Week 3. Topic 3 Chapter 3. ACT102 Introduction to Accounting. Accounting for end of financial period adjustments 21/02/2018

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1 ACT102 Introduction to Accounting Week 3 Accounting for end of financial period adjustments Topic 3 Chapter 3 2 RECAP Topic 2: Recording Business Transactions The accounting equation must always balance after each transaction is recorded. To achieve this balance, we record transactions using a double-entry accounting system A transaction occurs and is recorded on a source document Then, we identify the account names affected by the transaction and determine whether the accounts increased or decreased using the rules of debit and credit Next, we record the transaction in the journal, listing the debits first. We then post all transactions to the ledger Once the ledger balances are calculated, the ending balance for each account is transferred to the trial balance If the trial balance does not balance, there are methods for finding the errors 3 1

2 Objectives Differentiate between accrual and cash-basis accounting Explain why adjusting entries are needed Journalise and post adjusting entries Explain the purpose of and prepare an adjusted trial balance Prepare the financial statements from the adjusted trial balance Describe the ethical challenges in accrual accounting 4 Two Bases of Accounting Accrual-basis: Transactions are recorded when revenues are earned or expenses are incurred when transaction occurs Cash-basis: Transactions are recorded when cash is paid or cash is received ignores payables and receivables. 5 Accrual versus Cash Accounting Profit can be calculated on a cash basis or on an accrual basis. Cash basis: profit is calculated by the excess of cash received from revenues less cash paid for expenses. Accrual basis: profit is calculated by the excess of revenues earned less expenses incurred. 6 2

3 Accrual versus Cash Example For example, in January 2012, Vervaci Bar & Grill entered into an agreement with a customer to make their premises available for a fashion parade on the first Friday night of March for the next three years. The contract specifies that the customer has to pay $15,000 in advance. Yearly expenses for the night are $2,000. What is the profit or loss? 7 Accrual versus Cash Example ( 000 omitted) Cash-Basis Accounting Cash inflows $15 $ 0 $ 0 Cash outflows Net profit (loss) $13 ($2) ($2) 8 Accrual versus Cash Example ( 000 omitted) Accrual-Basis Accounting Revenues $ 5 $ 5 $ 5 Expenses Net profit (loss) $ 3 $ 3 $ 3 9 3

4 The Revenue Principle When is revenue recognized? When it is deemed earned. Recognition of revenue and cash receipts do not necessarily occur at the same time. 10 The Matching Principle What is the matching principle? It is the basis for recording expenses. Expenses are the costs of assets and the increase in liabilities incurred in the earning of revenues. Expenses are recognized when the benefit from the expense is received. Recognition of expenses and cash outflows do not necessarily occur at the same time. 11 Adjusting Journal Entries In last week s lecture we recorded transactions in the journal, posted to the ledger and extracted a trial balance. The unadjusted trial balance reflects all these transactions recorded. But it is incomplete because it omits transactions that affect more than one accounting period. Accrual accounting requires adjustments. 12 4

5 Adjusting Journal Entries Assign revenue to the correct period earned. Assign expenses to the correct period incurred. Bring related asset and liability accounts into correct balance. 13 Two Types of Adjusting Entries Prepayments (Deferrals) Cash payment occurs before expense incurred or Cash received before revenue is earned. Accruals Expenses incurred but cash not paid yet or Revenue earned but cash not collected yet. 14 Five Categories of Adjusting Entries Prepaid expenses e.g. rent prepaid, insurance prepaid Accrued expenses e.g. wages payable, electricity payable Unearned revenues e.g. payment received for services not complete Accrued revenues e.g. payment not received for completed services Depreciation on non-current assets e.g. non-current asset purchased and expense recognized over time 15 5

6 1. Prepaid Expenses On June 1, Vervaci Bar & Grill prepays $3,000 for three months rent. Prepaid Rent 1/6 3,000 Cash 1/6 3,000 What is the journal entry on June 30? Prepaid Expenses Date Account and Explanation Debit Credit June 30 Rent Expense 1,000 Prepaid Rent 1,000 To record rent expense ($3,000 3 = $1,000) 1/6 3,000 30/6 1,000 Bal. $2,000 Prepaid Rent 30/6 1,000 Bal. $1,000 Rent Expense Cost used up, incurred or expired Prepaid Expenses What was the determining factor in matching this expense? TIME 18 6

