Essay about Generally Accepted Accounting Principles and Financial Statements

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Lecture 4 Accrual Accounting and Adjusting Entries
Chapter 4: Financial Acct

Learning objectives
LO1: Accrual and cash bases of accounting
LO2: Adjusting journal entries
LO3: Adjusting journal entries, adjusted trial balance & financial statements
LO4: The closing process
LO5: The accounting cycle

Quick Review from Lecture 3

What is the accounting equation?

What is an account?

What does debit mean? What does credit mean?

How does a business record transactions?

What are the rules of debit and credit?

LO1: Accrual and cash bases of accounting

One of the main functions of accounting is to calculate profit.
Revenue – Expenses = Profit
But when should we record revenues and when should we record expenses. There are two approaches:

Cash Basis of Accounting
Records revenue when cash is received
Records expenses when cash is paid

Accrual Basis of Accounting
Records revenues when they are earned
Records expenses when they are incurred (when they happen)
This method follows the revenue recognition and matching principles
Accrual basis method shows a more accurate picture of business activites and is required by GAAP.
Information about cash flows is shown on the Cash Flow Statement

Calculate the profit for The Royal for 2013 under both cash and accrual bases:
During 2013, The Royal earned $110 000 from services provided and incurred expenses of $31 000.
At the end of the year, the company had received $71 500 from revenues and had paid expenses of $23 200.
Also during 2013, The Royal received $7 000 cash for services to be performed in 2014 and paid $9 000 for rent for the first six months of 2014.

LO2: Adjusting journal entries

To ensure that revenues are recorded when they are earned and expenses when they are incurred, adjustments need to be made at the end of each period.
In other words, accrual accounting requires adjusting journal entries to calculate the correct profit amount.
Adjusting entries are required because the cash payment/receipt may not be in the same period as the expense incurred or revenue earned.

Four types of adjusting entries:
1. Deferred Revenue: cash is received before revenue is earned.
2. Accrued Revenue: cash is received after revenue is earned.
3. Deferred Expense: cash is paid before expense incurred.
4. Accrued Expense: cash is paid after expense is incurred.

1. Deferred Revenue

Deferred revenue: when a company receives cash before it provides the goods or service.

Examples of deferred revenue:
Airlines get your money before you fly
Gift cards

Example: A company sells 12 month subscriptions to its monthly magazine. On 1 October the company receives $1200 for 20 subscriptions.

The normal journal entry to record this transaction:
1 Oct. Cash 1200 Unearned Subscription Revenue 1200
(to record cash received for future magazines)

During October the company sends out its monthly magazine to subscribers.
The company prepares financial statements at the end of October. Does any adjustment need to be made?

Adjusting journal entry on 31st October:
31 Oct. Unearned Subscription Revenue 100 Subscription Revenue 100

2. Accrued Revenue
Accrued Revenue: when a company provides the service/products first and then collects cash later.

Examples of businesses who may have accrued revenue:
Doctors
Lawyers
Accountants

Example:

On 23 September an accounting firm performs $1000 of work for a client.
On 10 October the accounting firm sends the bill to the client.
On 21 October the accounting firm receives the money from the client.

On 30 September the accounting firm prepares monthly financial statements. In accrual basis accounting revenue is recorded when it is earned. So an adjusting entry is required at the end of September.

Adjusting entry:
30 Sept.
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