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Chap004

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  • Chapter 4: The Accounting Cycle—Accruals and Deferrals.
  • At the end of the period, we need to make adjusting entries to get the accounts up to date for the financial statements.
    The accrual basis dictates that revenues be recognized when earned and expenses be recognized when incurred. The accrual basis of accounting is considered to be in compliance with generally accepted accounting principles, GAAP. Every adjusting entry involves a revenue or expense and an asset or liability.
  • There are two broad categories of adjustments.
    The first is when payments are made or cash is received before the expense or revenue is recognized. This category includes prepaid or deferred expenses (including depreciation), and unearned or deferred revenues.
    The second major category of adjustments is when cash is paid or received after the expense or revenue is recognized. These are very common adjustments. This category includes accrued expenses and accrued revenues.
  • Part IWhen an adjusting entry is used to convert an asset to expense, a transaction took place in a prior period that involved the advance payment of an expense. Three common examples of adjusting entries to convert assets to expenses are the recognition of depreciation expense on plant assets, the using up of office supplies during the period, and the expiration of prepaid insurance.Part IIThe adjusting entry is made at the end of the current period to recognize the converting of the prepaid asset into an expense. The asset account is reduced and the expense account is increased.
  • On January 1st of the current year, Webb Company purchased a one-year insurance policy paying $2,400 in advance. The amount was charged to an asset account, unexpired insurance. Each month should reflect $200 of insurance expense assuming Webb prepares monthly financial statements.
  • Here is the entry made by Webb on January 1st to record the purchase of the policy. A debit, or increase, is made to the asset Unexpired Insurance, and a credit, or decrease, is made to the asset account Cash for $2,400.
  • At the end of January, Webb is going to prepare its financial statements.
    The proper adjusting entry is to debit, or increase, the expense account Insurance Expense and to credit, or decrease, the asset account Unexpired Insurance for $200.Webb will make this adjusting entry at the end of each month.
  • After posting the adjusting entry to the general ledger accounts, it’s clear that the asset, Unexpired Insurance, has been partially converted into the expense account Insurance Expense.Both the asset account and the expense account are now carried at their proper balances.
  • Depreciation is the systematic and rational allocation of the cost of a depreciable asset to expense over its estimated useful life. There are many methods of depreciation; the straight-line method will be examined in this chapter.
    As a depreciable asset is used to produce revenue, the asset loses some of its utility and part of the asset is consumed. At the end of the accounting period, the expense relating to the consumption of the depreciable asset must be recorded.
  • Part I
    On May 2nd, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months. The lawn mower cost $2,500. JJ’s Lawn Care uses the straight-line method of depreciation and records depreciation expense monthly.
    Part II
    Depreciation expense is equal to the cost less any anticipated salvage value divided by the estimated useful life. Part IIISo, JJ’s Lawn Care should record depreciation expense of $50 per month. Let’s look at the adjusting entry required.
  • Part I
    The adjusting journal entry required on May 31st is to debit, or increase, Depreciation Expense on Equipment and credit, or increase, the account Accumulated Depreciation on Equipment for $50.
    Part II
    The account Accumulated Depreciation on Equipment is a contra asset account. A contra account is a reduction in an associated account. In this case, Accumulated Depreciation will be shown on the balance sheet as a reduction in the Equipment account.
  • Part IRemember that JJ’s Lawn Care purchased a truck for $15,000 on May 1st. The truck has an estimated useful life of five years, or 60 months. Can you calculate depreciation expense for the month of May on the newly acquired truck? When you are finished, go to the next screen.Part IIThe proper adjusting entry is to debit Depreciation Expense on Truck for $250, and credit Accumulated Depreciation on Truck for the same amount.The Accumulated Depreciation account will appear on the balance sheet as a reduction in the Truck account.
  • This slide shows how JJ’s Lawn Care shows its plant assets. Notice that the contra accounts are subtracted from the related asset account. The cost of an asset less the accumulated depreciation is equal to book value of that asset. Book value is not intended to represent an asset’s current market value.
  • Part INow let’s look at the adjusting entry associated with converting a recorded liability to a revenue. The adjusting entry is necessary when cash has been collected in advance of earning revenue. An example is when a magazine publishing company collects cash for a one- or two-year subscription. Other examples of transactions that require an adjusting entry to convert a liability to revenue are the sales of airline tickets, or season tickets for a sports team.
    Part IIAt the end of the accounting period, an adjusting entry will need to be recorded to recognize the revenue earned during the period and to reduce the liability account.
