Accrual accounting ACCRUAL VERSUS CASH BASIS OF ACCOUNTING. ACCRUAL VERSUS CASH BASIS OF ACCOUNTING continued. Chapter 3

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1 Chapter 3 Accrual accounting 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 Cash-based accounting Revenue recognised when the cash is received or paid. Expenses recognised when the cash is received or paid 2 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 $ Revenue $ - basis Expense Expense - Profit $ Profit $ - Cash Revenue $ - Revenue $ basis Expense Expense - Loss $(50 000) Profit $

2 TIMING ISSUES Accounting divides the economic life of a business into artificial time periods (period assumption) Relationships exist between revenue recognition expense recognition period assumption 4 TIMING ISSUES continued Period assumption Economic life of business can be divided into artificial periods Revenue recognition criteria Revenues recognised in the period in which the increase in assets or decrease in liabilities become probable and can be measured reliably Expense recognition criteria Expenses recognised in the period when the reduction in assets or increase in liabilities become probable and can be measured reliably Revenue and expense criteria Form part of generally accepted accounting principles (GAAP) 5 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) 6 2

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 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 7 Adjusting entries for prepayments Prepayments are either: a. prepaid expenses Asset Unadjusted Credit Expense Debit balance adjusting adjusting entry (-) entry (+) b. revenues received in advance Liability Debit Unadjusted adjusting balance entry (-) Revenue Credit adjusting entry (+) 8 Adjusting entries for prepayments continued Prepaid expenses 1. Supplies Supplies on hand 31 October: $1000 Supplies expense of $2500 originally recorded as an asset Journal entry: Oct. 31 Advertising Supplies Expense Advertising Supplies (To record supplies used) 9 3

4 Adjusting entries for prepayments continued Supplies on hand 31 October: $1000 General Ledger entry: Advertising Supplies Oct Oct. 31 Adj. Advertising Supplies Expense Advertising Supplies Expense Oct. 31 Adj. Advertising Supplies cross-reference cross-reference 10 Adjusting entries for prepayments continued 2. Insurance Insurance paid for 1 year in advance: $600 Insurance for October $600/12 = $50 Journal entry: Oct. 31 Insurance Expense 50 Prepaid Insurance 50 (To record insurance expired) General ledger: Prepaid Insurance Insurance Expense Oct Oct. 31 Adj. 50 Oct. 31 Adj 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) 12 4

5 Adjusting entries for prepayments continued General Ledger Office Equipment Oct Accumulated Depreciation - Office Equipment Depreciation Expense Oct. 31 Adj. 40 Oct. 31 Adj. 40 Statement of Financial Position Office Equipment $5 000 Less: Accumulated Depreciation 40 Carrying Value $ Adjusting entries for prepayments continued Revenues received in advance Example $100 received 2 October for advertising services to be completed 31 December Journal entry: Oct. 31 Service Revenue Received in Advance 40 Service Revenue 40 (To record revenue) General Ledger: Service Revenue Received in Advance Service Revenue Oct. 31 Adj. 400 Oct Oct Oct. 31 Adj. 400 Adjusting entries for accruals Accruals may be either: a. accrued revenues Asset Revenue Debit Credit adjusting adjusting entry (+) entry (+) b. accrued expenses Expense Debit adjusting entry (+) Liability Credit adjusting entry (+) 15 5

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 revenue not received and not recorded Once cash is received, receivable is reduced 16 Adjusting entries for accruals continued Example: Commission Revenue earned, but not yet received or recorded: $200 Journal entry: Oct. 31 Commissions Receivable 200 Commissions Revenue 200 (To accrue commissions revenue not recorded or collected) General Ledger: Commissions Receivable Commissions Revenue Oct. 31 Adj. 200 Oct. 31 Adj 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 Interest rate: 12% p.a. Interest owing: $5000 x 12% x 1/12 = $

7 Adjusting entries for accruals continued Journal entry Oct. 31 Interest Expense 50 Interest Payable 50 (To accrue interest on bank loan) General Ledger: Interest Expense Interest Payable Oct. 31 Adj. 50 Oct. 31 Adj 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 Oct. 31 Adj Oct. 31 Adj

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 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 22 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 The adjusted trial basis is the main basis for preparation of the financial statements 23 WONG PTY LTD Trial Balances as at 31 October 2007 Before adjustment After adjustment Dr Cr Dr Cr Cash $ $ Commissions Receivable 200 Advertising Supplies Prepaid Insurance Office Equipment Accumulated Depreciation Office Equipment $ 40 Accounts Payable $ Interest Payable 50 Service Revenue Received in Advance Salaries Payable Bank Loan Share Capital Retained Earnings Dividends Service Revenue Commissions Revenue Salaries Expense Advertising Supplies Expense Rent Expense Insurance Expense 50 Interest Expense 50 Depreciation Expense Profit $ $ $ $

9 Preparing financial statements Income statement prepared from revenue and expense accounts Current period profit (or loss) and dividends paid transferred to retained profits account Statement of financial position prepared from asset, liability, equity and balance of retained earnings accounts 25 Preparing financial statements continued 26 WONG PTY LTD Adjusted Trial Balance as at 31 October 2010 Account Debit Credit Cash $ Commissions Receivable 200 Advertising Supplies Prepaid Insurance 550 Office Equipment Accumulated Depreciation - Office Equipment $ 40 Accounts payable Interest payable 50 Service Revenue Received in Advance 800 Salaries Payable Bank Loan Share Capital Retained Earnings -- Dividends 500 Service Revenue Commissions Revenue 200 Salaries Expense Advertising Supplies Expense Rent Expense 900 Insurance Expense 50 Interest Expense 50 Depreciation Expense 40 WONG PTY LTD Statement of Financial Position as at 31 October 2010 Assets Cash $ Commissions Receivable 200 Adverting Supplies Prepaid Insurance 550 Office Equipment $5 000 Less: Accumulated Depreciation Total assets $ Liabilities and equity Liabilities Accounts payable py $2 500 Interest payable 50 Service Revenue Received in Advance 800 Salaries Payable Bank Loan Total liabilities $ Equity Share Capital Retained Earnings Total equity Total liabilities and equity $ $ $ Balance at 31 Oct. from calculation of retained earnings on previous slide 27 9

10 CLOSING THE BOOKS Temporary accounts relate to only a given accounting period i.e., revenues, expenses, dividends Permanent accounts are carried forward to future accounting periods i.e., assets, liabilities, equity 28 Preparing closing entries Closing entries are used to transfer the temporary account balances to the permanent equity account, retained earnings They produce a zero balance in each temporary account 29 Preparing closing entries continued Each revenue and expense account is closed to the Income Summary, another temporary account The Income Summary account is closed to Retained Earnings Dividends are closed to the Retained Earnings This will result in all temporary accounts having a closing balance of zero 30 10

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 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 31 SUMMARY OF THE ACCOUNTING CYCLE 1. Analyse transactions 2. Journalise transactions 3. Post to ledger accounts 4. Prepare a trial balance 5. Journalise and post adjusting entries: prepayments/accruals 6. Prepare an adjusted trial balance 32 SUMMARY OF THE ACCOUNTING CYCLE continued 7. Prepare financial statements Income statement Calculation of retained earnings Statement of financial position 8. Journalise and post closing entries 9. Prepare a post-closing trial balance 33 11

12 DECISION TOOLKIT People Care Ltd Work through on your own and check your results with the suggested solution provided 34 DEMONSTRATION PROBLEMS 1. Green Thumb Lawn Care Ltd 2. Rosy Narr Work through on your own and check your results with the suggested solution provided