Lecture 3-Accrual Accounting Concepts


>>Okay, today’s topic is
accrual accounting concepts. This is possibly the toughest
chapter in the financial accounting, and it’s just — it’s difficult material. I’m going to do my best to give you an
understandable explanation of the process here. But anyway, what we’re doing is we’re applying
the two basic rules of accrual accounting. Accrual accounting is required by
generally accepted accounting principles. All publicly traded companies, which
are all the big companies we know, have to use accrual accounting. And many private companies also have to use
accrual accounting if they apply for a loan at a bank, bank is going want to
see financial statements used — that have been preparing
using accrual accounting. Small companies can still get away
with a cash basis of accounting, and I’m going to talk briefly about
the cash basis only for the purpose of comparing it to accrual accounting. But we really have to focus on accrual
accounting concepts, so you don’t need to worry about the cash basis other than
to simply compare the difference between cash basis and accrual basis, okay? So we’re going to introduce the
concept of revenue recognition which is how, when do we record revenue. We’re going to look at expense recognition,
which we call the matching principle, also called the matching concept. So if you hear me say concept or
principle related to matching, same thing. And then we’re going to spend a lot of
time looking at adjusting journal entries, which I may abbreviate AJE, adjusting
journal entries, which are required in accrual accounting before we
prepare financial statements. Remember, we always prepare financial
statements at the end of the period. And I say period, because it
could be the end of the month if we prepare monthly financial statements,
it could be the end of the quarter if we prepare quarterly financial statements,
which publicly held companies are required to release to the public every quarter. And, of course, every company
prepares year-end financial statements. So the period could be month, quarter,
or year, but at the end of that period, we prepare financials, and before we do, we
have to prepare adjusting journal entries to make sure all related accounts
that need adjustment are up to date and that we’re presenting
accurate information, okay? So this is what we’re going
to be talking about today. Now, let’s just talk about revenue recognition. The word recognition in accounting simply
means when do we record a journal entry and credit the revenue account, okay. Expense recognition, which we call the matching
principle, says we should record an expense in the same time period that
it helps to generate revenue. And the matching principle, in
order for us to follow this rule, we have to make a certain assumption that
I’m going to give you some examples of these. But sometimes it’s very easy to identify
what we should record an expense. Other times, it’s not quite as easy, okay. This is what makes this area difficult, okay. And then, because of these two basic rules,
revenue recognition and the matching principle, they generate all sorts of
adjusting journal entries, which most people have a
very difficult time with. So I’m kind of laying that out there, because
you’re going to have to read the stuff over a few times and practice it
in order to survive the experience. Again, probably the toughest
chapter in the whole class. Okay. Now under the cash basis of accounting,
which, by the way is how most people would tend to think who have never had an accounting
class, cash basis basically says, I’m going to record revenue. I’m going to recognize revenue when I
get money, when I receive the cash, okay. Not an unreasonable assumption. I’m going to record the expense
when I pay the bill. Again, seems perfectly logical, okay. But notice the cash basis of accounting is
not in accordance with GAAP, which is why we have
to use the accrual basis of accounting. And I’m going to explain why just momentarily. Under the cash basis of accounting, we
record revenue when we’ve earned it, okay. Notice what the first bullet point says. Transactions recorded in the periods
in which the event occurs, okay. Which means something, some activity may
have happened, but we have not yet paid for it or received the money for it. That’s fine. It’s the event, or the activity
that drives recording revenues and expenses in accrual-based accounting. Revenues are recognized or
recorded with a journal entry when they’re earned rather
than when the cash is received. And again, I’m going to give
you specific examples of this. Expenses are recognized when incurred
rather than when paid, and again, we try to match the expense for the same time
period that it helped to generate revenue. All expenses that we incur, and we said
expenses at cost we incur to run our business, we wouldn’t be incurring any expenses if
we weren’t trying to generate revenue, so we match the expense to the revenue
under accrual basis accounting. I’m going to compare the two bases of
accounting, cash basis versus accrual basis. All right, let’s just take a look at
this slide just to reinforce the concept. We record revenue in the
period in which it’s earned. In a serviced-based business,
doctor, lawyer, accountant, anything where you’re providing is
service, revenue is considered to be earned at the time the service a performed, okay. If I’m the New York Giants, the
Los Angeles Lakers, whoever, whatever sports team I am,
how do I provide that service? I entertain the crowd by playing a game. I win, I lose, whatever,
I’ve provided the service. Airlines, how do they provide the service? They get you from point A to point
B. How does a hotel provide service? Well, you go to sleep, you wake up the next
morning and they’ve earned their revenue. Okay, now in a retail business or a
merchandise-based business, the Walmarts and Home Depots of the world, the sale typically
is recorded when you pay for the inventory. You buy a product, you pay for it, you walk
out of the store; they recognize revenue. Okay, in the early goings of this class
we focused on service-based businesses because it’s simply easier to account for, and then
after we’ve introduced basic accounting concepts, we then introduce inventory
and the issues related with inventory, okay. So notice the little graphic there says,
we recognize revenue when we have provided, and provided ending with the letters ED,
says past tense, done, right, finished. We’ve provided the service,
we now recognize revenue. Matching principle, match the expense to