  • Webb Company is a landlord. On January 1st, Webb received $6,000 in advance for a one-year rental on office space it owns. Because Webb prepares monthly financial statements, it should recognize $500 per month in rental revenue. Let’s see how this transaction was recorded by Webb.
  • On January 1st, Webb debited Cash for $6,000 and credited the liability account called Unearned Rent Revenue for the same amount.Don’t let the word revenue in the liability account title mislead you. The important descriptor is the word Unearned. Unearned revenue is a liability. Webb must do something to earn this revenue.Let’s look at the journal entry required on January 31st to recognize the revenue earned during the month.
  • On January 31st, Webb would debit, or reduce, the liability account Unearned Rent Revenue and credit, or increase, the Rental Revenue account for $500, one-months rent earned.
  • The balance in the Unearned Rental Revenue account represents 11 months of unearned rent at $500 per month.
    The balance in the Rental Revenue account for January is $500. This amount will appear on Webb’s income statement.
  • Part IOne of the keys to understanding the accrual of expenses is to realize that an expense has been incurred in the current accounting period but will not be paid until the following accounting period. For example, you may purchase gasoline from the local service station using a credit card. You have incurred the expense for the gasoline but have not recorded the cost. You probably will not record your expense until the following period when the credit card statement comes. Companies cannot follow this practice because expenses would be recorded in the wrong accounting period and thus violate the matching principle.
    Part IIThe adjusting entry required is to debit, or increase, an expense account and credit, or increase, a liability account. Almost all expense accruals will require this type of entry. Some common accrued expenses include interest owed on loans, wages and salaries owed to employees, and property taxes owed to the local taxing authority.
  • Here is an example of accrued wages. Webb Company pays its employees each Friday. The end of the current month, May, is on Wednesday. There have been $3,000 in wages earned by Webb’s employees from Monday, May 29th, through Wednesday, May 31st.
    Can you prepare the adjusting journal entry required of Webb on May 31st?
  • As with most expense accruals, Webb will debit an expense account, in this case Wages Expense, for $3,000 and credit a liability account, in this case Wages Payable, for $3,000.The wages earned by employees during May will be recorded in the proper period.
  • The balance in the Wages Payable liability account is $3,000 and will appear on the balance sheet of Webb at May 31st. The Wages Expense account will be increased by $3,000, and this amount will be included on May’s income statement.
  • Two thousand dollars of wages were earned by employees on Thursday, June 1st, and Friday, June 2nd. Let’s look at the entry Webb will make on payday, Friday, June 2nd.We need to be careful because part of the $5,000 of total wages expense has already been recognized.Try to make this entry to record the wages on June 2nd before going to the next screen.
  • Wages Expense should have a debit for $2,000, the portion of the total payroll applicable to June. Next, eliminate the Wages Payable for $3,000. The balance in the Wages Payable account is now zero. Finally, credit the Cash account for the full cost of the payroll, $5,000.
  • Part IA revenue accrual is necessary when revenue has been earned in the current accounting period but the cash will not be collected until the next period. Examples of revenue accruals include interest earned on investments or loans made to others, and work completed but not yet billed to the customer.
    Part IIIn the adjusting entry we will record a receivable, an asset account, and recognize the revenue earned.
  • Webb has deposits at a bank in an interest-bearing account. Interest is paid by the bank on the 15th of each month.The end of Webb’s accounting period falls on January 31st. From the 15th of January until the 31st, Webb earned $170 on its account at the bank.Let’s make the adjusting entry to recognize the interest earned from January 15th to January 31st.
  • Webb will debit the asset account, Interest Receivable, for $170 and credit the revenue account, Interest Revenue, for the same amount.
  • The asset, Interest Receivable, will appear on Webb’s balance sheet at January 31st. The Interest Revenue account will be shown on Webb’s income statement for the month ended January 31st.
  • Webb earned an additional $150 from the 1st of February until the 15th when interest was paid. Webb will receive a total of $320 on February 15th.
    Once again, be careful because part of the $320 has already been recognized as revenue. Try to record the entry for the receipt on February 15th before going to the next screen.
  • First, debit the asset account, Cash, for the full $320. Next, credit the Interest Revenue account for $150, the amount earned during the month of February. Finally, eliminate the Interest Receivable account for $170. This must be done because the cash has now been received.
