting revenue recognition focuses on when CASH is RECEIVED from an operating activity regardless of when the revenue is earned. **Practice:** Indicate in which month we record revenue: 1. --------------------- -- ------------------------ -- Accrual accounting: Cash basis accounting: --------------------- -- ------------------------ -- 2. --------------------- -- ------------------------ -- Accrual accounting: Cash basis accounting: --------------------- -- ------------------------ -- **Expense Recognition (Matching Principle):** Record an expense when an asset is used up to earn revenue or a liability is incurred to earn revenue. (Match the cost with the revenue the cost helped earn in the period it was earned). **Determining when to Record an Expense** -recording expenses -used an asset or -incurred a liability to generate revenue -a cash outflow is not necessarily an "expense." -expense recognition is NOT driven by cash payment...INCURRED TO EARN REVENUE is most important -deferred expense, "prepaid expense" (is NOT an expense) it's an ASSET \*Direct costs incurred to earn revenue are expensed when the revenue is earned. \*PERIOD costs are indirect costs incurred to earn revenue. Matching period costs directly to revenue is difficult so they are matched to the period in which they occur instead of directly to revenue. **Practice---Expense Recognition:** ---- \$ ---- A. Rand Co. pays \$3,000 rent for the month of January by the end of the month. How much rent expense should Rand recognize for the month of JANUARY? ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** 1/31 ------ ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- Record the transaction: 1/31 ------ -- -- -- Post the transaction -- -- -- -- -- -- -- -- -- -- B. TEA Corp received a \$1,500 electric bill for January on January 31^st^ and paid it on February 5th. For this transaction, how much should TEA Corp recognize as electric expense for ---- \$ ---- January? -- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** -- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- Record the expense: -- -- -- -- -- -- -- -- Post the transaction -- -- -- -- -- -- -- -- -- -- **Accrual Basis Compared with Cash Basis Accounting** Accrual Basis Accounting recognizes expenses using the matching principle which is based on when expenses are INCURRED not when paid. Cash Basis Accounting recognizes expenses based on when CASH is PAID for an operating item. **Practice:** Indicate in which month we record expense: 1. Purchased/Paid for supplies in May but did not use the supplies until June. --------------------- -- ------------------------ -- Accrual accounting: Cash basis accounting: --------------------- -- ------------------------ -- 2. Paid employees in December for work performed in November. --------------------- -- ------------------------ -- Accrual accounting: Cash basis accounting: --------------------- -- ------------------------ -- **\ The Measurement Process** **The Accounting Cycle** **Phase 1** (during the accounting period) Transaction analysis Recording journal entries in the general journal; and Post amounts to ledger accounts (T accounts). Prepare a trial balance **Phase 2** (at the VERY end of the accounting period) Analyze adjustments Record and post adjusting entries Prepare and distribute financial statements Record and post closing entries **Adjusting Entries** -record events that have occurred but have not been recorded yet -adjusts the balance of a balance sheet account -records an income statement account -purpose is to make sure all accounting events have been recognized in the accounting records -an adjusting entry will NEVER affect the CASH account **ADJUSTING ENTRIES FOR PREPAYMENTS or "*Deferrals"*** ***Cash received or paid/obligation to pay before a revenue or expense has been recognized*** **Prepaid expense or Deferred expenses**: ASSET **Deferred revenue**: LIABILITY **Practice\--Prepaid Expense:** On January 1^st^ Clark Company purchased three years of flood insurance paying \$45,000 (\$15,000 per year). Original Entry on January 1^st^ 1/1 Prepaid Insurance (A+) 45,000 ----- ------------------------ -------- -------- Cash (A-) 45,000 ---- \$ ---- How much insurance expense should be reported on the income statement for the year 20XA? ------- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** 12/31 ------- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- 1. 