the same time period as the revenue, okay. And sometimes we’re going to see,
with both revenues and expenses, the money gets either received for revenue
or paid before we do the recognition, and sometimes the money gets paid
or received after the recognition. And this is where the adjusting
journal entries come in. Okay, why do we have these
adjusting journal entries? Adjusting entries make it possible
to report the correct balances on both the balance sheet
and the income statement. If we don’t do adjusting entries, as
we’re going to see, both balance sheet and income statement are going to be wrong. Wrong balances, and people are making decisions
to invest in your business, to loan you money, to extend credit, to do business with you,
okay, based on your financial statements. If they’re reading wrong information,
this is a potential problem. So we need to do adjusting journal entries
to make sure that both balance sheet and income statement have the correct amounts. Okay. As previously stated a company must
make adjusting entries every time it prepares financial statements, and we always
prepare financial statements at the end of a time period, because we have to
have seen how much activity took place. How much revenue did we generate,
how much expense was incurred. That takes place at the end of the time period. Notice, this is a very important
rule, and hopefully it’ll guide you and prevent you from making mistakes. Every adjusting journal entry has to have
one account from the income statement and one account from the balance sheet. Now it could be a debit or a credit, it
just depends on the adjusting journal entry, but there’s always one balance sheet
and one income statement account in every adjusting journal entry, and cash, the cash
account is never part of an adjusting journal entry. If you debit or credit cash, by definition,
it’s not an adjusting entry, okay. And so we’re going to see how this works. Okay, revenues are recorded in the time
period in which the event took place. Expenses are matched to the expenses,
and we prepare adjusting entries to make sure we’re following the two
basic rules of accrual accounting, the two basic rules being revenue recognition and
the matching concept or matching principle, okay? And these adjusting entries are
prepared to make sure that both revenues and expenses are recorded on the income
statement in the proper time period, okay. This is a busy slide, okay,
let’s take look at this thing. We have two basic types of adjusting entries. We have what’s called deferrals,
and we have accruals. Those are the two basic types of
adjustments, deferrals and accruals. Now notice under deferrals we
have both expenses and revenues, and under accruals we have both
expenses and revenues, okay. Let’s take a look at the definitions here. A deferral, which is kind of confusing
word, is when we’ve either received money in advance before we provide a service to
our customer, or when we’ve paid for something
in advance that is going to later become an expense. Notice that for deferrals, we
call them prepaid expenses, and we call deferred revenue unearned revenue. So try, you as a student have to put all this
stuff together, unearned revenue is a form of deferred revenue, and a prepaid
expense is a deferred expense. And the reason we use the word deferred is
simply because the revenue or expense is going to be recorded in a future time period. The money for a prepaid expense,
we’re paying it in this month, it’s not going to become an expense
until next month or a following month. And we’ll see an example. Unearned revenue, my customer
paid me in advance, and I will provide the service
in a future month. So we’re deferring the recognition of revenue
or expense until a future time period. An accrual is the opposite scenario,
where we’re going to provide the service, in the case of accrued revenues, we’re
going to apply the service first, and we’re going to record revenue, and then
we’re going to get paid in a future time period. An accrued expense, I incur an
expense in this time period, but I don’t pay that expense
until a future time period. So if the first example of deferrals, the
money gets paid or received before the revenue or expense is recorded, and an
accrual, the money gets paid or received after the recognition of
revenue or expense, okay. And this again, this gets very confusing,
so you simply have to try to sort the information
in small bits and pieces, and again, reading the chapter a few times, not just once, unfortunately,
and perhaps watching this video a couple of times hopefully
will reinforce the information. So let’s just go ahead, and let’s
just read these together, all right. A prepaid expense. Expenses paid in cash and
are recorded as an asset. First, we record it as an asset
before they are used up or consumed. They will become an expense at a future time
period when we’ve used it up, such as supplies, office supplies, or when time
has consumed the benefit. For example, we pay for rent in
advance or insurance in advance. The passage of time, the rent
and insurance, expire, okay. Unearned revenue, cash is received, in
other words we were paid in advance, and we initially record the receipt of
cash — think of the journal entry — we’re going to receive cash, so
it’s going to be a debit to cash. But instead of crediting revenue, I’m going
to credit a liability called unearned revenue, okay, because we haven’t done the work yet. Once I do the work, okay, once we do the work
that our customer has paid us in advance for, we will then recognize revenue, and
then we’ll reduce that liability, and that’s called an adjusting entry, and
we’re going to see an example of that. Accruals, accrued revenue, revenues have been
earned, but not yet received in cash or recorded in our accounting record, so we’ve done
the work, and now we have to say, okay, even though we’re not going to get
paid until a future time period, we’ve got to record the revenue now. We did the work and now have to record
the revenue and an account receivable; we will get paid in a future time period. An accrued expense, we’ve incurred
expenses, but we have not yet paid that bill, so we have to accrue it. We have to record the expense even though
we’re going to pay it in a future time period. We record the expense in this time period,
okay, when we receive this month’s utility bill, for example, but we will pay it
in the next time period, okay. So we’re going to see examples
of all of this, okay. And this becomes especially important because