  • A corporation must pay income tax on its taxable income. Corporate taxes are due on March 15th of the year following the year in which the income was earned. The corporate income taxes for 2008 are due on March 15, 2009. It is always necessary to accrue income taxes for a corporation. The adjusting entry is just like the entry we record for any accrued expense.The adjusting entry is to debit Income Taxes Expense for the amount of the accrual and credit Income Taxes Payable for the same amount. In this case, the taxes due are $780.
  • Adjusting entries help us match costs with revenues either directly by associating certain costs with specific revenues, or through the allocation process. Allocation was used to record depreciation expense in this chapter.
  • Generally, accountants are most concerned about amounts that are determined to be material in nature. An amount is material if it may influence the decision of an informed user of financial information.When amounts involved are not material, many companies have established a policy of expensing the amount immediately. We know that light bulbs may last through several accounting periods. It is not cost beneficial to record the bulbs as assets and allocate a portion of their cost to each month of operation. We normally expense the cost of these and similar items as they are incurred.
  • We identified four types of adjusting entries, each of which involves one income statement account and one balance sheet account. The effects of these adjustment types on the income statement and balance sheet are summarized on this slide.
  • We have highlighted just a few of the adjusting entries prepared at the end of May 2009. Like the trial balance, the adjusted trial balance shows that the total of the debit balance accounts is equal to the total of the credit balance accounts. Our books are in balance after recording our adjusting entries.
  • End of chapter 4.
  • Transcript

    • 1. The Accounting Cycle: Accruals and Deferrals Chapter 4 McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
    • 2. Adjusting Entries Adjusting entries are needed whenever revenue or expenses affect more than one accounting period. Every adjusting entry involves a change in either a revenue or expense and an asset or liability. 4-2
    • 3. Types of Adjusting Entries  Converting  Converting assets to assets to expenses expenses  Converting  Converting liabilities to liabilities to revenue revenue  Accruing  Accruing unpaid unpaid expenses expenses  Accruing  Accruing uncollected uncollected revenue revenue 4-3
    • 4. Converting Assets to Expenses End of Current Period Prior Periods Transaction Transaction Paid cash in Paid cash in advance of advance of incurring incurring expense expense (creates an (creates an asset). asset). Current Period Future Periods Adjusting Entry Adjusting Entry  Recognizes portion  Recognizes portion of asset consumed of asset consumed as expense, and as expense, and  Reduces balance of  Reduces balance of asset account. asset account. 4-4
    • 5. Converting Assets to Expenses $2,400 Insurance Policy Coverage for 12 Months $200 Monthly Insurance Expense Jan. 1 Dec. 31 On January 1, Webb Co. purchased a On January 1, Webb Co. purchased a one-year insurance policy for $2,400. one-year insurance policy for $2,400. 4-5
    • 6. Converting Assets to Expenses Initially, costs that benefit more than one Initially, costs that benefit more than one accounting period are recorded as assets. accounting period are recorded as assets. GENERAL JOURNAL Date Account Titles and Explanation Jan. 1 Unexpired Insurance Cash P R Debit Credit 2,400 2,400 Purchase a one-year insurance policy. 4-6
    • 7. Converting Assets to Expenses The costs are expensed as they are The costs are expensed as they are used to generate revenue. used to generate revenue. GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Monthly Adjusting Entry for Insurance Jan. 31 Insurance Expense Unexpired Insurance 200 200 Insurance expense for January. 4-7
    • 8. Converting Assets to Expenses Balance Sheet Balance Sheet Cost of assets Cost of assets that benefit that benefit future periods. future periods. Income Statement Income Statement Cost of assets Cost of assets used this period to used this period to generate revenue. generate revenue. Unexpired Insurance 1/1 2,400 1/31 200 Bal. 2,200 Insurance Expense 1/31 200 4-8
    • 9. The Concept of Depreciation Depreciation is the systematic allocation of Depreciation is the systematic allocation of the cost of a depreciable asset to expense. the cost of a depreciable asset to expense. Fixed Fixed Asset Asset (debit) (debit) On date when initial payment is made . . . Cash Cash (credit) (credit) The asset’s usefulness is partially consumed during the period. Depreciation Depreciation Expense Expense (debit) (debit) At end of period . . . Accumulated Accumulated Depreciation Depreciation (credit) (credit) 4-9
