FA Ch04 WS1617

Fachhochschule Sdwestfalen
We create momentum
Prof. Dr. Valerie Wulfhorst
Financial Accounting
Agenda
1. Introduction to Financial Statements

2. A Further Look at Financial Statements
3. The Accounting Information System
4. Accrual Accounting Concepts
5. Merchandising Operations and the Multiple Step Income Statement
6. Reporting and Analyzing Inventory
7. Fraud, Internal Control, and Cash
8. Reporting and Analyzing Receivables
9. Reporting and Analyzing Long-Lived Assets
10. Reporting and Analyzing Liabilities
11. Reporting and Analyzing Stockholders Equity
12. Statement of Cash Flows
13. Financial Analysis: The Big Picture
Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

2 I Financial Accounting I Ch. 4.0. I WS 2016/17
Agenda Ch4.: Accrual Accounting Concepts
Timing Issues
The Basics of Adjusting Entries
The Adjusted Trial Balance and Financial Statements
Closing the Books
Quality of Earnings

Study Objectives
1. Explain the revenue recognition principle and the matching principle.

2. Differentiate between the cash basis and the accrual basis of accounting.
3. Explain why adjusting entries are needed, and identify the major types of adjusting
entries.
4. Prepare adjusting entries for deferrals.
5. Prepare adjusting entries for accruals.
6. Describe the nature and purpose of the adjusted trial balance.
7. Explain the purpose of closing entries.
8. Describe the required steps in the accounting cycle.
9. Understand the causes of differences between net income and cash provided by
operating activities.
10. Describe the purpose and the basic form of a worksheet.

Accrual Accounting Concepts
Accrual Accounting Concepts
Timing
Issues
Revenue
recognition
principle
Matching
principle
Accrual
versus cash
basis of
accounting
The Basics
of Adjusting
Entries
The Adjusted
Trial Balance
and Financial
Statements
Types of
adjusting
entries
Adjusting
entries for
deferrals
Adjusting
entries for
accruals
Summary of
basic
relationships
Preparing
the adjusted
trial balance
Preparing
financial
statements

Closing the
Books
Preparing
closing entries
Preparing a
post-closing
trial balance
Summary of
the accounting
cycle
Quality of
Earnings
Earnings
management
SarbanesOxley
Agenda Ch4.: Accruals & Deferrals
TIMING
ISSUES

Timing Issues
Accountants divide the economic life of a business into artificial time periods (Time
Period Assumption).
.....
Jan.
Feb
.
Mar
.
Apr.
Generally a month, a quarter, or a year.

Fiscal year vs. calendar year

Dec
.
Timing Issues
Review Question
The time period assumption states that:
a. revenue should be recognized in the accounting period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into artificial time periods.
d. the fiscal year should correspond with the calendar year.

Timing Issues
Revenue Recognition Principle

Companies recognize revenue in the accounting
period in which it is earned.
Revenue is considered to be earned, when work
is performed (e.g. when the customer receives
the service or product).
Revenue is earned,
when work is performed.

Timing Issues
Illustration
Assume Conrad Dry Cleaners cleans clothing on June 30, but customers do not claim
and pay for their clothes until the first week of July.
The journal entries for June and July would be:

Timing Issues
Matching Principle
Matching Principle
Expenses matched with revenues in the period
when efforts are expended to generate revenues
Let the expenses follow the revenues.

Timing Issues GAAP Relationships in Revenue and

Expense Recognition

Timing Issues
Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting Financial Accounting
Transactions recorded in the periods in which the events occur (independent from cash
flows)
Revenues are recognized when earned, rather than when cash is received.
Expenses are recognized when incurred, rather than when paid.

Timing Issues
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting Outlook: Corporate Finance!
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

Timing Issues
Illustration
Suppose that Fresh Colors paints a large building in 2009. In 2009 it incurs and pays
total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but
does not receive payment until 2010.

Timing Issues
Review Question
One of the following statements about the accrual basis of accounting is false. That
statement is:
a.Events that change a companys financial statements are recorded in the periods in
which the events occur.
b.Revenue is recognized in the period in which it is earned.
c.The accrual basis of accounting is in accord with generally accepted accounting
principles.
d.Revenue is recorded only when cash is received, and expenses are recorded only
when cash is paid.

THE BASICS OF
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.
Every adjusting entry will include one income statement account and one balance sheet
account.
The trial balance may not be up-to-date and complete. Reasons:
Some events are not recorded daily.
Some costs are not recorded because they expire
with the passage of time.
Some items may be unrecorded.

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.

Review Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they are incurred.
b. revenues are recorded in the period in which they are earned.
c. balance sheet and income statement accounts have correct balances at the end of an
accounting period.
d. all of the above.

Types of Adjusting Entries
Deferrals
Accruals
1. Prepaid Expenses. Expenses

paid in cash and recorded as
assets before they are used or
consumed.
3. Accrued Revenues. Revenues

earned but not yet received in
cash or recorded.
2. Unearned Revenues.
Cash received and recorded as
liabilities before revenue is
earned.
4. Accrued Expenses. Expenses

incurred but not yet paid in cash
or recorded.

