Accounting 2000 Chapter 4 Notes Identify the major types of adjusting entries 1 Explain the revenue recognition principle and the expense recognition principle 2 Differentiate between the cash basis and the accrual basis of accounting 3 4 Prepare adjusting entries for deferrals 5 Prepare adjusting entries for accruals 6 Describe the nature and purpose of the adjusted trial balance 7 Explain the purpose of closing entries 8 Describe the required steps in the accounting cycle Timing Issues The periodicity Assumption requires accountants to divide the economic life of a business into artificial time periods Companies recognize revenue in the accounting period in which it is earned This is called the Revenue Recognition Principle Expenses are matched with revenues in the period when efforts are expended to generate revenues This is called the Expense Recognition Principle Accrual versus Cash Basis of Accounting Accrual Basis Accounting Transactions recorded in the periods in which the events occur Revenues are recognized when earned even if cash was not received Expenses are recognized when incurred even if cash was not paid Cash Basis Accounting Revenues are recognized only when cash is received Expenses are recognized only when cash is paid Prohibited under generally accepted accounting principles GAAP Page 1 of 10 Accounting 2000 Chapter 4 Notes Example Suppose that Fresh Colors paints a large building in 2011 In 2011 it incurs and pays total expenses salaries and paint costs of 50 000 It bills the customer 80 000 but does not receive payment until 2012 Prepare income statements using the cash basis Income Statement Cash Basis Total 80 000 50 000 30 000 Cash Receipts Cash Payments Net Income Loss Prepare income statements using the accrual basis 2011 0 50 000 50 000 2012 80 000 0 80 000 Income Statement Accrual Basis 2011 80 000 50 000 30 000 2012 0 0 0 Total 80 000 50 000 30 000 Revenues Expenses Net Income Loss Adjusting Entries Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement A company makes adjusting entries every time it prepares financial statement Includes one income statement account and one balance sheet account Needed to ensure that the revenue recognition and expense recogintion principles are followed Types of Adjusting Entries DEFERRALS cash occurs before economic events 1 2 Expenses paid in cash and recorded as assets before they are used or consumed are called prepaid expenses Cash received and reported as liabilities before revenue is earned are called unearned revenue 1 Prepaid Expenses Costs that expire either with the passage of time or through use Adjusting entry results in an increase a debit to an expense account and a decrease a credit to an asset account Page 2 of 10 Accounting 2000 Chapter 4 Notes Example Supplies Sierra Corporation purchased supplies costing 2 500 on October 5 Sierra recorded the purchase by increasing debiting the asset Supplies This account shows a balance of 2 500 in the October 31 trial balance An inventory count at the close of business on October 31 reveals that 1 000 of supplies are still on hand Oct 5 debit supplies 2500 Credit cash 2500 What is the adjusting journal entry October 31st Debit Credit Supplies Expense 1 500 Supplies 1 500 Before Adjustment Example Prepaid Insurance On October 4 Sierra Corporation paid 600 for a one year fire insurance policy Coverage began on October 1 Sierra recorded the payment by increasing debiting Prepaid Insurance This account shows a balance of 600 in the October 31 trial balance Insurance of 50 600 12 expires each month Oct 4 Dr Prepaid In 600 Supplies assets overstated Expense understated Cr Cash 600 What is the adjusting journal entry Oct 31st Debit Insurance Expense Credit Prepaid Insurance 50 50 Before Adjustment Preapid Insurance assets overstated Page 3 of 10 Accounting 2000 Chapter 4 Notes Example Depreciation For Sierra Corporation assume that depreciation on the office equipment is 480 a year or 40 per month What is the adjusting journal entry Debit Depreciation Expense 40 Credit Accumulated Depreciation equipment 40 Statement Presentation for Depreciation Accumulated Depreciation Equipment is a contra asset account Appears just after the account it offsets Equipment on the balance sheet Before Adjustment Equipment Asset Expense overstated understated 2 Unearned Revenues Adjusting entry to record the revenue that has been earned and to show the liability that remains Adjusting entry results in a decrease a debit to a liability account and an increase a credit to a revenue account Page 4 of 10 Accounting 2000 Chapter 4 Notes Example Sierra Corporation received 1 200 on October 2 from R Knox for guide services for multi day trips expected to be completed by December 31 Unearned Service Revenue shows a balance of 1 200 in the October 31 trial balance From an evaluation of the service Sierra performed for Knox during October the company determines that it has earned 400 in October Oct 2 Debit Cash 1200 Credit Unearned Revenue 1200 liability What is the adjusting journal entry Debit Credit ACCRUALS 3 4 Revenues earned but not yet received in cash or recorded are called accrued revenues Expenses incurred but not yet paid in cash or recorded are called accrued expenses 3 Accrued Revenues This adjusting entry shows the receivables that exists Records the revenue earned Example In October Sierra Corporation earned 200 for guide services that were not billed to clients before October 31 What is the adjusting journal entry Dr Cr accounts recevieable Service revenue Page 5 of 10 Accounting 2000 Chapter 4 Notes Before Adjustment Asset is understated Revenue is understated 4 Accrued Expenses This adjusting entry records the liability Recognizes the expense Example Interest Sierra Corporation signed a three month note payable in the amount of 5 000 on October 1 The note requires Sierra to pay interest at an annual rate of 12 What is the adjusting journal entry Debit Interest Expense Credit Interest Payable 50 50 Before adjustment Expense is understated Liability is understated Example Salaries Sierra Corporation last paid salaries on October 26 the next payment of salaries will occur on Nov 9 The employees receive total salaries of 2 000 for a 5 day work week or 400 per day Thus accrued salaries at October 31 are 1 200 400 3 days Page 6 of 10 Accounting 2000 Chapter 4 Notes What is the adjusting journal entry Salaries Expenses Debit