    • 10. Depreciation Is Only an Estimate On May 2, 2009, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash. Using the straight-line method, calculate the monthly depreciation expense. Depreciation Cost of the asset expense (per = Estimated useful life period) $50 = $2,500 50 4-10
    • 11. Depreciation Is Only an Estimate JJ’s Lawn Care Service would make the JJ’s Lawn Care Service would make the following adjusting entry. following adjusting entry. GENERAL JOURNAL Date Account Titles and Explanation May 31 Depreciation Expense: Equipment Accumulated Depreciation: Equipment P R Debit Credit 50 50 To record one month's depreciation. Contra-asset Contra-asset 4-11
    • 12. Depreciation Is Only an Estimate JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and make the journal entry. GENERAL JOURNAL Date Account Titles and Explanation May 31 Depreciation Expense: Truck P R Debit Credit 250 Accumulated Depreciation: Truck 250 To record one month's depreciation. $15,000 ÷ 60 months = $250 per month $15,000 ÷ 60 months = $250 per month 4-12
    • 13. Depreciation Is Only an Estimate Accumulated depreciation would Accumulated depreciation would appear on the balance sheet as appear on the balance sheet as follows: follows: Cost - Accumulated Depreciation = Book Value Cost - Accumulated Depreciation = Book Value 4-13
    • 14. Converting Liabilities to Revenue End of Current Period Prior Periods Transaction Transaction Collect cash in Collect cash in advance of advance of earning revenue earning revenue (creates a (creates a liability). liability). Current Period Future Periods Adjusting Entry Adjusting Entry  Recognizes portion  Recognizes portion earned as revenue, earned as revenue, and and  Reduces balance of  Reduces balance of liability account. liability account. 4-14
    • 15. Converting Liabilities to Revenue $6,000 Rental Contract Coverage for 12 Months $500 Monthly Rental Revenue Jan. 1 Dec. 31 On January 1, Webb Co. received $6,000 in On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. advance for a one-year rental contract. 4-15
    • 16. Converting Liabilities to Revenue Initially, revenues that benefit more than one Initially, revenues that benefit more than one accounting period are recorded as liabilities. accounting period are recorded as liabilities. GENERAL JOURNAL Date Account Titles and Explanation Jan. 1 Cash Unearned Rent Revenue P R Debit Credit 6,000 6,000 Collected $6,000 in advance for rent. 4-16
    • 17. Converting Liabilities to Revenue Over time, the revenue is recognized Over time, the revenue is recognized as it is earned. as it is earned. GENERAL JOURNAL Date Account Titles and Explanation P R Debit Credit Monthly Adjusting Entry for Rent Revenue Jan. 31 Unearned Rent Revenue Rental Revenue 500 500 Rental revenue for January. 4-17
    • 18. Converting Liabilities to Revenue Balance Sheet Balance Sheet Liability for Liability for future periods. future periods. Unearned Rental Revenue 1/31 500 1/1 6,000 Bal. 5,500 Income Statement Income Statement Revenue earned Revenue earned this period. this period. Rental Revenue 1/31 500 4-18
    • 19. Accruing Unpaid Expenses End of Current Period Prior Periods Current Period Future Periods Transaction Transaction Pay cash in Pay cash in settlement of settlement of liability. liability. 4-19
    • 20. Accruing Unpaid Expenses $3,000 Wages Expense Monday, May 29 Wednesday, May 31 Friday, June 2 On May 31, Webb Co. owes wages of On May 31, Webb Co. owes wages of $3,000. Payday is Friday, June 2. $3,000. Payday is Friday, June 2. 4-20
    • 21. Accruing Unpaid Expenses Initially, an expense and a liability are Initially, an expense and a liability are recorded. recorded. GENERAL JOURNAL Date Account Titles and Explanation May 31 Wages Expense Wages Payable P R Debit Credit 3,000 3,000 To accrue wages owed to employees. 4-21
    • 22. Accruing Unpaid Expenses Balance Sheet Balance Sheet Liability to be Liability to be paid in a future paid in a future period. period. Wages Payable 5/31 3,000 Income Statement Income Statement Cost incurred this Cost incurred this period to generate period to generate revenue. revenue. Wages Expense 5/31 3,000 4-22
    • 23. Accruing Unpaid Expenses $5,000 Weekly Wages $3,000 Wages Expense Monday, May 29 $2,000 Wages Expense Wednesday, May 31 Friday, June 2 Let’s look at the entry for June 2. Let’s look at the entry for June 2. 4-23