Trial Balance
Each account is analyzed
to determine whether it is
complete and up-to-date.
Every adjusting entry will
include one income statement
account (rev/exp) and one
balance sheet account
(assets/liab).

Adjusting Entries for Deferrals
Deferrals are either:

Prepaid expenses
OR
Unearned revenues.

Adjusting Entries for Prepaid Expenses
Payment of cash, that is recorded as an asset because service or benefit will be

received in the future.
Cash Payment
BEFORE
Prepayments often occur in regard to:

insurance
supplies
advertising

Expense Recorded
Prepaid Expenses
Costs that expire either with the passage of time or through use.
Adjusting entries (1) to record the expenses that apply to the current accounting period,
and (2) to show the unexpired costs in the asset accounts.

Adjusting entries for prepaid expenses
Increases (debits) an expense account and

Decreases (credits) an asset account.
Common types: supplies, insurance, depreciation

Illustration
Sierra Corporation purchased advertising supplies costing $2,500 on October 5. Sierra
recorded the payment by increasing (debiting) the asset Advertising Supplies. This
account shows a balance of $2,500 in the October 31 trial balance. An inventory count
at the close of business on October 31 reveals that $1,000 of supplies are still on hand.
Adjusting Entry:
Oct. 31
Advertising supplies expense

Advertising supplies

1,500
1,500
Illustration
On October 4 Sierra Corporation paid $600 for a one-year fire insurance policy.
Coverage began on October 1. Sierra recorded the payment by increasing (debiting)
Prepaid Insurance. This account shows a balance of $600 in the October 31 trial
balance. Insurance of $50 ($600 / 12) expires each month.
Oct. 31 Insurance expense
50
Prepaid insurance
50
50!
550!
Depreciation
Buildings, equipment, and vehicles (long-lived assets) are recorded as assets, rather
than an expense, in the year acquired.
Companies report a portion of the cost of a long-lived asset as an expense
(depreciation) during each period of the assets useful life (Matching Principle).
Adjusting Entry:
Credit accumulated depreciation (contra asset account; normally a credit balance)
Increase (debit) a depreciation expense.

Illustration
For Sierra Corporation, assume that depreciation on the office equipment is $480 a
year, or $40 per month.
Oct. 31 Depreciation expense
Accumulated depreciation

40
40
Depreciation (Financial Statement Presentation)

Accumulated Depreciation is a contra asset account (normal balance = credit).
Appears just after the account it offsets (Equipment) on the balance sheet.

Summary

Adjusting Entries for Unearned Revenues
Receipt of cash that is recorded as a liability because the revenue has not been
earned.
Cash Receipt
BEFORE
Unearned revenues often occur in regard to:

rent
airline tickets
school tuition
magazine subscriptions
customer deposits

Revenue Recorded
Unearned Revenues
Company makes an adjusting entry to record the revenue that has been earned and to
show the liability that remains.
The adjusting entry for unearned revenues results in a decrease (a debit) to a liability
account and an increase (a credit) to a revenue account.

Adjusting entries for unearned revenues
Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.

Illustration
Sierra Corporation received $1,200 on October 2 from R. Knox for advertising services
expected to be completed by December 31. Unearned Service Revenue shows a
balance of $1,200 in the October 31 trial balance. From an evaluation of the work
Sierra performed for Knox during October, the company determines that it has earned
$400 in October.
Oct. 31 Unearned service revenue
Service revenue

400
400
Summary

Adjusting Entries for Accruals
Made to record:
Revenues earned
OR
Expenses incurred
in the current accounting period that have not been recognized through daily entries.

Adjusting Entries for Accrued Revenues
Revenues earned but not yet received in cash or recorded.

Adjusting entry results in:
Revenue Recorded
BEFORE
Accrued revenues often occur in regard to:

rent
interest
services performed

Cash Receipt
Accrued Revenues
An adjusting entry serves two purposes:
It shows the receivable that exists, and
It records the revenues earned.

Adjusting entries for accrued revenues
Increases (debits) an asset account and

Increases (credits) a revenue account.

Illustration
In October Sierra Corporation earned $200 for advertising services that were not billed
to clients before October 31.
Oct. 31 Accounts Receivable
Service Revenue

200
200
Summary

Adjusting Entries for Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.

Adjusting entry results in:
Expense Recorded
BEFORE
Unearned revenues often occur in regard to:

rent
interest
taxes
salaries

Cash Payment
Accrued Expenses
It records the obligations, and
It recognizes the expenses.

Adjusting entries for accrued expenses
Increases (debits) an expense account and

Increases (credits) a liability account.

Illustration
Sierra Corporation signed a three-month note payable in the amount of $5,000 on
October 1. The note requires Sierra to pay interest at an annual rate of 12%.
Oct. 31 Interest expense
50
Interest payable

50
Illustration
Sierra Corporation last paid salaries on October 26; the next payment of salaries will
not occur until November 9. The employees receive total salaries of $2,000 for a fiveday work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200
($400 x 3 days, excl. weekend).
Oct. 31 Salary expense
1,200
Salary payable
1,200
Salaries Payable

Accrued Expenses
It records the obligations, and
It recognizes the expenses.

