Chapter 3 Slides

Chapter 3
Copyright 2012 Pearson Education, Inc. Publishing as
Differentiate between accrual and cashbasis accounting

Define and apply the accounting period
concept, revenue recognition and matching
principles, and time period concept
Explain why adjusting entries are needed
Journalize and post adjusting entries
Explain the purpose of and prepare an

adjusted trial balance
Prepare the financial statements from the
Understand the alternate treatment of
unearned revenues and prepaid expenses
(see Appendix 3A, located at
myaccountinglab.com)
1
Differentiate between accrual and cash-basis
accounting
Accrual Basis
Cash Basis
Revenues
recognized when
earned
Revenues
recognized when cash
received
Expenses
recognized when
incurred
Expenses
recorded when cash
paid
Not GAAP
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Accrual basis revenue transactions
Cash-basis revenue transactions
Accrual basis
Cash-basis
The Johnny Flowers Law Firm uses a client

database. Suppose Johnny Flowers paid $2,900
for a computer.
Requirements:
1. Describe how the business should account for
the $2,900 expenditure under
a. the cash basis.
Record expense
$2,900
Record expense
$2,900
b. the accrual basis.
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S3-2: COMPARING ACCRUAL AND CASH-BASIS

ACCOUNTING
2. State why the accrual basis is more

realistic for this situation.
The accrual basis is more realistic because the
computer is an asset and it will benefit the
business for more than one year. To record the
cost of the computer as an expense is
unrealistic.
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2
Define and apply the accounting period
concept, revenue, and matching principles
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Businesses prepare financial statements for

specific periods to evaluate performance
Basic accounting period = one year
Calendar year
Fiscal year
Interim periods
Financial statements of less than one year
Monthly
Quarterly
Semi-annually
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When to record revenue?

When it is earned
When service is provided
When the product delivered
When the earnings process is complete
Not when cash is received, accrual method
The amount of revenue to recorded?

Value of item or service transferred to customer
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Measure all expenses incurred during the

period
Match the expenses against the revenues
earned during the same period
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Requires that accounting information be

reported at regular intervals
Accounts are updated at the end of each
accounting period
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On May 31, Smart Touch recorded

salary expense of $900 that is owed to
an employee at the end of the month.
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3
Explain why adjusting entries are needed
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Prepared at end of an accounting period

Assigns:
Revenues to the period when earned
Expenses to the period when incurred
Update asset and liability accounts

Need to properly match revenues and expenses
to measure:
Net Income
Assets and Liabilities
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4
Journalize and post adjusting entries
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Advance payments of expenses

Examples:
Rent
Insurance
Supplies
Recorded as an asset
Adjusting entry records amount used as an
expense
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At May 31st, this amount is too high.

One month has been used.
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Plant assets
Long-lived tangible assets used in business
operations
Examples:
Land, buildings, equipment, and furniture
Depreciation
Allocation of a plant assets cost to expense over its
useful life
Land is not depreciated
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Contra asset
account
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Amount
calculated based
on depreciation
method
Contra asset
Normal credit balance
Always paired with related account
Holds sum of all depreciation recorded on a

plant asset
Book value:
Cost minus accumulated depreciation
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Expenses incurred before payment is made

Results in a liability
Opposite of a prepaid expense

Examples:
Salaries
Interest
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Revenue earned before cash is received

Results in a receivable
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Cash is collected before revenue is earned

Results in a liability
Owes a product or service or refund
Also called deferred revenue
BEFORE
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To properly measure net income for the period

The entry affects a revenue or an expense
To update the balance sheet

The entry affects an asset or a liability
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Category of Adjusting Entry
Debit
Credit
Prepaid expense
Expense
Asset
Depreciation
Expense
Contra asset
Accrued expense
Expense
Liability
Accrued revenue
Asset
Revenue
Unearned revenue
Liability
Revenue
37
A select list of transactions for Anuradhas Goals

follows:
Apr 1 Paid six months of rent, $4,800.
Prepaid expense
10 Received $1,200 from customer for six-month
service contract that began April 1.
Unearned revenues
15 Purchased computer for $1,000.
Depreciation
Requirement:
1. For each transaction, identify what type of adjusting
entry would be needed.
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A select list of transactions for Anuradhas Goals

follows:
Apr 18 Purchased $300 of office supplies on account.
Prepaid expense
30 Work performed but not yet billed to customer,
$500.
Accrued revenues
30 Employees earned $600 in salary that will be paid
May 2.
Accrued expenses
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The following data at January 31, 2012 is given for

EBM, Inc.
a. Depreciation, $500
b. Prepaid rent expired, $600
c. Interest expense accrued, $300
d. Employee salaries owed for Monday through Thursday of
a five-day workweek; weekly payroll, $13,000
e. Unearned service revenue earned, $1,300
Requirement:
1. Journalize the adjusting entries needed on January 31,
2012.
40
Journal
ACCOUNTS AND
POST.
DATE
EXPLANATIONS
REF. DEBIT CREDIT
Adjusting Entries
2013
Jan
31 Depreciation expense
500
a.
Accumulated depreciation
500
b.
c.
d.
31 Rent expense
Prepaid rent
600
31 Interest expense
Interest payable
300
600
31 Salary expense
Salary payable
e.
31 Unearned service revenue

Service revenue
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300
10,400
10,400
1,300
1,300
2. Suppose the adjustments made in Requirement 1

were not made. Compute the overall overstatement
or understatement of net income as a result of the
omission of these adjustments.
Net income would be overstated by $10,500.
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5
Explain the purpose of and prepare an adjusted
trial balance
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Prepared after adjusting entries are posted

