Module 3 (Accrual Accounting)

What are the five steps a selling company needs to apply to determine the proper revenue to recognize?

1. Identify the contract with a customer. 2. Identify the performance obligations (or promises) in the contract. 3. Determine the transaction price. 4. Allocate the transaction price to the performance obligations in the contract. 5. Recognize revenue at the point the performance obligations have been satisfied.

Recording Previously Unrecorded Expenses (Accrued Expenses)

A company often incurs expenses before paying for them. Employee wages, utilities, and income taxes are all examples of expenses that are typically incurred by a business before payment is made. If the accounting period ends on a date that does not coincide with a scheduled cash payment date, an adjusting entry must be recorded to reflect the expense incurred during the period.

When is a temporary account closed?

A temporary account is closed when an entry is made that changes its account balance to zero -- that is, the entry is equal in amount to the account's ending balance but is opposite to the balance as a debit or credit. An account that is closed is said to be closed to the account that receives the offsetting debit or credit. Thus, a closing entry simply transfers the balance of one account to another account.

Expense Recognition (Matching) Principle

Accounting requires that the expenses incurred to generate revenues be recognized (matched) in the same period. In other words, business expenses are recognized (matched) with sales revenues so that they are reported on the same income statement. It is the recognition of revenue, and NOT the payment of cash, that determines when expenses are recognized under the accrual basis of accounting.

Straight-Line Depreciation

Acquisition Cost ______________________________ Estimated Useful Life Estimates the annual amount of depreciation expense by dividing the acquisition cost of the asset by its estimated useful life in years.

Book Value

Acquisition Cost - Accumulated Depreciation Represents the unexpired asset cost to be applied as an expense against future periods.

Deferrals

Adjustments in the first two categories -- prepaid expenses and unearned revenues. The distinguishing characteristic of a deferral is that the adjustment deals with an amount that has previously been recorded, or deferred, in a balance sheet account. The adjusting entry, in effect, decreases the balance sheet account and increases an income statement account.

Accruals

Adjustments in the last two categories -- accrued expenses and accrued revenues. The unique characteristic of an accrual is that the adjustment deals with an amount that has not previously been recorded in an account. Consequently, the adjusting entry increases both a balance sheet account and an income statement account.

Adjustment for Prepaid Expenses

Allocating previously recorded assets to expenses to reflect the proper expenses incurred during the period.

Adjustment for Unearned Revenues

Allocating previously recorded unearned revenue to revenue to reflect revenue during the period.

Purpose of the Contra Account Accumulated Depreciation

Allows the original cost of the related asset to be reported in the company's balance sheet, followed by the accumulated amount of depreciation taken to date. Users of financial statements want to see both of these amounts so that they can estimate how much of an asset has been used and how much remains to benefit the business in future periods.

Temporary accounts

Are used to gather information for a particular accounting period. Revenue, expense, and dividend accounts are temporary subdivisions of stockholders' equity. At the end of the accounting period, temporary account balances are transferred to Retained Earnings, which is a permanent stockholders' equity account.

Revenue Earned After Cash is Received

Assume the Albertsons prepays for its donut purchases by giving Krispy Kreme a cash payment prior to receiving any donuts. Even though Krispy Kreme has received cash, it has not delivered the donuts, and thus, will defer the recognition of sales revenue until it does. Krispy Kreme will record a liability account, Unearned Revenue, for the cash received. When the donuts are delivered to the Albertsons, it will recognize the revenue.

Revenue Earned When Cash is Received

For most sales, Krispy Kreme will receive cash at the same time that the customer receives donuts. Under these circumstances, accrual accounting recognizes sales revenue at the same time that the company receives payment for its product. As a consequence, Krispy Kreme will debit Cash and credit Sales Revenue.

Adjustment for Accrued Revenues

Recording revenues that have not yet been received or recorded to reflect revenue earned during the period.

Adjusting Entries

Journal entries to record accounting adjustments. Each adjusting entry affects one or more balance sheet accounts (an asset or liability account) and one or more income statement accounts (a revenue or expense account).

Allocating Previously Recorded Assets to Expenses

Outlays for these expenditures are normally debited to an asset account at the time of payment. Then, at the end of each accounting period, the estimated portion of the expenditure that has expired, or that has been used up, during the period is transferred from the asset account to an expense account to achieve a proper recognition of revenue and expenses. These adjustments are commonly identified by inspecting the unadjusted trial balance for costs that benefit multiple accounting periods. Common examples include purchases of buildings, equipment, and supplies; prepayments of rent and advertising; and prepayments of insurance premiums.

Post-Closing Trial Balance

Provides evidence that an equality of debits and credits has been maintained in the general ledger throughout the adjusting and closing processes, and that the general ledger is in balance to start the next accounting period. This balance occurs after closing entries are recorded in the general journal and posted to the general ledger, and all of the temporary accounts have zero balances. Because the temporary accounts have been closed, only the balance sheet (or permanent) accounts appear in the post-closing trial balance.

