Accounting Cycle and Accrual Accounting

The Accounting Cycle Measurement Process

• The accounting cycle includes:
  • Recording and posting external transactions.
  • Recording and posting adjusting entries.
  • Preparing financial statements.
  • Recording and posting closing entries.

Cash-Basis Accounting

• Transactions are recorded only when cash is received or paid.

Accrual-Basis Accounting

• Assets are recorded when resources are obtained.
• Liabilities are recorded when obligations occur.
• Revenues are recorded when goods and services are provided to customers.
• Expenses are recorded when costs are used in running the company.

Key Point: Accrual-Based Accounting

• Economic events affecting assets, liabilities, revenues, and expenses are recorded as they occur under accrual-based accounting.

Concept Check 3-1

• Under accrual-basis accounting, economic events that affect assets, liabilities, revenues, and expenses are recorded as they occur.

Accrual-Basis vs. Cash-Basis for Revenue-Related Transactions

• Accrual-Basis:
  • Service Provided: Revenue Recorded.
  • Cash Received: Not recorded until cash received.
• Cash-Basis:
  • Service Provided: No revenue recorded.
  • Cash Received: Revenue Recorded.

Examples:

• (6) Dec. 12: Provide soccer training to customers for cash, 43,000.
  • Accrual-Basis: Revenue Recorded - 43,000
  • Cash-Basis: Revenue Recorded - 43,000
• (7) Dec. 17: Provide soccer training to customers on account, 20,000.
  • Accrual-Basis: Revenue Recorded - 20,000
  • Cash-Basis: No entry
• (8) Dec. 23: Receive cash in advance for soccer training sessions to be given in the future, 6,000.
  • Accrual-Basis: Record as Deferred Revenue (liability) until service provided - 6,000
  • Cash-Basis: Revenue Recorded - 6,000

Accrual-Basis vs. Cash-Basis for Expense-Related Transactions

• Accrual-Basis:
  • Cost Used: Expense Recorded.
  • Cash Paid: Not recorded until cash paid.
• Cash-Basis:
  • Cost Used: No expense recorded
  • Cash Paid: Expense Recorded.

Examples:

• (4) Dec. 1: Pay one year of rent in advance, 60,000 (5,000 per month).
  • Accrual Basis: Record as Prepaid Rent (asset) until rent expires (5,000/month)
  • Cash Basis: Expense Recorded - 60,000
• (5) Dec. 6: Purchase supplies on account, 23,000.
  • Accrual Basis: Record as Supplies (asset) until supplies used
  • Cash Basis: No entry.
• (9) Dec. 28: Pay salaries to employees, 28,000.
  • Accrual Basis: Expense Recorded - 28,000
  • Cash Basis: Expense Recorded - 28,000

Timing Differences

• Under both accrual-basis and cash-basis accounting, all revenues and expenses are eventually recorded for the same amount.
• The difference is in the timing of when revenues and expenses are recorded.

Generally Accepted Accounting Principles (GAAP)

• Cash-basis accounting is not part of GAAP.
• Accrual-basis accounting is part of GAAP.

Accrual-Basis Compared with Cash-Basis Accounting

Key Point

• The difference between accrual-basis and cash-basis accounting is timing.
• Accrual-basis: Revenues recorded when goods/services are provided; expenses when costs are used.
• Cash-basis: Revenues recorded when cash is received; expenses when cash is paid.
• Cash-basis accounting is not allowed for financial reporting for most major companies.

Concept Check 3–2

• For cash-basis accounting, an expense is recorded when cash is paid for a cost of operating the business. The company paid cash for supplies and would therefore record Supplies Expense under cash-basis accounting.

Concept Check 3–3

• For accrual-basis accounting, an expense is recorded when a cost is used to help generate revenues. A company that uses utilities has incurred a cost that helped to generate revenue in the current period and would therefore record Utilities Expense under accrual-basis accounting.

Adjusting Entries

• Accrual-basis accounting creates timing differences between cash inflows/outflows and their related revenues/expenses.
• These timing differences are reported as assets and liabilities.
• Adjusting entries update balances of assets, liabilities, revenues, and expenses.