12/31/20A ----------- -- -- -- ------------------- -- -- -- -- Prepaid Insurance 45,000 ------------------- -- -- -- -- If Clark company *failed* to record the adjustment, how would that failure affect their financial statements? **Deferred Revenue**---cash is received before the good or service has been provided; it is a liability until provided. **Practice:** A popular ski magazine company receives a total of \$12,000 in September from subscribers for a one year subscription. The subscriptions begin in October. (*See Original entry on page 3-2 of notes---Case B*). \(2) Record the adjustment necessary at December 31^st^ to recognize revenue earned. ------- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** 12/31 **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** ------- ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- 12/31 ------- -- -- -- ------------------ -------- -- -- -- Deferred Revenue 12,000 ------------------ -------- -- -- -- If the magazine company failed to record the adjustment, how would that failure affect their financial statements? The matching principle says if the company uses an asset to help earn revenue an expense needs to be recorded. **DEPRECIATION EXPENSE** is the name of the expense recognized when the company uses a long-term asset. DEPRECIATION IS A ***COST ALLOCATION METHOD*** (we use straight-line depreciation in chapter 3, other cost allocation methods will be discussed in Chapter 7). -cost allocation\--spreading the cost of the asset over the periods used to earn revenue **Contra Accounts---(X)---goes against and has an opposite balance of the primary account** **-ACCUMULATED DEPRECIATION is a contra assetgoes against long-term assets** **-it adds up (accumulates) the total depreciation taken on a long-term asset** **-it has a "credit" balance (opposite of the long-term asset)** **Book Value** = Cost -- Accumulated depreciation Depreciation will be recognized as an adjusting entry, depreciation expense (income statement account) and accumulated depreciation (balance sheet). **Practice:** ABC purchased a truck on **January 1, [20XA]** for \$50,000. They expect to use the truck for six years and each year they use the truck they will prepare an adjustment that allocates **\$7,500** of the truck's cost to depreciation expense; satisfying the matching principle. \(3) Record the adjustment for depreciation at the end of **[20XC]** (end of third year). ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- **Balance Sheet** **Income Statement** **Assets** **Liabilities** **Stockholders' Equity** **Revenues** **Expenses** **Net Income** ------------------- ---------------------- -------------------------- -------------- -------------- ---------------- 12/31/20C ----------- -- -- -- -------------------------- ---------- -- -- -- Accumulated Depreciation \$15,000 -------------------------- ---------- -- -- -- What is the truck's book value on December 31, 20XC? -------------------------------------------- -- -------------------------------------------- Truck (A) Historical Cost (purchased on 1/1/XA) Accumulated Depreciation-Truck (XA) Depreciation for 3 years @ \_\_\_\_\_/year Truck, net of accumulated depreciation (A) Book Value as of 12/31/20XC -------------------------------------------- -- -------------------------------------------- **ADJUSTING ENTRIES FOR *ACCRUALS*** ***Cash not paid or received yet**:* **Accrued expenses: expense INCURRED before cash is paidcreates a liability.** **Accrued revenue**: provided a good or service before cash is received creates an asset. Wage Expense Utilities Expense Interest Revenue or Expense **Interest Calculation** P x R x T where: P = Principal (FACE Value) is the amount borrowed R = Annual interest rate (for this class INTEREST IS ALWAYS STATED IN ANNUAL TERMS) T = length of time the money was used in the accounting period (based on a year because the ***interest rate is an annual rate***). **Practice---Accrued expense:** R Company borrowed \$100,000 at 9% interest for six months on December 1, 20XA. ---- \$ ---- How much interest expense should be reported on the income statement for the year-ending 12/31/20XA? \(4) Record the adjusting entry for interest expense 12/31 ------- -- -- -- -- -- -- -- -- -- -- -- -- -- **\ Practice---Accrued revenue: TR** Company provided \$300 of services to customers on December 31^st^ but have not billed the customers as of the end of the month. These customers will be billed January 3^rd^ and are expected to pay the full amount on January 6^th^. \(5) Record the adjusting entry for service revenue 12/31 ------- -- -- -- -- -- -- -- -- -- -- -- -- -- If TR Company failed to record the adjustment, how would that failure affect their financial statements? **Not all accounts need to be adjusted.** ADJUSTED TRIAL BALANCE **Practice---Adjustments** (*see next page for trial balance*) Seneca Company has provided the following information to you and has asked that you prepare the adjusting entries prior to preparing the financial statements. Items that need to be adjusted are: a. a. ---- -- -- -- +-------------+-------------+-------------+-------------+-------------+ | Prepaid | | | | | | insurance | | | | | +-------------+-------------+-------------+-------------+-------------+ | \+ | \- | | \+ | \- | | | | | | | | 5000 | | | | | +-------------+-------------+-------------+-------------+-------------+ | | | | | | +-------------+-------------+-------------+-------------+-------------+ **Using the adjustments from a above and b, c, complete the trial