Adjustment for Accrued Expenses

Recording operating expenses that have not yet been paid or recorded to reflect expenses incurred during the period.

Accrual Basis of Accounting

Requires a business to measure and report its operating performance regardless of whether all revenues have been collected in cash and all expenses have been paid with cash.

Recording Previously Unrecorded Revenues (Accrued Revenues)

Revenues from selling a product or providing a service must be recognized in the period in which the goods are sold or the services are performed. A company, however, may provide services during a period that are neither paid for by customers nor billed at the end of the period. The value of these services represents revenue that must be included in the current period income statement. To accomplish this, end-of-period adjusting entries are made to reflect any revenues for the period that have been earned but have not yet been paid or billed. Such accumulated revenue is often called accrued revenue.

Revenue Earned Before Cash is Received

Safeway purchases large quantities of Krispy Kreme donuts for resale in its grocery stores. Assume that Safeway agrees to pay for the donuts thirty days after delivery. Even though Krispy Kreme has not received payment for the delivered donuts, the company has earned the right to receive the cash, and consequently, Krispy Kreme must recognize the sales revenue prior to cash collection. In this case, it will debit Accounts Receivable and credit Sales Revenue at the time of the sale. The subsequent collection of cash on the account does not result in sales revenue being recognized.

Accounting Cycle

Sequence of accounting procedures that occurs each fiscal period and represents a systematic process for accumulating and reporting the financial data of a business.

Allocating Previously Recorded Unearned (Deferred) Revenue to Revenue

Sometimes a business receives fees for services or products before the services or products are rendered. Such transactions are initially recorded by debiting the Cash account and crediting a liability account called Unearned Revenue. The Unearned Revenue account is also called Deferred Revenue and represents an obligation to perform a service, or provide a product, in the future. Once the service or product is provided, the revenue is recognized. The required adjusting entry is a debit to the Unearned Revenue account, which reduces the liability account, and a credit to the Revenue account for the amount of revenue earned in the current period.

Permanent accounts

The accounts presented on the balance sheet. They consist of the asset, liability, and stockholders' equity accounts. The distinguishing feature of a permanent account is that any balance in account at the end of an accounting period is carried forward to the following accounting period.

Depreciation Expense

The allocation of the cost of revenue-generating assets over the many periods that they help produce revenues is an application of the expense recognition principle.

Accrued Interest

The amount of interest expense must be reflected in net income for the period. Interest expense (or interest revenue) is computed based on three factors: 1. The principal amount of the money borrowed (or loaned); 2. The rate of interest expressed as an annual rate; and 3. The amount of time in the calculation.

What is the process for closing entries?

The closing entries occur only at the end of an accounting period and consist of three steps, which are graphically shown below: 1. Close the revenue accounts. Debit each revenue account for an amount equal to its current credit balance, and credit the Retained Earnings account for the total amount of earned revenue. 2. Close the expense accounts. Credit each expense account for an amount equal to its current debit balance, and debit the Retained Earnings account for the total amount of expenses. 3. Close the Dividends account. Debit the Retained Earnings account and credit the Dividends account for an amount equal to the balance in the Dividends account.

Unadjusted Trial Balance

The end-of-period adjustment process begins with the preparation of a trial balance of all general ledger accounts. Because this trial balance reports the account balances before any adjustments have been made, it is referred to as the unadjusted trial balance. It is prepared to ensure that the general ledger is in balance before the end-of-period adjusting process begins. Accumulating all general ledger account balances in one location makes it easier to review the accounts and determine which account balances must be adjusted.

Key Point of Expense Recognition Principle

The key point is that under accrual accounting the recognition of expense is matched to the recognition of revenue in the same period. This may occur after the cash expenditure, before the cash expenditure, or at the same time as the cash expenditure.

Revenue Recognition Principle

The principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied. Has NOTHING to do with when cash is received!!!

Depreciation

The process of allocating the cost of buildings, equipment, and vehicles to the periods benefiting from their use. Because these long-lived assets help generate revenue for a company over many years, each accounting period in which the assets are used must reflect a portion of their cost as an expense.

Closing Process (Closing Procedures)

The process of transferring the balances in temporary accounts to Retained Earnings.

Cash Basis of Accounting

The receipt and payment of cash are the determining factors for when sales revenue is recognized and when expenses are deducted.

Types of Adjustments

There are four types of accounting adjustments made at the end of an accounting period: 1. Prepaid Expenses 2. Unearned Revenues 3. Accrued Expenses 4. Accrued Revenues

Contra Accounts

They are used to record reductions in, or offsets against, a controlling account.

Accumulated Depreciation (Contra Account)

When recording depreciation expense the reduction is recorded in this contra account, as opposed to reducing assets directly. In this case, the Accumulated Depreciation contra account offsets the controlling account, Office Equipment, which has a normal debit balance. Accumulated depreciation therefore has a normal credit balance and appears in the balance sheet as a deduction against Office Equipment.