Summary

Summary of Basic Relationships

THE ADJUSTED
TRIAL BALANCE
AND FINANCIAL
STATEMENTS

The Adjusted Trial Balance
After all adjusting entries are journalized and posted the company prepares another
trial balance from the ledger accounts (Adjusted Trial Balance).
Its purpose is to prove the equality of debit balances and credit balances in the ledger.


Review Question
Which of the following statements is incorrect concerning the adjusted trial balance?
a. An adjusted trial balance proves the equality of the total debit balances and the total
credit balances in the ledger after all adjustments are made.
b. The adjusted trial balance provides the primary basis for the preparation of financial
statements.
c. The adjusted trial balance lists the account balances segregated by assets and
liabilities.
d. The adjusted trial balance is prepared after the adjusting entries have been
journalized and posted.

Preparing Financial Statements
Financial Statements are prepared directly from the Adjusted Trial Balance.
Balance
Sheet
Income Statement

Retained
Earnings
Statement


CLOSING
THE BOOKS

Closing the Books
Temporary accounts relate to only a given accounting period (REV/EXP/DIV).

Permanent accounts: balances are carried forward into future accounting periods (A/L/
SE).
Closing entries: At the end of the accounting period, companies transfer the
temporary account balances to the permanent stockholders equity accountRetained
Earnings.
After closing the books:
Temporary accounts have zero balances.
But: Permanent accounts are not closed!

Closing the Books
In addition to updating Retained Earnings to its correct ending balance, closing entries
produce a zero balance in each temporary account.

Closing the Books

Closing the Books

Preparing a Post-Closing Trial Balance
The purpose of this trial balance is to prove the equality of the permanent account
balances that the company carries forward into the next accounting period.
All temporary accounts will have zero balances.

Summary of the Accounting Cycle
1. Analyze business transactions

9. Prepare a post-closing trial
balance
2. Journalize the transactions
8. Journalize and post closing

entries
3. Post to ledger accounts
7. Prepare financial
statements
4. Prepare a trial balance
6. Prepare an adjusted trial

balance
5. Journalize and post

adjusting entries

QUALITY
OF EARNINGS

Quality of Earnings
Quality of Earnings company provides full and transparent information.

Earnings Management - the planned timing of revenues, expenses, gains, and losses
to smooth out bumps in net income. Companies may manage earnings by:
one-time items to prop up earnings numbers.
inflate revenue numbers in the short-run
improper adjusting entries
As a result of the Sarbanes-Oxley Act, many companies are trying to improve the
quality of their financial reporting.

Keep an Eye on Cash
Sierra Corporations income statement shows net income of $2,860. Net income and
net cash provided by operating activities often differ.
Net income on a cash basis is referred to
as Net cash provided by operating
activities.
The statement of cash flows, reports net
cash provided by operating activities.

Keep an Eye on Cash
Sierra Corporations income statement shows net income of $2,860. Net income and
net cash provided by operating activities often differ.

Keep an Eye on Cash
The difference for Sierra is $2,840 ($5,700 - $2,860). The following summary shows the
causes of this difference of $2,840.

The Worksheet
As its name suggests, the worksheet is a working tool for the accountant. A worksheet
is not a permanent accounting record; it is neither a journal nor a part of the general
ledger. The worksheet is merely a supplemental device used to make it easier to
prepare adjusting entries and the financial statements. Small companies with relatively
few accounts and adjustments may not need a worksheet. In large companies with
numerous accounts and many adjustments, a worksheet is almost indispensable

Adjusting Entries Using a Worksheet (Appendix)


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Fachhochschule Sdwestfalen

Prof. Dr. Valerie Wulfhorst

1. Introduction to Financial Statements

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Agenda Ch4.: Accrual Accounting Concepts

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

1. Explain the revenue recognition principle and the matching principle.

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Accrual Accounting Concepts

Accrual Accounting Concepts

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Agenda Ch4.: Accruals & Deferrals

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Generally a month, a quarter, or a year.

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Revenue Recognition Principle

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Let the expenses follow the revenues.

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Timing Issues GAAP Relationships in Revenue and

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Accrual- vs. Cash-Basis Accounting

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Accrual- vs. Cash-Basis Accounting

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Agenda Ch4.: Accruals & Deferrals

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

The Basics of Adjusting Entries

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

The Basics of Adjusting Entries

Revenues - recorded in the period in which they are earned.

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

The Basics of Adjusting Entries

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Types of Adjusting Entries

1. Prepaid Expenses. Expenses

3. Accrued Revenues. Revenues

4. Accrued Expenses. Expenses

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

The Basics of Adjusting Entries

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Deferrals

Deferrals are either:

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Prepaid Expenses

Payment of cash, that is recorded as an asset because service or benefit will be

Prepayments often occur in regard to:

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Prepaid Expenses

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Prepaid Expenses

Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Prepaid Expenses

Advertising supplies expense

Prof. Dr. Valerie Wulfhorst I Business Administration Focus on Controlling

Adjusting Entries for Prepaid Expenses

Adjusting Entries for Prepaid Expenses