7 Supplies Supplies are accounted for in the same way as prepaid expenses. On June 1, Vervaci Bar & Grill purchased $500 worth of Office Supplies in addition to the $100 on hand Office Supplies OB 100 1/ /6 600 Cash 1/ Supplies At the end of the month, a stocktake indicated that $200 of Office Supplies remained. What is the journal entry on June 30? Date Account and Explanation Debit Credit June 30 Supplies Expense 400 Office Supplies 400 To record office supplies expense ($600 - $200 = $400) Bal. $200 Office Supplies 1/ /6 400 Supplies Expense 30/6 400 Bal. $400 Cost used up, incurred or expired. 20 Supplies What was the determining factor in matching this expense? USAGE 21 7

8 2. Depreciation Depreciation refers to the process of allocating the cost of a non-current asset (i.e. an asset with a useful life of greater than one year) across the years in which the owner will derive benefit from ownership. The portion of the asset s cost that is assigned to expense. Note: any depreciation amount is an estimate only, i.e., often don t know exactly the estimated useful life of an asset or its sales value at the end of its life. Note: different depreciation calculation methods: straight-line, reducing balance, units of production, sum-of-year s digits Depreciation On June 1, Vervaci Bar & Grill purchased a delivery van for $25,000 cash. The delivery van is expected to last for 10 years. The estimated salvage value in 10 years is $2,000. What is the journal entry on June 30? Using straight-line depreciation method the monthly depreciation expense is: Purchase price salvage value = $25,000 - $2,000 = $2,300 per year Useful life of asset 10 years Monthly depreciation expense = $2,300 = $192 (approximately) Depreciation Date Account and Explanation Debit Credit June 30 Depreciation Expense 192 Accumulated Depreciation 192 To record depreciation on delivery van Depreciation Expense 30/6 192 Bal. $192 Accumulated Depreciation 30/6 192 Bal. $192 Cost used up, incurred or expired. 24 8

9 Accumulated Depreciation A contra account has a companion account. Accumulated depreciation is a contra account to the delivery van asset account. A contra account s normal balance is opposite to that of the companion account. Accumulated depreciation balance is accumulated over life of asset. 25 Accumulated Depreciation Partial Balance Sheet June 30 Vehicle assets: Delivery van $25,000 Less: Accumulated depreciation 192 Total $24,808 Contra account Carrying Amount or Book 26 value Accruals What is an accrual? It is the recognition of an expense or revenue that has arisen but has not yet been recorded. Expenses and revenues are recorded before the cash settlement. Expenses incurred but not yet paid for. Service provided but payment not yet received. 27 9

10 3. Accrued Expenses Employees at Vervaci Bar & Grill are paid every Friday. Weekly salaries (Sat. to Fri.) total $1,800. The business is closed Monday and Tuesday. The employees were last paid Friday 24th June. They will be paid again on Friday 1st July Accrued Expenses June July Accrued Expenses What is the normal weekly journal entry? Date Account and Explanation Debit Credit weekly Salaries Expense 1,800 Cash 1,800 To record salaries paid But because it is the end of the year, it is not a full week that we need to accrue. What is the journal entry on June 30? Staff worked 25 th, 26 th, 29 th & 30 th June. $1,800 5 = $360 per day. $360 x 4 days = $1,440 Date Account and Explanation Debit Credit June 30 Salaries Expense 1,440 Salaries Payable 1,440 To record accrued salaries expense 30 10

11 3. Accrued Expenses 30/6 1,440 Bal. $1,440 Salaries Expense Salaries Payable 30/6 1,440 Bal. $1,440 Cost used up, incurred or expired. Salaries (or wages) payable (or accrued) is a liability account on the Balance Sheet. When salaries paid, salaries payable liability will be reduced Accrued Expenses 30/6 1,440 Bal. $1,440 Salaries Expense Salaries Payable 30/6 1,440 Bal. $1,440 Cost used up, incurred or expired. On Friday 1 st, when the employees are paid, the entry will be Dr Salaries expense (1 day) 360 Dr Salaries payable 1440 Cr Cash 1800 After this entry, the weekly payment will revert to what it normally is. 4. Accrued Revenues In the last week of June, Vervaci Bar & Grill provided functions for customers for $3,000. At the end of June, the customers have not as yet been billed. What is the journal entry on June 30? Date Account and Explanation Debit Credit June 30 Accounts Receivable 3,000 Function Revenue 3,000 To record accrued revenue 33 11