External Transactions (Illustration 3-5)

• Examples of common business transactions:
  1. Sell shares of common stock for 200,000 to obtain funds.
  2. Borrow 100,000 from the bank, promising repayment in three years.
  3. Purchase equipment for giving soccer training for 120,000 cash.
  4. Pay one year of rent in advance: 60,000 (5,000 per month).
  5. Purchase supplies on account: 23,000.
  6. Provide soccer training for cash: 43,000.
  7. Provide soccer training on account: 20,000.
  8. Receive cash in advance for training sessions: 6,000.
  9. Pay employee salaries: 28,000.
  10. Pay cash dividends to shareholders: 4,000.

Prepaid Expenses

• Arise when a company pays cash to acquire an asset that is not used until a later period.
• There's a timing difference: cash is paid now, expense is recognized later.
• Payments are recorded as assets at purchase.
• Adjusting entry needed to:
  1. Decrease the asset's balance to its remaining amount.
  2. Recognize an expense for the cost of the asset used.

Prepaid Expense - Rent

• Example: Purchased one year of rent in advance for 60,000 (5,000 per month) on December 1.
• By December 31, one month of rent has expired.
• Adjusting entry:
  • Debit Rent Expense: 5,000
  • Credit Prepaid Rent: 5,000

Prepaid Expense - Supplies

• Example: Purchased supplies for 23,000 on account on December 6.
• At the end of December, a count reveals only 13,000 of supplies remain.
• Adjusting entry:
  • Debit Supplies Expense: 10,000
  • Credit Supplies: 10,000

Prepaid Expense - Depreciable Assets

• Example: Purchased equipment for 120,000 cash on December 1.
• By December 31, one month of the equipment's use has expired.
• Depreciation expense = 120,000 \div 60 months = 2,000 per month.
• Adjusting entry:
  • Debit Depreciation Expense: 2,000
  • Credit Accumulated Depreciation: 2,000

Concept Check 3-4

• The adjusting entry involving a prepaid expense always involves a debit to an expense and a credit to an asset or a contra account.

Reporting Depreciation of Property and Equipment

• Balance Sheet Presentation (Example: Federal Express)
  • Property and Equipment, at Cost
  • Less accumulated depreciation
  • Net property and equipment

Concept Check 3-5

*The book value of the asset is the asset’s original cost net of its accumulated depreciation. Another common word that is synonymous with book value is carrying value because this is the amount the asset is “carried” in the books.

Deferred Revenues

• Arise when a company receives cash in advance from customers, but products/services won't be provided until a later period.
• Company owes the customer a service in return, creating a liability.
• In the period services are provided, the liability is settled; adjusting entry is needed to:
  1. Decrease the liability to its remaining amount owed.
  2. Recognize revenue.

Example

• Received 6,000 cash in advance from customers on December 23.
• By December 31, 2,000 of services have been provided.
• Adjusting entry:
  • Debit Deferred Revenue: 2,000
  • Credit Service Revenue: 2,000

Accrued Expenses

• Occur when a company has used costs in the current period but hasn't yet paid cash.
• Company is obligated to pay for costs used to operate in the current period.
• Adjusting entry needed to:
  1. Record the liability to be paid.
  2. Recognize the cost as an expense.

Accrued Expenses - Salaries

• Example: By December 31, 3,000 in salaries have been earned by employees for the final three days of the month, but not paid.
• Adjusting entry:
  • Debit Salaries Expense: 3,000
  • Credit Salaries Payable: 3,000

Concept Check 3-6

• Since the employee worked two days in the last week of December (Monday and Tuesday), the amount of the accrual should be for 200 (= 100 per day × 2 days).
  • Salaries Expense 200
  • Salaries Payable 200

Accrued Expenses - Utilities

• Example: By December 31, utilities costs of 9,000 have been incurred but have not been paid.
• Adjusting entry:
  • Debit Utilities Expense: 9,000
  • Credit Utilities Payable: 9,000

Accrued Expenses - Interest

• Example: By December 31, one month of interest has been charged for borrowing 100,000 at 12% interest (= 100,000 \times 12\% \times 1/12).
• Adjusting entry:
  • Debit Interest Expense: 1,000
  • Credit Interest Payable: 1,000

Concept Check 3-7

• The formula to calculate interest for November and December (two months) is:

  • 200 = $20,000 \times 6\% \times 2/12

• The adjusting entry on December 31 would be:

  • Interest Expense 200
  • Interest Payable 200

Accrued Revenues

• Occur when a company provides products/services but hasn't yet received cash.
• Company has the right to receive payment; adjusting entry is needed to:
  1. Record an asset for the amount expected to be received.
  2. Recognize revenue.