    • 24. Accruing Unpaid Expenses The liability is extinguished when the The liability is extinguished when the debt is paid. debt is paid. GENERAL JOURNAL Date Account Titles and Explanation June 2 Wages Expense (for June) Wages Payable (accrued in May) Cash P R Debit Credit 2,000 3,000 5,000 Weekly payroll for May 29-June 2. 4-24
    • 25. Accruing Uncollected Revenue End of Current Period Prior Periods Current Period Adjusting Entry Adjusting Entry Recognizes revenue Recognizes revenue earned but not yet earned but not yet recorded, and recorded, and Records receivable. Records receivable. Future Periods Transaction Transaction Collect cash in Collect cash in settlement of settlement of receivable. receivable. 4-25
    • 26. Accruing Uncollected Revenue $170 Interest Revenue Saturday, Jan. 15 Monday, Jan. 31 Tuesday, Feb. 15 On Jan. 31, the bank owes Webb Co. On Jan. 31, the bank owes Webb Co. interest of $170. Interest is paid on the interest of $170. Interest is paid on the 15th day of each month. 15th day of each month. 4-26
    • 27. Accruing Uncollected Revenue Initially, the revenue is recognized and Initially, the revenue is recognized and a receivable is created. a receivable is created. GENERAL JOURNAL Date Account Titles and Explanation Jan. 31 Interest Receivable Interest Revenue P R Debit Credit 170 170 To recognize interest revenue. 4-27
    • 28. Accruing Uncollected Revenue Balance Sheet Balance Sheet Receivable to Receivable to be collected in a be collected in a future period. future period. Interest Receivable 1/31 170 Income Statement Income Statement Revenue earned Revenue earned this period. this period. Interest Revenue 1/31 170 4-28
    • 29. Accruing Uncollected Revenue $320 Monthly Interest $170 Interest Revenue Saturday, Jan. 15 $150 Interest Revenue Monday, Jan. 31 Tuesday, Feb. 15 Let’s look at the entry for February 15. Let’s look at the entry for February 15. 4-29
    • 30. Accruing Uncollected Revenue The receivable is collected in a future The receivable is collected in a future period. period. GENERAL JOURNAL Date Account Titles and Explanation Feb. 15 Cash P R Debit Credit 320 Interest Revenue (for February) 150 Interest Receivable (accrued Jan. 31) 170 To record interest received. 4-30
    • 31. Accruing Income Taxes Expense: The Final Adjusting Entry As a corporation earns taxable income, it As a corporation earns taxable income, it incurs income taxes expense, and also a incurs income taxes expense, and also a liability to governmental tax authorities. liability to governmental tax authorities. GENERAL JOURNAL Date Account Titles and Explanation Dec. 31 Income Taxes Expense Income Taxes Payable P R Debit Credit 780 780 Estimated income taxes applicable to taxable income earned in December. 4-31
    • 32. Adjusting Entries and Accounting Principles Costs are matched with revenue Costs are matched with revenue in two ways: in two ways:  Direct association of costs  Direct association of costs with specific revenue with specific revenue transactions. transactions.  Systematic allocation of costs  Systematic allocation of costs over the “useful life” of the over the “useful life” of the expenditure. expenditure. 4-32
    • 33. The Concept of Materiality An item is “material” if knowledge of the An item is “material” if knowledge of the item might reasonably influence the item might reasonably influence the decisions of users of financial statements. decisions of users of financial statements. Many companies immediately charge the cost of immaterial items to expense. Light bulbs Supplies 4-33
    • 34. Effects of the Adjusting Entries Income Statement Adjustment Type I Converting Assets to Expenses Type II Converting Liabilities to Revenue Type III Accruing Unpaid Expenses Type IV Accruing Uncollected Revenue Revenue Expenses No effect Increase Increase Assets Liabilities Decrease Decrease No effect No effect Increase No effect Increase Increase Net Income Balance Sheet No effect Decrease Decrease No effect Increase No effect Increase Increase No effect Owners' Equity Decrease Increase Decrease Increase 4-34
    • 35. Adjusted Trial Balance JJ's Lawn Care Service Adjusted Trial Balance May 31, 2009 Cash $ 3,925 Accounts receivable 75 Tools & equipment 2,650 Accum. depreciation: tools & eq. $ 50 Truck 15,000 Accum. depreciation: truck 250 Notes payable 13,000 Accounts payable 150 Capital stock 8,000 Dividends 200 Sales revenue 750 Gasoline expense 50 Depreciation exp.: tools & eq. 50 Depreciation exp.: truck 250 Total $ 22,200 $ 22,200 All balances are taken from the ledger accounts on May 31 after preparing the two depreciation adjusting entries. 4-35
    • 36. End of Chapter 4 4-36

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