12 4. Accrued Revenues What was the determining factor in recognizing this service revenue? PERFORMANCE Deferred Revenue What is deferred (or unearned) revenue? It is amounts received before the service is performed. On the 23 rd June, Vervaci Bar & Grill received $1,000 from a customer to provide lunches for the next 2 weeks. 23/6 1,000 Cash at Bank Unearned Revenue 23/6 1, Deferred Revenue What is the journal entry on June 30? Date Account and Explanation Debit Credit June 30 Unearned revenue 500 Bar & Grill Revenue 500 To record revenue collected in advance 30/ /6 1,000 Bal. $500 Unearned Revenue Revenue 30/6 500 Revenue earned 36 12

13 5. Deferred Revenue Unearned revenue is a liability account. Need to convert to revenue as revenue is earned. 37 Adjusting Entries Adjusting entries always have one income statement account and, Adjusting entries always have one balance sheet account. Adjusting entries never involve cash

14 Adjusted Trial Balance The adjusting process starts with the unadjusted trial balance. Adjusting entries are made at the end of the accounting period and then an adjusted trial balance is prepared. The adjusted trial balance prepared to check that adjustments have been correctly recorded. Adjusted trial balance reflects the balance in the ledger accounts after end-of-period adjusting entries. Debits must still equal credits! The adjusted trial balance serves as the basis for the preparation of the financial statements Financial Statements Financial statements have two parts: The first includes: Name of the entity Title of the statement Date or period covered The second part is the body of the statement

15 Prepare an adjusted trial balance. Vervaci Bar & Grill Adjusted Trial Balance as at 30 th June Debit Credit Cash $ 21,960 Accounts Receivable 3,000 Bar & Grill inventory 26,660 Office Supplies 200 Prepaid Rent 2,000 Delivery Van 25,000 Accumulated depreciation van $ 192 Plant & equipment 90,000 Accounts payable 2,850 Salaries payable 1,440 Unearned revenue 500 Bank Loan 75,000 D. Vervaci, Capital 85,000 D. Vervaci, Drawings 2,500 Bar & Grill revenue 13,700 Function revenue 3,000 Cost of goods sold 6,190 Electricity expense 1,140 Rent expense 1,000 Supplies expense 400 Salaries expense 1,440 Depreciation expense 192 $181,682 $181, Prepare financial statements. Vervaci Bar & Grill Income Statement For the period ending 30 th June $ $ Sales revenue 16,700 less Cost of goods sold 6,190 Gross profit 10,510 less Electricity expense 1,140 Rent expense 1,000 Supplies expense 400 Salaries expense 1,440 Depreciation expense 192 Net profit $6, Prepare financial statements. Vervaci Bar & Grill Statement of Changes in Equity For the period ending 30 th June Donnayella Vervaci, capital, 1 st June $60,000 Add: Owner contributions 25,000 Add: Net profit 6,338 91,338 Less: Drawings 2,500 Donnayella Vervaci, capital, 30 th June $88,

16 Prepare financial statements. Vervaci Bar & Grill Balance Sheet as at 30 th June Current Assets Current Liabilities Cash 21,960 Accounts payable 2,850 Accounts receivable 3,000 Salaries payable 1,440 Bar & grill inventory 26,660 Unearned revenue 500 Office supplies 200 Prepaid Rent 2,000 Non-current Assets Non-Current Liabilities Plant & equipment 90,000 Bank loan 75,000 Delivery Van 25,000 Less: accumulated depreciation ,808 Total Liabilities 79,790 Owners Equity Capital 88,838 Total Liabilities Total Assets $ 168,628 & Equity $168, Ethical issues in accrual accounting Accrual accounting provides opportunities for unethical behaviour For example, a dishonest businessperson could omit depreciation expense at the end of the year Failing to record depreciation would overstate profit as calculated by mandated accrual principles and disclose a more favourable picture of the business financial position than actually existed 47 Next Week Lecture - Topic 4 Completing the Accounting Cycle Tutorial - Topic 3 Tutorial Questions Complete the following questions for next weeks tutorial Starters: S3.1, S3.3, S3.8 Exercises: E3.2, E3.7 Problem: P3.3 Continuing Exercise: CE