Useful step in preparing financial statements
Often appears on a work sheet
Tool accountants use at end of period
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Supplies on hand,
$300.
Depreciation,
$1,000.
Accrued interest expense, $600.
a) 300
800
300
19,100
b)1,000
2,000
200
600
2,500
7,400
14,800
c) 600
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a) 600
b)1,000
c) 600
2,200 2,200
4,500
600
1,000
1,200
27,500
27,500
6
Prepare the financial statements from the
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The Balance Sheet is

prepared last.
A= L+ E
Statement of Retained
Earnings is second
Income Statement is
prepared first.
Revenue - Expenses
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Refer to the adjusted trial balance in Exercise 3-21

for the month ended April 30, 2012.
Requirements:
1.Prepare the income statement.
2. Prepare the statement of retained earnings.
3. Prepare the balance sheet.
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Jobs-4-U Employment Service, Inc.

Income Statement
Month Ended April 30, 2012
Revenue:
Service revenue
Expenses:
Salary expense
10,600
6,200
4,400
3,700
Rent expense
1,000
Depreciation expense
1,000
Supplies expense
Total expenses
Net income
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500

Statement of Retained Earnings
Month Ended April 30, 2012
Retained earnings, March 31, 2012
$ 10,300
Net income
4,400
17,900
Dividends
4,800
Retained earnings, April 30, 2012
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9,900

Balance Sheet
April 30, 2012
Assets
Cash
Accounts receivable
Supplies
Equipment
$32,500
Accu. Depr.
(15,400)
Liabilities
$
900
5,600
500
17,100
Salary payable
Stockholders Equity
Common stock
13,000
Retained earnings
9,900
Total stockholders equity
Total assets
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$24,100
$ 1,200
Total liabilities and

stockholders equity
22,900
$24,100
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Prepaid Expenses (normally)

Advance payments of expenses
Debit an asset account
Adjust at end of period
Alternative
Debit an expense account
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Initially debit and expense account
Adjust at end of period for unused amount
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Unearned Revenues (normally)

Advance receipt of revenuescreates liability
Credit a liability account
Alternative
Credit a revenue account
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Initially credit a revenue account
Adjust at end of period for unearned amount
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Cash-basis accounting and accrual accounting

are different. Accrual accounting records
revenues and expenses when they are
earned/incurred. Cash-basis accounting records
revenues and expenses when cash is received or
paid.
The principles guide us as to when (the time
period and accounting period concepts) and how
(the revenue recognition and matching
principles) to record revenues and expenses.
62
We adjust accounts to make sure the balance

sheet shows the value of what we own (assets)
and what we owe (liabilities) on a specific date.
We also adjust to make sure all revenues and
expenses are recorded in the period they are
earned or incurred. Adjusting journal entries
either credit a revenue account or debit an
expense account, but they NEVER affect the
Cash account.
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The adjusting process has two purposes:

1. To capture all transactions that should be
reported in the period shown on the income
statement. Every adjustment affects a revenue or
an expense.
2. To update the balance sheet so that all accounts
are properly valued. Every adjustment affects an
asset or a liability (but never the Cash account).
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The adjusted trial balance includes all the

transactions captured during the period on the
trial balance plus/minus any adjusting journal
entries made at the end of the period. The
adjusted trial balance gives us the final adjusted
values that we use to prepare the financial
statements.
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The financial statements must be prepared in

order:
income statement first,
statement of retained earnings, second, and
balance sheet, third.
It is important for accountants to prepare

accurate and complete financial statements as
other people rely on the data to make decisions.
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Copyright
All rights reserved. No part of this publication may be reproduced,

stored in a retrieval system, or transmitted, in any form or by any
means, electronic, mechanical, photocopying, recording, or
otherwise, without the prior written permission of the publisher.
Printed in the United States of America.
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Chapter 3

Copyright 2012 Pearson Education, Inc. Publishing as

Differentiate between accrual and cashbasis accounting

Copyright 2012 Pearson Education, Inc. Publishing as

Explain the purpose of and prepare an

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Accrual basis revenue transactions

Cash-basis revenue transactions

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

The Johnny Flowers Law Firm uses a client

b. the accrual basis.

Copyright 2012 Pearson Education, Inc. Publishing as

S3-2: COMPARING ACCRUAL AND CASH-BASIS

2. State why the accrual basis is more

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Businesses prepare financial statements for

Copyright 2012 Pearson Education, Inc. Publishing as

When to record revenue?

Not when cash is received, accrual method

The amount of revenue to recorded?

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Measure all expenses incurred during the

Copyright 2012 Pearson Education, Inc. Publishing as

Requires that accounting information be

Copyright 2012 Pearson Education, Inc. Publishing as

On May 31, Smart Touch recorded

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Prepared at end of an accounting period

Update asset and liability accounts

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Advance payments of expenses

Copyright 2012 Pearson Education, Inc. Publishing as

At May 31st, this amount is too high.

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Holds sum of all depreciation recorded on a

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Expenses incurred before payment is made

Opposite of a prepaid expense

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

Revenue earned before cash is received

Copyright 2012 Pearson Education, Inc. Publishing as

Cash is collected before revenue is earned

Also called deferred revenue

Copyright 2012 Pearson Education, Inc. Publishing as

Copyright 2012 Pearson Education, Inc. Publishing as

To properly measure net income for the period

To update the balance sheet

Copyright 2012 Pearson Education, Inc. Publishing as

Category of Adjusting Entry