a lot of businesses have credit extended to
them, or they extend credit to customers. Okay, and sometimes you have
deferred payment plans. We’ve all seen commercials on TV where there’s
no payments for another 15 or 18 months, okay, but we still have to record
the revenues and expenses in the period in which the sale took place. Okay, and this goes to the heart of what
accrual accounting is trying to accomplish, and that is to measure the actual dollars
and cents value of all the activity taking place,
even when credit is involved and deferred payments are involved, okay. Okay, journal entries, comparing
the different methods of accounting, we’re going to compare the
accrual basis to the cash basis. Now, I’m going to show you
three separate scenarios. Let’s read this together. There are three scenarios. For each scenario, my company or we should
say, our company since we always account for our business, we are hired in November, and
we’re going to perform this service for my customer in December. I will be paid a different month, in
a different month for each customer to illustrate the difference
between the two methods of accounting, cash basis versus accrual basis. My fees for this service are $500. Let’s just assume we’re doing their tax
returns or painting their house, you know, cutting their grass or something
like that, and we pay, we charge a monthly fee of
500 for this service, okay. So we’re just dealing with one month here. First scenario, which is an
example of deferred revenue. Okay, now, hopefully you can
see this on your computer, but, the journal entry for the cash basis
is in red and the journal entry for the accrual basis is in black, okay. So remember what we said. We get hired in November and we’re
going to do the work in December. But in example one we’re
going to get paid in November. So we’re getting the money in advance. This is an example of deferred
revenue, which we call unearned revenue. Same thing, unearned revenue, deferred revenue. So in November, we get paid. Under the cash basis, remember we said the
cash basis says, oh, if I get paid in November, I’m going to record revenue in
November, and that’s what they did. They debited cash and they credited
service revenue, again, cash basis. The accrual basis says, well I’m getting paid
in November, I have to record the receipt of
cash and since I have not yet done the work I have to recognize a liability, an obligation
to perform service in the future. And so we’re going to credit a liability
account called unearned revenue for 500. In the month of December we do the
work to the customer’s satisfaction, and now we have to see what journal
entries do I record in December when the work is actually performed. Well, cash basis, there is no journal entry,
because I received the cash in November, I recognized revenue in November. Accrual basis, I now can recognize
revenue because I’ve done the work. So I’m going to reduce the liability by
500, because I no longer have an obligation. I fulfilled the obligation. And I’m going to recognize revenue. Here’s the recognition part,
revenue recognition, I’m going to credit service revenue. So notice in November we credited
liability, in December we debit the liability and that gets rid of the liability. The 500 debit and credit in
unearned revenue offsets. We now have a zero balance,
and I now have a credit balance and service revenue because
I provided work, okay. And there’s your revenue recognition. This is an example of deferred
revenue under accrual accounting. Second scenario. Remember, all three scenarios,
we get hired in November, maybe a phone call, and we
do the work in December. Now in this example they’re paying me in
December, and so when I do the work in December and I get paid in December, notice cash
basis and accrual basis are identical. No journal entry in November because I didn’t
receive any cash, so cash basis has nothing to record, and I didn’t do any work in November,
and so there’s no journal entry under either scenario. If I don’t show up to my customer’s house
to do the work, they’re not out any money. They’ll be annoyed, because they were
expecting me to do service, and I didn’t, but they’re not out any money, okay. So no journal entry in November
under either case. In December I do the work, I finish the job,
I knock on the door, he hands me 500 cash, so cash basis, since I got paid in December,
I’m going to record the receipt of cash and revenue in December. Accrual basis, since I provided the service,
I have to recognize revenue in that month, and since I’m getting paid cash, I’m going
to debit cash, credit service revenue. Same journal entry, both
methods, because we got paid in the same month that we provided the service. When that happens, the two
produce identical results. It’s when money gets paid either
before the service is provided or after the service is provided, that’s when
the two methods produce different results. Previously, we got paid in advance, okay. And so I had to recognize a liability
under accrual accounting, okay. And in the next example, I’m going
to provide the service in December, but I’m not going to get paid until January. Let’s take a look at that one. Here I’m getting paid in January. They hired me in November. I actually provide the work in December,
but they’re going to pay me in January. Notice, cash basis, November, no journal entry. December, I do the work, but since I’m
not getting paid, no journal entry. I get paid in January, so I debit cash
and I credit service revenue in January. Accrual basis, no journal entry in November,
nothing happened other than the phone call. In December I do the work and so I
have to recognize revenue in December, but since I’m not getting paid, I’m
going to record an account receivable. Debit accounts receivable,
credit service revenue. There’s my accrual. And in January when they actually pay me
the cash, I’m simply going to debit cash, and I’m going to reduce the account receivable,
since I’ve collected what was owed me, and so I eliminate the account receivable. The debit and credit for 500 offset each
other, and there’s a zero balance, okay. So you should compare the three
different scenarios to see the difference between a deferral and an accrual. A deferral we receive money in advance,
did the service in a following time period. In accrual, we did the work in this time
period, got paid in the following time period. But notice, I’m going to go
back to the previous slides. First example, I want you to
notice under the accrual basis, revenue is being recognized in
