Download Chapter 3 (part 2)

Chapter 3
Adjusting the Accounts
ACCT 100
Objectives of the Chapter
I. Introduce the accrual accounting
concept.
II. Introduce the adjusting entries.
Accrual Accounting and the Financial Statements
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I. Accrual Accounting
1. The time-period concept, the revenue
recognition and the matching
principles.
2. Accrual versus cash basis accounting.
Accrual Accounting and the Financial Statements
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The Time-Period Concept (Periodicity)

Income and financial position of a
business are reported periodically, not
until the end of life of a business.
Accrual Accounting and the Financial Statements
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Revenue Recognition Principle
(SFAS No. 5) (-An Accrual Basis)




Revenue is recognized when it is earned
and realized.
Earned : the entity has substantially
accomplished what it must do to be entitled
to compensation.
Realized: goods are exchanged for cash or
claims.
In general, these conditions are met at time
of sale (delivery) or when services are
rendered regardless whether cash is
collected or not.
Income Measurement And Profit Analysis
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The Matching Principle


If revenues are recognized in a period, all
related expenses should be recognized in
the same period regardless whether
expenses are paid or not.
The related expenses include traceable
costs (i.e., product costs), period costs, (i.e.,
interest and rent expenses) and
estimated/allocation expenses (i.e.,
depreciation expense and bad debt expense).
Accrual Accounting and the Financial Statements
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Accrual vs. Cash Basis Accounting
Accrual-basis accounting:
Revenues are recognized based on revenue
recognition principle (i.e., recognized when
realized and earned regardless whether
cash is collected or not).
Expenses are recognized based on
matching principle.
Note: revenue and expense recognize before
cash settlement.

Accrual Accounting and the Financial Statements
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Accrual vs. Cash Basis Accounting
(contd.)

Cash-basis accounting:
The accountant does not record a
transaction until cash is received or
paid.
Cash-basis accounting is NOT
acceptable for financial reporting.
Accrual Accounting and the Financial Statements
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II. Adjusting Entries


Due to the periodicity concept, financial
reports are prepared periodically.
Based on revenue recognition principle,
adjusting entries are prepared at the
end of a period to recognize revenues
earned during the period but not yet
recorded (i.e., accrued revenues).
Accrual Accounting and the Financial Statements
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Adjusting Entries (contd.)

Based on the matching principle, the
accrued expenses (i.e., expenses
incurred but not yet paid/recorded) and
estimated expenses (i.e., depreciation
expense and bad debt expense) are
recorded at the end of a period.
Accrual Accounting and the Financial Statements
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Types of Adjusting Entries
A. Accruals
B. Deferrals
C. Estimated Expenses
Accrual Accounting and the Financial Statements
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A. Accruals

Unrecorded revenues or expenses (i.e.,
revenues earned or expenses occurred
but not yet recorded).
a. Accrued expenses.
b. Accrued revenues.
Accrual Accounting and the Financial Statements
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a. Accrued Expenses- An Example

A one-year note payable was issued on
11/1/x1 to purchase an equipment. The full
amount of the note is $2,400. The annual
interest rate is 10% and interests are paid on
4/30/x2 and 11/1/x2.
11/1/x1 Equipment
2,400
Note Payable
2,400
Adjusting Entry:
12/31/x1 Interest Expense
40
Interest payable
40
Accrual Accounting and the Financial Statements
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b. Accrued Revenues – An
Example

A one year note was received from a credit
sale with a face amount of $3,000 and an
annual interest rate of 12% on 9/1/x1.
Interests are received on 3/1/x2 and 9/1/x2.
9/1/x1 Note Receivable
3,000
Sales Revenue
3,000
Adjusting Entry:
12/31/x1 Interest Receivable 120
Interest Revenue
120
Accrual Accounting and the Financial Statements
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B. Deferrals

Postponing the recognition of Revenues
or expenses
a. Unearned revenues
b. Prepaid expenses
Accrual Accounting and the Financial Statements
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a. Unearned Revenues

Receiving $2,400 for a one-year advanced
rent payment from a tenant on 12/1/x1
(I/S Approach)
(B/S Approach)
12/1/x1
12/1/x1
Cash
2,400
Cash
2,400
Rent Revenue
2,400
Unearned Rent 2,400
12/30/x1
12/30/x1
Rent Revenue 2,200
Unearned Rent 200
Rent Unearned 2,200
Rent Revenue
200
Accrual Accounting and the Financial Statements
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b. Prepaid Expense

Prepaid a 12 month insurance premium of
$1,200 on 11/1/x1
(I/S Approach)
(B/S Approach)
Insurance Exp. 1,200
Prepaid Insur. 1,200
Cash
1,200
Cash
1,200
12/31/x1
12/31/x1
Prepaid Insur. 1,000
Insurance Exp. 200
Insurance Exp. 1,000
Prepaid Insurance 200
Accrual Accounting and the Financial Statements
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C. Estimated Expenses (based on the
matching principle)
Depreciation Expense
12/31 Depreciation Expense
XXX
Accumulated Depreciation
XXX
Bad Debt Expense
12/31 Bad Debt Expense
Allowance for B/D
XXX
XXX
Income Tax Expense
12/31 Income Tax Expense
Income Tax Payable
XXX
Accrual Accounting and the Financial Statements
XXX
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Example (from Financial Accounting by Harrison and Horngren):
Information for Adjustments at 4/30/ 19x1
(a) Prepaid rent expired, $1,000.
(b) Supplies on hand, $400 (balance of
supplies equals $700 before adjustment).
(c) Depreciation on furniture, $275.
(d) Accrued salary expense, $950.
(e) Accrued service revenue, $250.
(f) Amount of unearned service revenue that
has been earned, $150.
(g) Accrued income tax expense, $540.
Accrual Accounting and the Financial Statements
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Adjusting Entries
(a) Rent Expense
1,000
Prepaid Rent
1,000
To record rent expense.
(b) Supplies Expense
300
Supplies
300
To record supplies used.
(c) Depreciation Exp. - Furniture
275
Accumulated Depr. - Furniture
275
To record depreciation on furniture.
(d) Salary Expense
950
Salary Payable
950
To accrue salary expense.
Accrual Accounting and the Financial Statements
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Exhibit 3-9 Panel B (contd.)
(e) Accounts Receivable
Service Revenue
To accrue service revenue.
250
250
(f) Unearned Service Revenue
150
Service Revenue
150
To record unearned revenue that has been
earned.
(g) Income Tax Expense
Income Tax Payable
To accrue income tax expense.
540
Accrual Accounting and the Financial Statements
540
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