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 Test Question What document do you prepare financial statements from Adjusted trial balance Timing Issues The Periodicity Assumption requires accountants to divide the economic life of a business into artificial time periods Companies recognize make the journal entry 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 incurred This is called the Expense Recognition Principle Accrual versus Cash Basis of Accounting 1 Accrual Basis Accounting GAPP rules Transactions recorded in the periods in which the events occur Revenues are recognized record when earned even if cash was not received Expenses are recognized record when incurred even if cash was not paid 2 Cash Basis Accounting not GAPP Revenues are recognized record only when cash is received Expenses are recognized record only when cash is paid Prohibited under generally accepted accounting principles GAPP Page 1 of 20 Accounting 2000 Chapter 4 Notes Example Suppose that Fresh Colors paints a large building in 2013 In 2013 it incurs owe and pays total expenses salaries and paint costs of 50 000 expenses It bills the customer 80 000 for services preformed but does not receive payment until 2014 Prepare income statements using the cash basis 2014 80 000 0 80 000 2013 0 50 000 50 000 Income Statement Cash Basis Total 80 000 50 0000 30 000 Cash Receipts Cash Payments Net Income Loss Prepare income statements using the accrual basis Income Statement Accrual Basis Total 80 000 50 000 30 000 2013 80 000 50 000 30 000 2014 0 0 0 Revenues Expenses Net Income Loss timing difference 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 about making corrections every time it prepares financial statements Includes one income statement revenues or expenses account and one balance sheet asset or liability account Needed to ensure that the revenue and expense principles are followed Types of Adjusting Entries DEFERRALS 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 revenues 1 Prepaid Expenses exs prepaid insurance supplies depreciation Costs that expire either with the passage of time or through use Page 2 of 20 Accounting 2000 Chapter 4 Notes Adjusting entry results in an increase a debit to an expense account and a decrease a credit to an asset account Oct 5 Oct 4 Adj Oct 31 Adj Oct 31 Journal Entry Journal Entry Supplies assets up Prepaid insurance Cash assets down Cash Supplies expense up Insurance expense Supplies asset down Prepaid insurance Debit Credit Debit Credit 2500 600 2500 600 1500 50 1500 50 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 What is the adjusting journal entry Purchased 2500 On hand 1000 Used up 1500 Used up 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 used up expires each month What is the adjusting journal entry Page 3 of 20 Accounting 2000 Chapter 4 Notes Oct 2 Adj Oct 31 Journal Entry equipment Cash Depreciation expense Accumulated depreciation contra asset Debit Credit 500 500 40 40 amount left amount used up 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 Accumulated depreciation use this to show value go down over time Statement Presentation for Depreciation Accumulated Depreciation Equipment is a account Appears just after the account it offsets Equipment on the balance sheet asset is reduced Page 4 of 20 Accounting 2000 Chapter 4 Notes 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 Example Sierra Corporation received 1 200 on October 2 from in advance 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 What is the adjusting journal entry Oct 2 Adj Oct 31 Journal Entry cash Unearned service rev Unearned service rev Service rev Debit Credit 1200 1200 400 400 Page 5 of 20 Accounting 2000 Chapter 4 Notes ACCRUALS 3 4 Revenues earned but not yet received in cash or recorded are called accrued revenue Expenses incurred owe but not yet paid in cash or recorded are called accrued expenses 3 Accrued Revenues This adjusting entry shows the receivable 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 Earned but not yet received or billed Adj Oct 31 later Nov when customer pays Journal Entry Accounts receivable service rev cash Debit Credit 200 200 200 Acct receivable 200 interest is earned Interest receivable Interest revenue XX XX Page 6 of 20 Accounting 2000 Chapter 4 Notes 4 Accrued Expenses This adjusting entry records the liability payable Recognizes the expense or amounts owed incurred not yet paid Example Interest Sierra Corporation signed a three