December in all three cases. Even though I’m getting paid beforehand, okay,
I’m still recognizing revenue in December. Second example, I’m recognizing revenue
in December, I got paid in December, and third example, I’m recognizing revenue
in December even though I’m getting paid in the following time period, okay. And this is what accrual accounting is all
about, is recognizing revenues and expenses in the time period in which the event took
place whether or not money was received beforehand
or afterwards, or paid beforehand in the case of an expense, or afterwards, okay. And this is stuff that simply takes practice. Very few people are very
good at accrual contracting, you know, without some practice, okay. Now, let’s just talk about which accounts
are involved in various adjustments. And we’re not going to cover all
of them, there are many accounts. We’re going to cover about five or six
different accounts to illustrate the concepts. A deferral is for prepaid
expenses and unearned revenue. Prepaid expense, deferred expense, same thing. Unearned revenue, deferred revenue, same thing. Unearned revenue and prepaid expense is the
terms more commonly used, but you simply have to recognize that they’re
both examples of a deferral. Prepaid expenses include supplies, prepaid
insurance, prepaid rent and equipment, or more broadly, property plant and equipment. There is a related expense in
account and an asset account for each of these adjustments, and we’ll see these. Okay, now for unearned revenue,
the only one we’re going to see is what we do work, and
we just saw it a moment ago. Okay, now accruals, there’s no
other fancy words for accruals, they’re simply accrued expenses
and accrued revenue. Accrued expenses include wages or salaries,
utilities and interest, and there are others, but these are the only examples
we’re going to really take a look at. In fact, I don’t think we’re
even taking a look at interest. For these accounts, we will have both
an expense and a liability account. For accrued revenue, we have a
revenue and an asset account. For this adjusting journal
entry, we’ll use service revenue, and we’ll have accounts receivable. Okay. Okay, now related to the deferral
or deferred expense with equipment, we need to provide some additional information
to talk about the concept of depreciation. Okay, so when we have a piece of equipment
or a vehicle or furniture or a computer, whatever,
we need to know three pieces information. We need to the know cost,
which is easily determined. Then we have to estimate what we call
salvage value or residual value; and that is, at the end of this asset’s expected useful
life, the third item, which again is an estimate,
what do we think we’re going to be able to recover? Okay, just like when you have a car,
maybe you hang onto a car for five years. At the end of the five years, it has
maybe a hundred thousand miles on it, hopefully you’re going to sell it for
seven, eight, nine thousand dollars. It depends on the car, obviously. That would be salvage value. Five years would be your estimated useful
life, and that’s just simply based on previous experience. We tend to hang onto vehicles
for about five years. If you turn cars over every three
years, then use three years. If you hang for 10 years, use 10 years. There’s no one correct number. It simply depends on what you expect
to happen in both the salvage value of what you think you can recover, and maybe
you use Kelly Blue Book for the useful life. Now we also need to have a few definitions
here, which you’re going to have to commit to memory. The first thing is what’s
called depreciable cost. And that’s simply cost minus salvage value. Now I’m going to do a quick
example on the board here. Let’s assume we buy a vehicle and
the cost is, we’ll say $30,000. And the salvage value, we’re going
to estimate at, we’ll say $10,000. And the useful life, we’re
going to estimate at five years. To calculate depreciation, what we’re
going to call straight line depreciation, we need a formula, and that formula is this:
Cost minus salvage value divided by the useful life. So if we plug in the numbers, cost is
30,000, minus salvage value of 10,000 divided by five years — and I’m running out of space
here so I’m going to put it underneath — that equals 20,000, which is my depreciable
cost, divided by five is $4,000 per year. So the depreciable cost is simply the portion
of the cost, the portion of the 30,000 that I’m not going to recover, okay. I think I’m going to recover $10,000,
so my true cost is 30 minus 10, 20,000, that’s the amount we’re going
to depreciate, okay. And if I use a time line, I
have a five-year useful life, each year I’m going to depreciate $4,000. Okay, 4K, $4,000 depreciation expense each
year. Now if I want to know what
my monthly depreciation is, I would simply divide 4,000 by 12. If I want to know what a quarterly
depreciation is, I could either divide by 12 and then multiply by three months, or
I can simply divide annual by four. Okay, now the next thing we need to
know is the concept of book value and a new term, accumulated depreciation. The adjusting journal entry to record depreciation
expense is debit depreciation expense — I’m going
to abbreviate — in this case it’s an annual journal entry. It could be monthly. And I’m going to credit this new account,
and again, I have to abbreviate called, called accumulated depreciation for $4,000. Let’s have a look. Okay. And I need to erase the board
and I need some board space here. I’m going to get rid of my timeline up here. Okay. So I have my equipment account,
and I record the cost, 30,000, and I have a related account called accumulated
depreciation, and this is a contra-asset. Now we haven’t heard this term before. The word “contra” means opposite
or opposing, okay. And so the only time we ever
see accumulated depreciation is with an equipment related account,
building, vehicles, computers furniture. By the way, we never depreciate land. We’ll talk about that when
we talk about property plant and equipment in a future lecture, okay. And we always record the
accumulated depreciation. Each time period it accumulates, it
stays on the balance sheet, okay. And it’s going to show us what the
undepreciated part of our original cost it. Okay, so we call this thing, or this account,
a contra-asset because an asset has normal debit balance. A contra-asset, opposite, is
going to have a credit balance. Now, here’s my adjusting journal entry, debit
depreciation expense, credit accumulated depreciation. I don’t have the T account for
