Chapter 4 - Accrual Accounting Concepts.docx

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Western University
Business Administration
Business Administration 2257
Amy Shuh

Chapter 4: Accrual Accounting Concepts Michael Hua September 18, 2013  Accounting divides the economic life of a business into artificial time periods  Accounting time periods are one month, one quarter (3 months), or one year REVENUE RECOGNITION  Revenue is recognized when there is an increase in an asset or a decrease in a liability  Revenue Recognition – occurs when the sales or performance effort is substantially complete, the amount is determinable (measurable), and collection is reasonably assured  In a merchandise company, revenue is considered to be earned when the merchandise is sold  In a service company, revenue is considered earned at the time the service is performed EXPENSE RECOGNITION  Expenses are recognized when there is a decrease in an asset or increase in a liability and this change can be measured reliably  Expense Recognition – changes in assets and liabilities ACCRUAL VS CASH BASIS OF ACCOUNTING  Accrual Basis Accounting – transactions affecting a company’s financial statements are recorded in the periods in which the events occur, rather than when the company actually receives of pays the cash  Cash Basis Accounting – revenue is recorded only when cash is received, and an expense is recorded only when cash is paid THE BASICS OF ADJUSTING ENTRIES  Adjusting Entries – updated accounts at the end of the accounting period  These are necessary because the trial balance – the first pulling together of the transaction data – may not contain complete and up-to-date data  This may be because: 1. Some events are not recorded daily, because it wouldn’t be useful or efficient to do so. Examples are the use of supplies and the earning of salaries by employees 2. Some costs are not recorded during the accounting period, because these costs expire with the passage of time rather than as a result of recurring daily transactions. Examples include rent, insurance, and depreciation 3. Some items may be unrecorded. An example is a utility service bill that will not be received until the next accounting period. The bill, however, covers services delivered in the current accounting period  Adjusting entries are required every time financial statements are prepared  If a company is public and reporting under IFRS, quarterly (3 months) financial statements must be prepared  If a company is private and reporting under ASPE, adjusting entries need to be done only annually but may be done more frequently if management wishes TYPES OF ADJUSTING ENTRIES  Adjusting entries can be classified as either prepayments or accruals Prepayments: 1. Prepaid Expenses – Expenses paid in cash and recorded as assets before they are used or consumed 2. Unearned Revenues – Cash received and recorded as liabilities before revenue is earned Accruals: 1. Accrued Revenues – Revenues earned but not yet received in cash or recorded 2. Accrued Expenses – expenses incurred but not yet paid in cash or recorded ADJUSTING ENTRIES FOR PREPAYMENTS  Prepayments – increase current assets such as prepaid expenses and certain types of non-current assets such as buildings and equipment  A prepayment can be received rather than paid – which increases current liabilities such as unearned revenue Prepaid Expenses  Costs that are paid for in cash before they are used  An asset (prepaid) account should be increased (debited) – to show the service or benefit that will be received in the future – and cash should be decreased (credited)  Prepaid Expenses are costs that expire either with the passage of time (e.g., insurance, rent, and depreciable assets) or through use (e.g., supplies)  At each statement date, adjusting entries are made for two purposes: (1) to record the expenses (expired costs) applicable to the current accounting period, and (2) to show the remaining amounts (unexpired costs) in the asset accounts  Until prepaid expenses are adjusted, assets are overstated and expenses are understated  An adjusting entry for prepaid expenses results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account ASSET EXPENSES Unadjusted Credit Debit Balance Adjusting Entry Adjusting (-) Entry (+)  The purchase of supplies (i.e., paper) results in an INCREASE (debit) to an asset account  Insurance payments (premiums) made in advance are normally recorded in the asset account Prepaid Insurance  It is necessary to make an adjustment to increase (debit) Insurance expense and decrease (credit) Prepaid Insurance for the cost of insurance that has expired during the period  Useful life usually refers to the duration for which the item will be useful (to the business), and not how long the property will actually last.  Depreciation is a method of allocating the cost of a non-current (property, plant, and equipment) or tangible asset over its useful life.  Amortization is used in relation to intangible assets and depletion is used in relation to natural resources  Depreciation is an estimate rather than a factual value  Straight-Line Method of Depreciation – dividing the cost of the asset by its useful life (Cost ÷ Useful Life [in years] = Annual Depreciation Expense)  If we were to determine the depreciation for one month, we would multiply the annual result by one-twelfth as there are 12 months in a year  Contra Account – an account that is offset against (deducted from) a related account on the income statement or balance sheet  **Every contra account has increases, decreases and normal balances that are opposite to those of the account it relates to  Accumulated Depreciation – Equipment is a contra asset account (it is
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