The Accounting Cycle: Accruals and Deferrals
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This document discusses adjusting entries in accounting. It explains that adjusting entries are needed when revenue or expenses affect more than one accounting period. There are four main types of adjusting entries: 1) converting assets to expenses, 2) converting liabilities to revenue, 3) accruing unpaid expenses, and 4) accruing uncollected revenue. The document provides examples of each type of adjusting entry and explains how they affect the financial statements. It also discusses key accounting concepts like accruals, deferrals, and depreciation expense.
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The Accounting Cycle: Accruals and Deferrals
- 1. Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin The Accounting Cycle:The Accounting Cycle: Accruals and DeferralsAccruals and Deferrals otaleem.blogspot.comotaleem.blogspot.com for more presentation(follow me)for more presentation(follow me) Chapter 4
- 2. 4-2 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. Adjusting EntriesAdjusting Entries
- 3. 4-3 Types of Adjusting EntriesTypes of Adjusting Entries Converting asset to expenses (i.e Supplies, Unexpired Insurance) Converting liabilities to revenue (i.e Unearned revenue to revenue earned) Accruing unpaid expenses (i.e Interest Exp./Salary Exp.To Interest/Salary Payable) Accruing uncollected revenue (i.e A/R or Interest Receivable to Service Rev. Earned or interest Receivable)
- 4. 4-4 Converting Assets to ExpensesConverting Assets to Expenses An adjusting entries to convert an asset to expense consists of debit to an expense account and credit to an asset account. Prepaid Expenses It always be assets, becoming expenses only as service and goods are used up. (i.e Shop Supplies and Insurance policies)
- 5. 4-5 Prior Periods Current Period Future Periods Transaction Paid cash in advance of incurring expense (creates an asset). Transaction Paid cash in advance of incurring expense (creates an asset). End of Current Period Adjusting Entry Recognizes portion of asset consumed as expense, and Reduces balance of asset account. Adjusting Entry Recognizes portion of asset consumed as expense, and Reduces balance of asset account. Converting Assets to ExpensesConverting Assets to Expenses
- 6. 4-6 The Concept of DepreciationThe Concept of Depreciation Depreciation is the systematic allocation of the cost of a depreciable asset to expense. Depreciation is the systematic allocation of the cost of a depreciable asset to expense. Cash (credit) Cash (credit) Fixed Asset (debit) Fixed Asset (debit) On date when initial payment is made . . . The asset’s usefulness is partially consumed during the period. At end of period . . . Depreciation Expense (debit) Depreciation Expense (debit) Accumulated Depreciation (credit) Accumulated Depreciation (credit)
- 7. 4-7 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. $2,500 50 =$50$50 Depreciation expense (per period) = Cost of the asset Estimated useful life Depreciation Is Only an EstimateDepreciation Is Only an Estimate
- 8. 4-8 JJ’s Lawn Care Service would make the following adjusting entry. JJ’s Lawn Care Service would make the following adjusting entry. GENERAL JOURNAL Date Account Titles and Explanation P RDebit Credit May 31 Depreciation Expense: Equipment 50 Accumulated Depreciation: Equipment 50 To record one month's depreciation. Contra-assetContra-asset Depreciation Is Only an EstimateDepreciation Is Only an Estimate
- 9. 4-9 JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and make the journal entry. 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 P RDebit Credit May 31 Depreciation Expense: Truck 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 Depreciation Is Only an EstimateDepreciation Is Only an Estimate
- 10. 4-10 Accumulated depreciation would appear on the balance sheet as follows: Accumulated depreciation would appear on the balance sheet as follows: Depreciation Is Only an EstimateDepreciation Is Only an Estimate Cost - Accumulated Depreciation = Book ValueCost - Accumulated Depreciation = Book Value
- 11. 4-11 Prior Periods Current Period Future Periods Transaction Collect cash in advance of earning revenue (creates a liability). Transaction Collect cash in advance of earning revenue (creates a liability). End of Current Period Adjusting Entry Recognizes portion earned as revenue, and Reduces balance of liability account. Adjusting Entry Recognizes portion earned as revenue, and Reduces balance of liability account. Converting Liabilities to RevenueConverting Liabilities to Revenue
- 12. 4-12 Converting Liabilities to RevenueConverting Liabilities to Revenue Amount collected from customer in advance are recorded by debiting the cash account and crediting an unearned revenue(deferred revenue) account. For Examples: Advance Ticketing for Travel and sports match
- 13. 4-13 Prior Periods Current Period Future Periods Transaction Pay cash in settlement of liability. Transaction Pay cash in settlement of liability. End of Current Period Accruing Unpaid ExpensesAccruing Unpaid Expenses
- 14. 4-14 Accruing Unpaid ExpensesAccruing Unpaid Expenses It recognizes expenses that will be paid in future. (interest on borrowing, wages expense etc) Adjusting entry consists of a debit to an expense account and credit to a liability account. Examples: Accrual of Wages or salaries Expenses. Accrual of Interest Expenses.
- 15. 4-15 Prior Periods Current Period Future Periods Transaction Collect cash in settlement of receivable. Transaction Collect cash in settlement of receivable. End of Current Period Adjusting Entry Recognizes revenue earned but not yet recorded, and Records receivable. Adjusting Entry Recognizes revenue earned but not yet recorded, and Records receivable. Accruing Uncollected RevenueAccruing Uncollected Revenue
- 16. 4-16 Accruing Uncollected RevenueAccruing Uncollected Revenue A 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. In the adjusting entry we will record a receivable, an asset account, and recognize the revenue earned.
- 17. 4-17 Costs are matched with revenue in two ways: Costs are matched with revenue in two ways: Direct association of costs with specific revenue transactions. Direct association of costs with specific revenue transactions. Systematic allocation of costs over the “useful life” of the expenditure. Systematic allocation of costs over the “useful life” of the expenditure. Adjusting Entries and AccountingAdjusting Entries and Accounting PrinciplesPrinciples
- 18. 4-18 Effects of the Adjusting EntriesEffects of the Adjusting Entries Adjustment Revenue Expenses Net Income Assets Liabilities Owners' Equity Type I Converting Assets to Expenses No effect Increase Decrease Decrease No effect Decrease Type II Converting Liabilities to Revenue Increase No effect Increase No effect Decrease Increase Type III Accruing Unpaid Expenses No effect Increase Decrease No effect Increase Decrease Type IV Accruing Uncollected Revenue Increase No effect Increase Increase No effect Increase Income Statement Balance Sheet
- 19. 4-19 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. Adjusted Trial BalanceAdjusted Trial Balance
- 20. 4-20 End of Chapter 4End of Chapter 4
Editor's Notes
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.