Accrued Revenues - Services

• Example: By December 31, services of 7,000 have been provided to customers but have not yet been billed.
• Adjusting entry:
  • Debit Accounts Receivable: 7,000
  • Credit Service Revenue: 7,000

Concept Check 3-8

• All of the transactions listed would necessitate an adjusting entry.

Key Point (Adjusting entries 1 of 2)

• Adjusting entries are needed:
  1. When cash flows or obligations occur before the revenue- or expense-related activity (prepayment), or
  2. When cash flows occur after the revenue- or expense-related activity (accrual).

Key Point (Adjusting entries 2 of 2)

• Adjusting entries are unnecessary in two cases:
  1. For transactions that do not involve revenue or expense activities, and
  2. For transactions that result in revenues or expenses being recorded at the same time as the cash flow.

Adjusted Trial Balance

• Lists all account balances after updating them for adjusting entries.
• Prepared after posting the adjusting entries to the general ledger.
• Total Debits = Total Credits.

Key Point

• An adjusted trial balance is a list of all accounts and their balances at a particular date, after we have updated account balances for adjusting entries.

Relationship between Adjusted Trial Balance and Financial Statements

• Adjusted Trial Balance accounts are used to prepare the:
  • Balance Sheet: Assets = Liabilities + Stockholders’ Equity
  • Income Statement: Revenues − Expenses = Net Income
  • Statement of Stockholders’ Equity: Common Stock + Retained Earnings (Beg. RE + NI – Div) = Stockholders’ Equity

Income Statement

• Reports revenues and expenses for a period to arrive at net income.

Statement of Stockholders’ Equity

• Shows changes in stockholders' equity accounts (Common Stock and Retained Earnings) during a period.

Classified Balance Sheet

• Presents assets, liabilities, and stockholders' equity at a point in time.
• Classifies assets and liabilities into current and long-term categories.

Statement of Cash Flows

• Measures activities involving cash receipts and cash payments.
• Reflects a company’s operating, investing, and financing activities.

Concept Check 3-9

• Net income is the final result in the income statement. This amount is also transferred from the income statement to the statement of stockholders’ equity. So, the line item for net income would appear in both the income statement and the statement of stockholders’ equity.

Closing Entries

• Transfer the balances of all temporary accounts (revenues, expenses, and dividends) to the balance of the Retained Earnings account.
• Reduce the balances of these temporary accounts to zero to prepare them for the next period.

Closing Entries - Illustration 3-15

• (a) Close revenues to retained earnings
  • Debit Service Revenue
  • Credit Retained Earnings
• (b) Close expenses to retained earnings
  • Debit Retained Earnings
  • Credit Rent Expense, Supplies Expense, Depreciation Expense, Salaries Expense, Utilities Expense, Interest Expense
• (c) Close dividends to retained earnings
  • Debit Retained Earnings
  • Credit Dividends

Key Point

• Closing entries serve two purposes:
  1. Transfer the balances of temporary accounts (revenues, expenses, and dividends) to the Retained Earnings account, and
  2. Reduce the balances of these temporary accounts to zero to prepare them for measuring activity in the next period.
• Closing entries:
  • Increase retained earnings by the amount of revenues for the period and
  • Decrease retained earnings by the amount of expenses and dividends for the period.

Common Mistake

• Students sometimes believe that closing entries are meant to reduce the balance of Retained Earnings to zero.
• Retained Earnings is a permanent account, representing the accumulation of all revenues, expenses, and dividends over the life of the company.

Concept Check 3-10

• Only temporary accounts are closed. Temporary accounts include all revenues, expenses, and dividends. Balances of temporary accounts are transferred to the balance of Retained Earnings, which is a permanent account that is not closed.

Post-Closing Trial Balance

• A list of all accounts and their balances at a particular date after closing entries.
• Verifies that closing entries were prepared and posted correctly.
• Ensures accounts are ready for the next period's transactions.

Concept Check 3-11

• The only one of these four accounts that would remain on a trial balance after all of the revenues, expenses, and dividends were closed would be Retained Earnings. Dividends, rent expense, and service revenue would have been closed during the closing process and therefore would not be on the post-closing trial balance.