balance:** -------------------------- ------------ ------------- ------------------ -------- ------- -------- Unadjusted Adjustments Adjusted Balance Debit Credit Debit Credit Debit Credit Cash 1,800 Accounts receivable 9,000 Supplies 540 Prepaid insurance 5,000 Machinery 190,000 Accumulated depreciation 18,000 Accounts payable 1,500 Note payable 100,000 Common stock 22,900 Retained earnings 40,040 Dividends 500 Revenues 89,000 Cost of sales 35,000 Depreciation expense Insurance expense Supplies expense Utilities expense 3,500 Wage expense 19,900 Other expense 6,200 Totals 271,440 271,440 -------------------------- ------------ ------------- ------------------ -------- ------- -------- b. b. ---- -- -- -- +-------------+-------------+-------------+-------------+-------------+ | Supplies | | | | | +-------------+-------------+-------------+-------------+-------------+ | \+ | \- | | \+ | \- | | | | | | | | 120 | | | | | | | | | | | | 420 | | | | | +-------------+-------------+-------------+-------------+-------------+ | | | | | | +-------------+-------------+-------------+-------------+-------------+ c. c. ---- -- -- -- +-------------+-------------+-------------+-------------+-------------+ | Accumulated | | | | | | depreciatio | | | | | | n | | | | | +-------------+-------------+-------------+-------------+-------------+ | \- | \+ | | \+ | \- | | | | | | | | | 18,000 | | | | +-------------+-------------+-------------+-------------+-------------+ | | | | | | +-------------+-------------+-------------+-------------+-------------+ **PART B: The Reporting Process** Retained Earnings shown on the Trial Balance represents the beginning retained earnings amount. Ending Retained Earnings is computed on the Statement of Stockholders' Equity. All other amounts in the Adjusted Trial Balance are used to prepare the financial statements. **Income Statement** - - - **Financial Statements for Seneca Company** +-----------------------------------+-----------------------------------+ | Seneca Company | | | | | | Income Statement | | | | | | For the Year ended December 31, | | | 20XE | | +===================================+===================================+ | Total revenues | ***\$89,000*** | +-----------------------------------+-----------------------------------+ | ***EXPENSES*** | | +-----------------------------------+-----------------------------------+ | ***Cost of Sales*** | ***\$35,000*** | +-----------------------------------+-----------------------------------+ | ***Depreciation expense*** | ***6,000*** | +-----------------------------------+-----------------------------------+ | ***Insurance expense*** | ***2,000*** | +-----------------------------------+-----------------------------------+ | ***Supplied expense*** | ***465*** | +-----------------------------------+-----------------------------------+ | ***Utilities expense*** | ***3,500*** | +-----------------------------------+-----------------------------------+ | ***Wage expense*** | ***19,900*** | +-----------------------------------+-----------------------------------+ | ***Other expenses*** | ***[6,200]*** | +-----------------------------------+-----------------------------------+ | ***TOTAL EXPENSES*** | ***[73,065]*** | +-----------------------------------+-----------------------------------+ | Net income | ***\$15,935*** | +-----------------------------------+-----------------------------------+ **Statement of Stockholders' Equity** After finding net income on the Income Statement, the Statement of Stockholders' Equity is prepared. +-----------------+-----------------+-----------------+-----------------+ | Seneca Company | | | | | | | | | | Statement of | | | | | Stockholders' | | | | | Equity | | | | | | | | | | For the year | | | | | ended December | | | | | 31, 20XE | | | | +=================+=================+=================+=================+ | | ***Common | ***Retained | ***Total | | | Stock*** | Earnings*** | Stockholders' | | | | | Equity*** | +-----------------+-----------------+-----------------+-----------------+ | Beginning | ***\$22,900*** | ***\$40,040*** | ***\$62,940*** | | Balance | | | | +-----------------+-----------------+-----------------+-----------------+ | Issuance of | ***0*** | | ***0*** | | Common stock | | | | +-----------------+-----------------+-----------------+-----------------+ | Net income | | ***15,935*** | ***15,935*** | +-----------------+-----------------+-----------------+-----------------+ | Dividends | | ***[(500)]{.und | ***[(500)]{.und | | declared | | erline}*** | erline}*** | +-----------------+-----------------+-----------------+-----------------+ | Ending Balance | ***\$22,900*** | ***55,475*** | ***78,375*** | +-----------------+-----------------+-----------------+-----------------+ +-----------------+-----------------+-----------------+-----------------+ | Seneca Company | | | | | | | | | | Balance Sheet | | | | | | | | | | At December 31, | | | | | 20XE | | | | +=================+=================+=================+=================+ | **Assets:** | | **Liabilities:* | | | | | * | | +-----------------+-----------------+-----------------+-----------------+ | Current Assets: | | Current | | | | | Liabilities | | +-----------------+-----------------+-----------------+-----------------+ | Cash | \$1,800 | Accounts | [\$1,500]{.unde | | | | Payable | rline} | +-----------------+-----------------+-----------------+-----------------+ | Account | 9,000 | Total current | 1,500 | | Receivables | | liabilities | | +-----------------+-----------------+-----------------+-----------------+ | Supplies | 75 | | | +-----------------+-----------------+-----------------+-----------------+ | Prepaid | [3,000]{.underl | Note payable | [100,000]{.unde | | insurance | ine} | | rline} | +-----------------+-----------------+-----------------+-----------------+ | Total current | 13,875 | Total | 101,500 | | assets | | liabilities | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | Machinery, net | [166,000]{.unde | **Stockholders\ | | | | rline} | ' | | | | | equity:** | | +-----------------+-----------------+-----------------+-----------------+ | | | Common Stock | 22,900 | +-----------------+-----------------+-----------------+-----------------+ | | | Retained | [55,475]{.under | | | | earnings | line} | +-----------------+-----------------+-----------------+-----------------+ | | | Total | 78,375 | | | | stockholders' | | | | | equity | | +-----------------+-----------------+-----------------+-----------------+ | | | | | +-----------------+-----------------+-----------------+-----------------+ | Total assets | \$179,875 | Total | \$179,875 | | | | liabilities and | | | | | stockholders\' | | | | | equity | | +-----------------+-----------------+-----------------+-----------------+ **Classified Balance Sheet** Current Assets\-- Long-term Assets\-- Current Liabilities\-- Long-term Liabilities\-- **\ PART C: The closing Process** **Permanent Accounts---Balance sheet accounts (NOT CLOSED)** **Temporary Accounts---Income statement accounts and Dividends Declared (CLOSED)** **PURPOSE OF CLOSING ACCOUNTS:** 1. 2. **Example:** +-----------+-----------+-----------+-----------+-----------+-----------+ | Insurance | | | Revenue | | | | Expense | | | | | | +-----------+-----------+-----------+-----------+-----------+-----------+ | \+ | \- | | | \- | \+ | | | | | | | | | 2,000 | | | | | 89,000 | +-----------+-----------+-----------+-----------+-----------+-----------+ | | | | | | | +-----------+-----------+-----------+-----------+-----------+-----------+ ------------------- ---- Retained Earnings \- \+ ------------------- ---- Record the closing entry for Seneca Company ---------------------------------------- -- -------- Revenues (close revenue to Retained Earnings) Retained earnings 35,000 6,000 2,000 465 3,500 19,900 6,200 (close expenses to Retained Earnings) Retained Earnings (close dividends to Retained Earnings) ---------------------------------------- -- -------- Post the closing entry to Retained Earnings +-----------------------------------+-----------------------------------+ | Retained Earnings | | +-----------------------------------+-----------------------------------+ | \- | \+ | | | | | | 40,040 | +-----------------------------------+-----------------------------------+ | | | +-----------------------------------+-----------------------------------+ Prepare the Post Closing Trial Balance for Seneca +-----------------------+-----------------------+-----------------------+ | **Seneca Company** | | | | | | | | **Post-Closing Trial | | | | Balance** | | | | | | | | **December 31, 20XE** | | | +-----------------------+-----------------------+-----------------------+ | | Debit | Credit | +-----------------------+-----------------------+-----------------------+ | Cash | \$1,800 | | +-----------------------+-----------------------+-----------------------+ | Accounts receivable | 9,000 | | +-----------------------+-----------------------+-----------------------+ | Supplies | 75 | | +-----------------------+-----------------------+-----------------------+ | Prepaid insurance | 3,000 | | +-----------------------+-----------------------+-----------------------+ | Machinery | 190,000 | | +-----------------------+-----------------------+-----------------------+ | Accumulated | | \$24,000 | | depreciation | | | +-----------------------+-----------------------+-----------------------+ | Accounts payable | | 1,500 | +-----------------------+-----------------------+-----------------------+ | Note payable | | 100,000 | +-----------------------+-----------------------+-----------------------+ | Common stock | | 22,900 | +-----------------------+-----------------------+-----------------------+ | Retained earnings | | 55,475 | +-----------------------+-----------------------+-----------------------+ | Totals | \$203,875 | \$203,875 | +-----------------------+-----------------------+-----------------------+ Why are there no revenue, expense or dividend accounts shown?