depreciation expense on the board. If you want to write it down, that’s
fine, but at the end of year one, I’m going to credit the accumulated depreciation
expense, that’s posting it to the T account. I would post this 4,000 debit to
the depreciation expense account. But remember, I’m going to abbreviate here
— depreciation expense is an expense that goes on the income statement. Accumulated depreciation is a
contra-asset that goes on the balance sheet. If we think back to a previous slide, I said
every adjusting journal entry has one account from the income statement, one account
from the balance sheet, and here it is. Income statement, depreciation expense, okay. And balance sheet account,
accumulated depreciation, okay, contra-asset, so it goes to the balance sheet. Now remember, and we’ll see this coming up
soon. I’ve mentioned this before. Revenues, expenses and dividends, which are
part of retained earnings, are temporary accounts,
we means they’re going to get closed out at the end of the period after
we’ve prepared our financial statements. A balance sheet account, such
as accumulated depreciation, does not get closed out,
it’s a permanent account. So year after year after year it
accumulates, it keeps getting bigger. Look at the definition for book value. Book value equals cost minus
accumulated depreciation. So at the end of year one, the value
that I put on my balance sheet, which is required by GAAP,
is 30 minus 4, or $26,000. Okay. Depreciate expense
goes on the income statement, revenues and expenses will get
closed out, so they get zeroed out, and each year I continue to
record this journal entry. At the end of year two, I will have accumulated
$8,000, so my book value on the balance sheet at the end of year two would
be 30 minus 8, or 22,000, okay. And at the end of year three, I would
credit accumulated for another 4,000. Remember each year I took my timeline off
the board, but each year we put 4,000 expense on the income statement, and on the balance
sheet, this continues to accumulate, and I need to erase this, because I
want to show you what happens, okay. So I’m going to get rid of this. [ Pause ] End of year three, my book value
would be 30 minus 12, or 18,000. End of year four I have accumulated
another 4,000. End of year four, my book value is 30 minus
16 or 14,000, and the end of year five, which is the end of my estimated
useful life, accumulated has 20,000, my book value on the balance
sheet is now $10,000. When your book value is the
same as your salvage value, we’re not allowed to record any more
depreciation, stop depreciating. You can continue to drive that vehicle. You estimated five years, but if your business
is going through tough times and you need to hang on to the car for two or
three more years, that’s fine. It’s your car, you’re allowed to do that. This was your best estimate
when you bought the car. Okay, so, again at the end of the fifth year,
book value equals salvage value, we stop depreciating. We have what’s called a fully depreciated
asset. But for this lecture, the focus here
is on the adjusting journal entry. Each year I debit depreciation expense,
credit accumulated depreciation for 4,000. The expense goes on the income
statement, accumulated depreciation, which is a contra-asset,
goes on the balance sheet. Okay. All right, let’s take a look
at this big paragraph down here. We only depreciate those assets that we will
use for more than one year, such as equipment, buildings, vehicles, furniture,
computers, et cetera. Collectively, we call this property plant
and equipment, or fixed assets, and again, we’ll see this in a future lecture. Depreciation is simply spreading out the
cost over the useful life of the asset rather than recording the entire cost
as an expense in one year, okay. Think of that timeline I had on the board
and just spread it out over five years. That’s what depreciation is. Depreciation is not trying to determine
market value at any point in time. It’s an independent concept. When we sell this asset in
five, six, seven years from now, we’ll deal with market value
at that point in time. This is not trying to determine
market value, okay. We’re simply following the
rules of the matching principle. Depreciation is a good example of, if I’m
going to get five years use out of this vehicle,
it’s helping me to run my business for five years. We say that it’s helping to generate revenue
for five years, so I have to spread out the expense
to match the expense with the time period that it helps to generate revenues. It’s a good example of the
matching principle in effect. Now, why do we have this
accumulated depreciation account. I have two examples here to
illustrate the importance. Look at the top example where a
company simply shows us book value. Book value, which is cost minus
accumulated depreciation, right, is the undepreciated portion of the cost,
a hundred thousand for each company. So they have equipment worth $100,000,
it doesn’t give us that much information. I don’t know what it originally costs,
I don’t know if it’s an old machine, a new machine, look at example two. Same companies with the additional
information of cost and accumulated. Now this is providing more complete information,
better information than the first scenario. Notice the book value, 100,000 for each company
or for each piece of equipment, I should say. Well, we know that the first company’s
equipment cost a million originally, and that’s an old piece of equipment,
because, look we’ve written off 90 percent of it, 900,000 has been depreciated. That tells me this is an
older piece of equipment. The second piece of equipment
for company B is brand new. It cost 100,000, so it’s not nearly
at expensive as the first piece, but it’s also a brand new piece of equipment. So the second scenario on the bottom of
the slide gives us a more complete picture, which is why GAAP requires us to show any
equipment in property plant and equipment at cost and to have a separate account
for accumulated depreciation rather than simply credit the equipment account. This is a common mistake students make, is
rather than crediting accumulated depreciation, they credit the equipment account. GAAP says don’t do that. Show the original cost and show how
much depreciation has taken place in a separate account, and this way,
we can see what the original cost was, how old the asset is based on
the amount of depreciation, and what its current book value is. That is better picture, a more complete picture,
than the top half of the slide where we only show book value. Okay, onward. Now, what we’re going to do is
we’re going to look at this example, I’m going to need to erase the board here
because we need a lot of board space. And we’ve got a company. Joe Citrus started his own business,
JC, Inc., on March 1st, 2009. The trial balance at March
31st is as follows, okay. Remember we said you list assets
first with the debit balances? Then liabilities with credit balances, then
stockholders equity accounts with credit balances. If you have dividends, that would go
there, but it has a debit balance. Then revenue accounts, credit balance,
then expense accounts, debit balance, and remember on a trial balance,
debits must equal credits. And thankfully they do in this example. Okay, now I’m going to be kind of going back
and forth a little bit, and if you have this slide
in front of you, you may want to consider printing this slide, because I’m
not always going to have it up here, okay. But let’s take a look at this information,
and now we need additional information. Other data, so that we can prepare the adjusting
journal entries at the end of the period, whether it’s the month, quarter, or year. Supplies on hand, March 31st, total 980. We received a utility bill for
260 that has not been recorded and will not be paid until next month. The insurance policy is for a year, and since
we’re preparing a monthly financial statement, we have to do monthly adjusting journal entries. 3940 of unearned service revenue has
been earned at the end of this month. We paid salaries of 1500 – well,
actually we didn’t pay them, we were going to accrue them
at the end of the month. We’ll pay them some time in early April. The office equipment has a five-year life
with no salvage value and is being depreciated at 250 per month for 60 months,
which is simply five months — five years times 12 months a year. Invoices representing 3890 of services performed
during the month have not been recorded. We did the work, now we have
to accrue the revenue. So what I’m going to do it this. And work along with me, here,
break out a piece of paper. Let’s go back to the previous slide. All right, now what I want to do it this. I want to put the two accounts on the board,
and we’re going to adjust these accounts. Here’s supplies. Has a beginning balance of 2,080. I’m also going to put in a
supplies expense account up here. This is part of our adjusting entry. It has no balance at the moment. Okay, we have prepaid insurance. That has a beginning balance of 4800, and
right up here, I’m just going to put 400 per month. How do I get that? I simply divided 4,800 by 12 months and
we’re going to adjust prepaid insurance, which is an asset, 400 bucks per month. Because as time expires,
so too does the insurance. Okay, I’m going to need an insurance expense
account up here for the adjusting entry. Then we have unearned revenue. This is a liability. Okay. And the previous slide, or actually this
slide right here, unearned revenue has a balance of 5200, so a customer, or a few
customers, perhaps, paid us in advance. We received 5200, so we debited cash
and then we credited unearned revenue. When we do the work, we will then
reduce the liability and then after the service has been performed,
we can then recognize revenue. Okay. Then, I’ll put over here my
equipment account, which has a balance of 15,000, I believe, there we go. And remember, I’m not going to
adjust this account specifically, but as I record depreciation, I
will have depreciation expense and I will have accumulated depreciation. Okay. So now that we have these T accounts
here, we go to the additional data, all my T accounts that I
need for adjustment purposes. Remember cash is never involved in
an adjusting journal entry, okay. And certain accounts, I apologize, I need
to put a few more T accounts up here, okay. These are for the accruals. We’re going to have utility
expense, and utilities payable. We’re going to have wage
expense and wage payable. And last but not least, I need to put
accounts receivable up here, okay. Now, let’s take a look at all the
adjusting entries in order of the slide. [ Pause ] Okay. It says supplies on
hand at March 31st total $980. Okay. We began the month with 2,080 and
what we’re saying is, we counted supplies in the cabinet, and we only have 980 left. We started with 2,080, but
what do we do with supplies? We use them; we consume them in
the normal course of business. Now I can’t write the journal
entry, I’m going to describe it. And you need to think about this. In a previous lecture we talked about
how do you record a journal entry. If I used up supplies, then that’s when the
asset turns into or converts into an expense, because I don’t get my money back. I simply have to go out and
I have to buy more supplies. It’s just the way it is. When we first bought the supplies we
recorded an asset, because we were going to get a benefit, it was a resource. As we use it up, it becomes
a cost that we have to incur to run our business, it converts
into an expense. So my adjusting journal entry
is this: Debit supplies expense, and credit the supplies account, okay. Debit supplies, excuse me, debit
supplies expense, credit supplies. Okay, this goes on the income statement, and
the credit to supplies, which is an asset, reduces it from 2,080 down to the balance
of 980, which is what we have on hand, okay. You can’t just write in 980. In the world of accounting, you’ve
got to debit and credit your way to whatever balance you need to be in. Okay. Then it says a utility bill for 260
has not been recorded and will not be paid until next month, so we’ve been burning
through electricity, air conditioning, heating, whatever it maybe, lighting,
for the whole month. We get the bill, it’s 260 bucks. Since we used the electricity that month,
we have to record utility expense that month,
even though we’re not going to pay the bill until the following month. Okay, so what I’m going to do is I’m going
to accrue the expense and the related liability. My adjusting journal entry is to debit utilities
expense, which goes on the income statement, and I’m going to credit utilities payable. Okay, this is at accrued expense. I incurred the expense, I have
to record it in this time period, and I’ll pay it in the following time period. Now remember, an adjusting journal
entry does not include the cash account, so in the following month, what are
we in, I think we’re in March, okay, in April when I pay the bill,
that’s not an adjusting entry. This is the adjusting entry
to accrue the expense, to recognize the expense in the proper time period. Supplies, which we said earlier was
an example of a deferred expense, because we initially bought the
supplies, recorded it as an asset, and then we deferred calling it an expense,
or deferred recognizing the expense, until we actually used it up in
the following time period, okay. So we’ve seen a deferred expense, supplies,
and we’ve seen an accrued expense, utilities. Okay, now we’re going to look at insurance. Notice the insurance policy is for one year,
and since we’re preparing monthly financial statements, I have to record
one month worth of insurance expense. Insurance, we said 4800 divided by 12 months
is $400 per month, so each month as I use up insurance with the passage of
time, the asset is going to go down in value, and I don’t get my money back. I wish I did; I’d have a lot of money
since I’m pretty good person to be insured. I don’t get into too many accidents. Okay. And my adjusting journal entry is to debit
insurance expense and to credit prepaid insurance. So now, I have 11 months
of insurance left, okay. So the adjusting journal entry, debit insurance
expense, we always put the debits first, credit the asset, prepaid insurance
to reduce it, okay, and here it is. I always debit expenses, remember that, we
always debit expenses, and reduce the asset by one month’s worth of assurance
from 48 down to 4400. This goes on the income statement,
prepaid insurance, the adjusting entry on the balance sheet. So remember all adjusting journal entries,
one income statement account, one balance sheet account, okay. You don’t know which one is
going to be debited or credited until you know what type of
an adjusting entry it is. Okay. Be careful, you’re looking
for little shortcuts, okay. I always do this, I always do that. There are four different
types of adjusting entries and there are four different sets of rules. We have deferred expenses, deferred revenues;
we have accrued expenses, accrued revenues. And so be careful in terms of
drawing a conclusion prematurely. 3940 of unearned service revenue has been
earned at the end of the month, okay. Now notice unearned revenue, we originally
had 5200 and we’re saying that we recognized 3940,
so I’m going to reduce the liability by the portion that was owed, so I’m going
to debit unearned revenue, and I’m going to credit service revenue. Once I’ve earned the revenue,
I recognize the revenue. Here’s the revenue recognition right here,
and I have to reduce the liability from 5200 down to 1260, and what this 1260 represents
is money that we received in advance that we have not yet performed service
for, and we will in the future. Okay, but we were paid 5200 in advance, and
now we’ve done 3940 of work this month, therefore,
reduce the liability, recognize revenue. Service revenue goes to the income statement. This is a liability, we’re
reducing the liability because we’ve done the work,
and now we only owe them 1260. Salaries of 1500 are accrued at March 31st. Now this is very common. Most people get paid either
every other week or once a month. Some people get paid once a week or so. And it’s very common for a pay period
to start towards the end of one month and end in the beginning of
the following time month. In business, we have to allocate the number
of days’ work in each month to that time period. Now in this example, whether we get
paid — let’s just say it’s weekly, and a few of the days of this pay period were
in March and a few of them, say, Wednesday, Thursday, Friday, whatever, we’re in April,
then the two or three days that were in March, which is the 1500, have to be
recorded as an expense in March. And then those other remaining days
that were in April, they’ll get recorded as an expense in the month of April. Okay, so to accrue the expense, we’ve incurred
the expense, because my employees have worked. It’s now March 31st. They’ve worked for two or three days. I’ve got to put that expense in this month. So I’m going to debit wage expense,
1500, and since I’m not going to pay them for several more days — you usually pay
your employees after they’ve worked — I’m going to credit wage payable 1500. Now, let’s just say an April
8th or 9th, whenever payday is, when I pay them I’ll debit wage
payable and I’ll credit cash, okay. When we look at the current liabilities chapter,
we’ll talk a little bit more in detail about payroll. That’s not really our focus right now. The focus is the concept of an accrued
expense, which is what these two examples are. Utility expense and wage
expense are accrued expenses because we incur the expense this month; we’re going to pay
it the following time month, time period, excuse me. Okay, the office equipment has a
five-year life with no salvage value, and it’s being depreciated at 250 per month. So some types of equipment due
to obsolescence and technology, will have little to no salvage value. If we divide 15,000 by 5, that’s
$3,000 depreciation per year, and since we’re recording monthly depreciation,
3,000, which is annual depreciation divided by 12 months, 250 monthly depreciation. And as we saw previously on the
board, debit depreciation expense, which goes on the income statement,
credit accumulated depreciation, which goes to the balance
sheet, contra-asset, okay. So debit depreciation expense,
credit accumulated. And just real quickly, if I were preparing
a balance sheet at the end of March, in the noncurrent asset section under
equipment or property plant and equipment, my book value would be cost of 15
minus 250 of accumulated depreciation, book value would be 14,750, and that’s the
value we put equipment on the balance sheet. Last, invoices representing 3,890 of services
performed this month have not been recorded, so we have to accrue them. This is an example of accrued revenue. We did the work, now we’ve got
to send a bill to the customer. They’re going to pay us next month, and we
have to record the revenue this time period, even though we’re not going to get
pay until the following time period. This is an example of accrued revenue. So, I’m going to debit accounts
receivable of 3890, and I’m going to credit service revenue 3890. Now remember, even though service revenue,
we saw it related to unearned revenue when we got paid in advance, and now, here
we’re doing the service and we’re going to get paid after, I only need
one service revenue account. Okay. So debit accounts receivable,
credit service revenue. There’s my journal entry. Debit AR, credit service revenue. Next month when I get paid I will debit cash
and I’ll credit accounts receivable to get rid
of it since we’ve collected and they no longer owe us that money. So we always have to update receivables
and payables once we’ve received the money, or once we’ve paid it so that we don’t
think we have to pay it again and again or keep billing the customer
for the same amount. Okay, so we’ve just seen a whole
variety of adjusting journal entries. All right? And now we’re going to pause and we’re going
to look at the financial statement impact that adjusting entries have on
the actual financial statements. Okay, now what we’re going to do is
we’re going to take a look at an example, one example of a deferred expense, deferred
revenue, accrued expense and accrued revenue, and we’re going to look at the impact
that it has on the financial statements. And what we’re going to do is we’re going
to show, as we see on the board here, what the financial statements would look like with
the adjusting entry and without the adjusting entry. Now I’ve only put up the income statement
here on the board, and I’m going to kind of walk
you through the effect on the balance sheet. Now, first let’s take a look at supplies. We used $1,100 of supplies this month,
so we recorded the adjusting entry, debit supplies expense, credit supplies. Again, GAAP requires us to
perform adjusting entries, so we follow the rules of accrual accounting. What if we didn’t follow these rules
because we didn’t know what they were. We never had a class in accounting,
and for some crazy reason I ended up as the controller of a business. I’ve seen this happen. So, notice on the board here, on the
far right, we say if we didn’t record, if we did not record an adjusting entry,
this is what we would think we’d have for revenues, expenses, and net income. This column says this is really what we
have, and what we’re doing is, one at a time, we’re going to isolate the effect
of each adjusting entry if we did it versus did not do it, what the impact
is on the financial statements. Starting with supplies. Now, if I did not adjust the supplies account,
then I would think, I’m going to cover it up, that my supplies is actually 2,080
when, in fact, my supplies is 980. If I did not record the adjusting
entry, my assets would be too high, and the term we use is, they
would be overstated or overvalued. So my assets would be too
high, because I didn’t adjust. And the expense I would think was zero when,
in fact, the supplies expense should be 1100. My expenses would be too low. Let’s go to the income statement. Supplies expense is really 1100;
therefore, my net income is really 28,900. If I did not record this adjusting entry
I’d think my total expenses were 40,000, and my net income was 30,000. So on the balance sheet my
assets would be overvalued — I’m showing people that I have more
than I really do, it’s misleading — and on the income statement I’m reporting
30,000 when I should be reporting 28,900, because my expenses are really
41,100, add the two together. And my net income is 28-9. Okay, so the effect is assets would be
overvalued, expenses would be undervalued. If expenses are undervalued, my net
income is going to be over reported. Again, this is the effect if we
do not record the adjusting entry. We are required to record this adjusting entry. If we didn’t, expense too low, net income
too high, and as a result, net income we know
goes into retained earnings, stockholders equity would be too high. So on the kind of the accounting equation,
assets would be too high and equity would be too high. Notice we’re still in balance. That’s not the issue. The issue is, both the balance and the
income statement have an error on them. We’re reporting inaccurate information,
and if people make a decision based on inaccurate information and
things go wrong, they can sue us, because our financial statements
were in violation of GAAP. This is a very big issue because
— these are small numbers here. When you’re talking about big businesses you’re
talking about millions, tens of millions, hundreds of millions of dollars, and
adjusting entries can have a significant impact on the bottom line, on net income. Let’s look at unearned revenue. Now, we were paid 5200 in advance,
debit cash, credit earned revenue. During this month, we did 3940 of service,
and so I recognize 3940 of revenue, okay. And I reduce the liability, so now I
still owe them 1260 worth of service. If I did not adjust the unearned
revenue account and recognize revenue, I would think the liability was still
5200, so my liabilities would be too high, and I would not have recorded
3940 in service revenue. My revenue would be too low. Let’s take a look. I would think my total revenue was 70,000. Expenses were not affected
in this adjusting entry. Okay, we’re isolating one
adjusting entry at a time. I think net income was 30,000. When, in fact, my revenue is
really 70 plus 3940, right, so my net income is actually $33,940. I’m under reporting revenue and
net income in this case, okay, and so notice that each adjusting entry is
going to have a slightly different effect on both the balance sheet
and the income statement from an accounting equation standpoint. This is where things really get tricky. Again, if I did not record this adjusting
entry, I’d think my liabilities were 5200. My liabilities would be too high. My revenue, if I didn’t record
it, would be too low. If revenue is too low, net income is too low. And since this goes into retained earnings,
which is stockholders equity, my equity would be too low. So on the right side of the
accounting equation, here’s assets, here’s liabilities plus stockholders equity. I’m going to step over, which means here’s
liabilities, here’s stockholders equity. Liabilities, if I did not record the
adjusting entry, would be too high. Equity would be too low. They would offset each other, the right side
would still be in balance with the left side, but we would simple have a
mistake again on the balance sheet, and on the income statement, okay. This is the effect adjusting entries have
on our financial statements, because remember,
we said every adjusting entry has one account on the income statement, one account
on the balance sheet, okay. This is the rules of accounting,
accrual accounting, revenue recognition, the matching principle require us to prepare
four different types of adjusting entries: Deferred revenue, deferred expense,
accrued revenue, accrued expense. Okay, third example. And again, we’re isolating each
individual case to show the effect. Here, this one was, supplies
was a deferred expense. This was an example, unearned
revenue is deferred revenue. