Chapter 3
Accrual accounting
concepts
concepts
PowerPoint presentation by Anne Abraham University of Wollongong
©2009 John Wiley & Sons Australia, Ltd
ACCRUAL VERSUS CASH BASIS
OF ACCOUNTING
• Accrual-based accounting
– Revenue recognised when goods and
services are provided
– Expenses recognised when assets are
consumed or liabilities incurred
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consumed or liabilities incurred
• Cash-based accounting
– Revenue recognised when the cash is
received or paid.
– Expenses recognised when the cash is
received or paid
ACCRUAL VERSUS CASH BASIS
OF ACCOUNTING continued
Example:
Year 1 Year 2
Activity Purchased paint, painted Received payment for work building, paid employees done in Year 1
Accrual Revenue $ 80 000 Revenue $ -
basis Expense 50 000 Expense -
Profit $ 30 000 Profit $ -
Cash Revenue $ - Revenue $ 80 000
basis Expense 50 000 Expense -
Loss $(50 000) Profit $ 80 000
TIMING ISSUES
• Accounting divides the economic life of
a business into artificial time periods
(period assumption)
• Relationships exist between
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– revenue recognition
– expense recognition
– period assumption
TIMING ISSUES continued
Period assumptionRevenue recognition criteria Expense recognition criteria Economic life of business can
be divided into artificial periods
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Revenue recognition criteria Expense recognition criteria
Revenue and expense criteria
Expenses recognised in the period when the reduction in assets or increase in liabilities
become probable and can be measured reliably Revenues recognised in the
period in which the increase in assets or decrease in liabilities become probable and can be
measured reliably
Form part of generally accepted accounting principles (GAAP)
THE BASICS OF ADJUSTING ENTRIES
• Adjusting entries are necessary to make
sure:
– Revenues and expenses are recorded in
the correct accounting period (matching
principle)
– Recognition criteria are followed for
assets, liabilities, revenues and expenses
(revenue recognition principle)
Types of adjusting entries
Prepayments
1. Prepaid expenses: Amounts paid in cash
and recorded as assets until used
2. Revenue received in advance: Amounts
received from customers and recorded as
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a liability until services performed or
goods delivered
Accruals
1. Accrued revenues: Amounts not yet
received and recorded for which goods or
services have been provided
2. Accrued expenses: Amounts not yet paid
or recorded for goods or services already
received
Adjusting entries for prepayments
Prepayments are either:
a. prepaid expenses
Asset Unadjusted Credit
Expense Debit
dj ti
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b. revenues received in advance
balance adjusting entry (-)
adjusting entry (+)
Liability Debit Unadjusted adjusting balance entry (-)
Revenue Credit adjusting entry (+)
Adjusting entries for prepayments
continued
Prepaid expenses
1. Supplies
– Supplies on hand 31 October: $1000
– Supplies expense of $2500 originally Supplies expense of $2500 originally
recorded as an asset
– Journal entry:
Oct. 31 Advertising Supplies Expense 1 500
Advertising Supplies 1 500
(To record supplies used)
Adjusting entries for prepayments
continued
– Supplies on hand 31 October: $1000
– General Ledger entry:
Advertising Supplies
Oct 5 2 500 Oct 31 Adj Advertising 1 500
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Oct. 5 2 500 Oct. 31 Adj. Advertising 1 500 Supplies Expense
Advertising Supplies Expense Oct. 31 Adj. Advertising 1 500
Supplies
cross-reference
cross-reference
Adjusting entries for prepayments
continued
2. Insurance
– Insurance paid for 1 year in advance: $600
– Insurance for October $600/12 = $50
Journal entry:
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– Journal entry:
– General ledger:
Oct. 31 Insurance Expense 50
Prepaid Insurance 50
(To record insurance expired)
Prepaid Insurance Insurance Expense Oct. 4 600 Oct. 31 Adj. 50 Oct. 31 Adj. 50
Adjusting entries for prepayments
continued
3. Depreciation
– Allocation of the cost of the asset to
expense over its useful life
– Depreciation of office equipment: $480
p.a. or $40 monthly
– Journal entry:
Oct. 31 Depreciation Expense 40
Accumulated Depreciation - Office Equipment 40 (To record monthly depreciation)
Adjusting entries for prepayments
continued
– General Ledger
Office Equipment Oct. 2 5 000
Accumulated Depreciation
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– Statement of Financial Position
p
- Office Equipment Depreciation Expense Oct. 31 Adj. 40 Oct. 31 Adj. 40
Office Equipment $5 000
Less: Accumulated Depreciation 40
Carrying Value $4 960
Adjusting entries for prepayments
continued
Revenues received in advance
• Example
– $100 received 2 October for advertising
services to be completed 31 December
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services to be completed 31 December
– Journal entry:
– General Ledger:
Oct. 31 Service Revenue Received in Advance 40
Service Revenue 40
(To record revenue)
Service Revenue Received in Advance Service Revenue Oct. 31 Adj. 400 Oct. 2 1 200 Oct. 3 10 000
Oct. 31 Adj. 400
Adjusting entries for accruals
Accruals may be either:
a. accrued revenues
Asset Debit adjusting
t (+)
Revenue Credit adjusting
t (+)
b. accrued expenses
entry (+) entry (+)
Expense Debit
adjusting entry (+)
Liability Credit adjusting entry (+)
Adjusting entries for accruals continued
Accrued revenues are revenues earned
from providing goods or services that
have not as yet been recorded
• Revenue and receivable are recorded for
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revenue not received and not recorded
• Once cash is received, receivable is
reduced
Adjusting entries for accruals continued
• Example:
– Commission Revenue earned, but not yet
received or recorded: $200
– Journal entry:
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y
– General Ledger:
Oct. 31 Commissions Receivable 200
Commissions Revenue 200
(To accrue commissions revenue not recorded or collected)
Commissions Receivable Commissions Revenue Oct. 31 Adj. 200 Oct. 31 Adj. 200
Adjusting entries for accruals continued
Accrued expenses are expenses not yet
paid or recorded at balance date
1. Accrued interest
Accrued interest owing on loan of $5000
– Accrued interest owing on loan of $5000
– Interest rate: 12% p.a.
– Interest owing:
$5000 x 12% x 1/12 = $50
Adjusting entries for accruals continued
– Journal entry
Oct. 31 Interest Expense 50
Interest Payable 50
(To accrue interest on bank loan)
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– General Ledger:
Interest Expense Interest Payable Oct. 31 Adj. 50 Oct. 31 Adj. 50
Adjusting entries for accruals continued
2. Accrued Salaries
– Salaries outstanding for October: $1200
(3 days x $400)
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Adjusting entries for accruals continued
– Journal entry
Oct. 31 Salaries Expense 1200
Salaries Payable 1200
(To record accrued salaries)
– General Ledger:
Salaries Expense Salaries Payable Oct. 26 4000 Oct. 31 Adj. 1200 Oct. 31 Adj. 1200
Summary of basic relationships
Accounts before Adjusting Type of adjustment adjustment entry Prepaid expenses
If amt paid is initially Assets overstated Dr Expenses recorded as an asset Expenses understated Cr Assets If amt paid is initially Expenses overstated Dr Assets
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recorded as an expense Assets understated Cr Expenses Revenues received in advance
If amt received is initially Liabilities overstated Dr Liabilities recorded as a liability Revenues understated Cr Revenues If amt received is initially Revenues overstated Dr Revenues recorded as a revenue Liabilities understated Cr Liabilities Accrued revenues Assets understated Dr Assets
Revenues understated Cr Revenues Accrued expenses Expenses understated Dr Expenses Liabilities understated Cr Liabilities
THE ADJUSTED TRIAL BALANCE AND
FINANCIAL STATEMENTS
• The adjusted trial balance is prepared after
all adjusting entries have been made
• It is used to prove the equality of total debit
balances and total credit balances after the
adjusting entries have been made
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adjusting entries have been made
• The adjusted trial basis is the main basis
for preparation of the financial statements
WONG PTY LTD Trial Balances as at 31 October 2007 Before adjustment After adjustment
Dr Cr Dr Cr
Cash $15 200 $15 200
Commissions Receivable 200
Advertising Supplies 2 500 1 000
Prepaid Insurance 600 550
