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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

2

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

(2)

TIMING ISSUES

• Accounting divides the economic life of

a business into artificial time periods

(period assumption)

• Relationships exist between

4

p

– revenue recognition

– expense recognition

– period assumption

TIMING ISSUES continued

Period assumption

Revenue recognition criteria Expense recognition criteria Economic life of business can

be divided into artificial periods

5

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)

(3)

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

7

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

8

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)

(4)

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

10

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:

11

– 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)

(5)

Adjusting entries for prepayments

continued

– General Ledger

Office Equipment Oct. 2 5 000

Accumulated Depreciation

13

– 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

14

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 (+)

(6)

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

16

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:

17

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

(7)

Adjusting entries for accruals continued

– Journal entry

Oct. 31 Interest Expense 50

Interest Payable 50

(To accrue interest on bank loan)

19

– 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)

20

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

(8)

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

22

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

23

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

(9)

Preparing financial statements

• Income statement prepared from revenue

and expense accounts

• Current period profit (or loss) and

dividends paid transferred to retained

25

profits account

• Statement of financial position prepared

from asset, liability, equity and balance of

retained earnings accounts

Preparing financial statements continued

26

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

(10)

CLOSING THE BOOKS

• Temporary accounts relate to only a

given accounting period

– i.e., revenues, expenses, dividends

• Permanent accounts are carried forward

28

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

29

• 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

(11)

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

31

• 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

32

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

(12)

DECISION TOOLKIT

• People Care Ltd

• Work through on your own and check

your results with the suggested

sol tion pro ided

34

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

35

y gg

provided

References

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