Accrual- vs. Cash-Basis Accounting Accrual-Basis Accounting Adjusting the Accounts Transactions recorded in the periods in which the events occur Revenues are recognized when earned, rather than when cash is received. Expenses are recognized when incurred, rather than when paid. Cash-Basis Accounting Revenues are recognized when cash is received. Expenses are recognized when cash is paid. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Recognizing Revenues and Expenses Companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed Matching Principle Match expenses with revenues in the period when the company makes efforts to generate those revenues. Adjusting Entries Adjusting entries make it possible to report correct amounts on the balance sheet and on the income statement. A company must make adjusting entries every time it prepares financial statements. Revenues - recorded in the period in which they are earned. Expenses - recognized in the period in which they are incurred. Adjusting entries - needed to ensure that the revenue recognition and matching principles are followed. The four basic types of adjusting entries are: Prepaid expenses: expenses paid in cash and recorded as assets before they are used or consumed. Unearned revenues: Cash received and recorded as liabilities before revenue is earned. Accrued revenues: Revenues earned but not yet received in cash or recorded. Lecture 4 Page 1
Accrued Expenses: Expenses incurred but not yet paid in cash or recorded. 1. Illustration of Prepaid Expenses Example 1: Insurance policies are usually purchased in advance. Cash is paid up front to cover a future period of protection. Assume a three-year insurance policy was purchased on January 1, 20X9, for $9,000. The following entry would be needed to record the transaction on January 1: Prepaid Insurance 9000 Cash 9000 By December 31, 2009, $3,000 of insurance coverage would have expired (one of three years, or 1/3 of the $9,000). Therefore, an adjusting entry to record expense and reduce prepaid insurance would be needed by the end of the year: Insurance Expense 3000 Prepaid Insurance 3000 As a result of the above entry and adjusting entry, the income statement for 2009 would report insurance expense of $3,000, and the balance sheet at the end of 2009 would report prepaid insurance of $6,000 ($9,000 debit less $3,000 credit). The remaining $6,000 amount would be transferred to expense over the next two years by preparing similar adjusting entries at the end of 2010 and 2011. Example 2: Assume a two-year lease is entered and rent paid in advance on March 1, 2009, for $30,000. The following entry would be needed to record the transaction on March 1: Prepaid Rent 30,000 Cash 30,000 If financial statements were to be prepared at the end of December 2009, an adjusting entry to record rent expense and reduce prepaid rent would be needed on that financial statement date: Rent Expense 12,500 Prepaid Rent 12,500 Lecture 4 Page 2
2. Illustration of Unearned Revenues Example 3: A company received $1200 on October 1, 2009 from a customer for advertising services expected to be completed by October 1, 2010. The following entry would be needed to record the transaction on October 1, 2009: Cash 1,200 Unearned Service Revenue 9000 If we assume that the company earned $300 of those fees in December 1, 2009, an adjusting entry to record service revenue and reduce unearned service revenue would be needed as follow: Unearned Service Revenue 300 Service Revenue 300 3. Illustration of Accrued Revenues Example 4: In December 2009 Pioneer Advertising Agency earned $200 for advertising services that have not been recorded. Pioneer makes the following adjusting entry on December 31, 2009: Accounts Receivable 200 Service Revenue 200 On January 10, 2010, Pioneer receives cash of $200 for the service performed in December 2009 and makes the following entry: Cash 200 Account Receivable 200 Lecture 4 Page 3
4. Illustration of Accrued Expenses Example 5: Assume that a company has not paid December 2009 salaries of $10,000 to its employees yet. December Salaries will be paid in January 2010. The following Adjusting entry will be required: Salaries Expanse 10,000 Salaries Payable 10,000 When the salaries are paid in January 2010, the following entry is recorded: Salaries Payable 10,000 Cash 10,000 Closing Entries Temporary These account are closed All revenue accounts All expenses accounts Owner s drawing account Permanent These account are not closed All assets accounts All liability accounts Owner s capital account At the end of the accounting period, the company transfer temporary account balances (revenue, expense, and drawing) to the permanent owner s equity account, Owner s Capital, by means of closing entries. Four entries are required in order to close the temporary accounts at the end of the period. They are as follows: 1. Debit each revenue account for its balance, and credit for total revenue. The following journal entry closes revenue accounts: Revenues 2. Debit for total expenses, and credit each expense account for its balance. The following journal entry closes expense accounts: Expenses Lecture 4 Page 4
3. Debit and credit Owner s Capital for the amount of net income. The following journal entry closes net income to capital: Capital 4. Debit Owner s Capital for the balance in the owner s Drawing account, and credit Owner s drawing for the same amount. The following journal entry closes drawings to capital: Capital Drawings Key Terms English Accrual Basis Cash Basis Matching Principle Adjusting Entry Revenue Recognition Principle Prepaid Expense Unearned Revenue Accrued Revenue Accrued Expense Closing Entries Temporary Accounts Permanent Accounts Arabic اساس االستحماق االساس النمذي مبذأ الممابلة ليذ تسوية مبذأ االعتراف باإليراد مصروف ممذم ايراد ممذم ايراد مستحك مصروف مستحك ليود االلفال الحسابات المؤلتة الحسابات الذائمة ملخص الذخل Lecture 4 Page 5
Exercises 1. The ledger of ABC company shows the following balances for selected accounts at December 31,2009 before adjusting entries: Debit Credit Prepaid Insurance $2,400 Office Supplies $2,500 Unearned Revenue $10,000 An analysis of the accounts shows the following: a) Insurance expires at the rate of $300 per month. b) Supplies on hand total $900. c) 25% of the unearned revenue was earned in December. Prepare the adjusting entries for the month of December. 2. Prepare the adjusting entry on December 31, for a company prepaid insurance of $1000 for a one year policy effective on October 1. What should be reported on the balance sheet as of December 31? 3. On December 1, a payment of 3000 is made for prepaid rent for one year. What is the adjusting entry on December 31? Lecture 4 Page 6
4. Based on the following information, prepare the adjusting journal entries at December 31: a) Prepaid rent expired during the year, $500 b) Salaries earned but unpaid are $1,000 c) Unearned service revenue of $2000 was earned during the year 5. At the end of the reporting period, a company had the following balances in its expense and revenue accounts: Salaries Expense $4000 Rent Expense $3000 Advertising Expense $1000 Service Revenue $10,000 Interest Revenue $2,000 Prepare the closing entries for expense and revenue accounts. 6. After revenue and expense accounts had been closed at year s end, the Income Summary account had a debit balance of $83,000 and credit balance of $ 95,000. Capital had a credit balance of $38,000. a) Prepare the journal entry to close net income to capital b) What is the ending balance in Capital? Lecture 4 Page 7