Office Equipment 5 000 5 000
Accumulated Depreciation – Office
Equipment $ 40
Accounts Payable $ 2 500 2 500
Interest Payable 50
Service Revenue Received in Advance 1 200 800
Salaries Payable 1 200
Salaries Payable 1 200
Bank Loan 5 000 5 000
Share Capital 10 000 10 000
Retained Earnings -- --
Dividends 500 500
Service Revenue 10 000 10 400
Commissions Revenue -- 200
Salaries Expense 4 000 5 200
Advertising Supplies Expense 1 500
Rent Expense 900 900
Preparing financial statements
• Income statement prepared from revenue
and expense accounts
• Current period profit (or loss) and
dividends paid transferred to retained
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profits account
• Statement of financial position prepared
from asset, liability, equity and balance of
retained earnings accounts
Preparing financial statements continued
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WONG PTY LTD Statement of Financial Position
as at 31 October 2010 Assets
Cash $15 200
Commissions Receivable 200 Adverting Supplies 1 000 Prepaid Insurance 550 Office Equipment $5 000 Less: Accumulated Depreciation 40 4 960 Total assets $21 910
Liabilities and equity Liabilities
Accounts payable $2 500
WONG PTY LTD Adjusted Trial Balance as at 31 October 2010
Account Debit Credit
Cash $15 200
Commissions Receivable 200 Advertising Supplies 1 000 Prepaid Insurance 550 Office Equipment 5 000 Accumulated Depreciation
- Office Equipment $ 40
Accounts payable 2 500
Interest payable 50
Service Revenue Received
in Advance 800 p y
Interest payable 50
Service Revenue Received
in Advance 800
Salaries Payable 1 200
Bank Loan 5 000
Total liabilities $ 9 550 Equity
Share Capital 10 000
Retained Earnings 2 360
Total equity 12 360 Total liabilities and equity $21 910
Salaries Payable 1 200
Bank Loan 5 000
Share Capital 10 000
Retained Earnings --
Dividends 500
Service Revenue 10 400
Commissions Revenue 200
Salaries Expense 5 200
Advertising Supplies Expense 1 500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
$30 190 $30 190 Balance at 31 Oct. from
CLOSING THE BOOKS
• Temporary accounts relate to only a
given accounting period
– i.e., revenues, expenses, dividends
• Permanent accounts are carried forward
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Permanent accounts are carried forward
to future accounting periods
– i.e., assets, liabilities, equity
Preparing closing entries
• Closing entries are used to transfer the
temporary account balances to the
permanent equity account, retained
earnings
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• They produce a zero balance in each
temporary account
Preparing closing entries continued
• Each revenue and expense account is
closed to the Income Summary, another
temporary account
• The Income Summary account is closed y
to Retained Earnings
• Dividends are closed to the Retained
Earnings
• This will result in all temporary accounts
having a closing balance of zero
Preparing a post-closing trial balance
• A post-closing trial balance is a list of all
permanent accounts and their balances
after closing entries are journalised and
posted
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• The purpose of the post-closing trial
balance is to prove the equality of the
permanent accounts that are carried
forward to the next accounting period
SUMMARY OF THE ACCOUNTING
CYCLE
1. Analyse transactions
2. Journalise transactions
3. Post to ledger accounts
4 Prepare a trial balance
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4. Prepare a trial balance
5. Journalise and post adjusting entries:
prepayments/accruals
6. Prepare an adjusted trial balance
SUMMARY OF THE ACCOUNTING
CYCLE continued
7. Prepare financial statements
• Income statement
• Calculation of retained earnings
• Statement of financial position Statement of financial position
8. Journalise and post closing entries
9. Prepare a post-closing trial balance
DECISION TOOLKIT
• People Care Ltd
• Work through on your own and check
your results with the suggested
sol tion pro ided
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solution provided
DEMONSTRATION PROBLEMS
1. Green Thumb Lawn Care Ltd
2. Rosy Narr
• Work through on your own and check
your results with the suggested solution
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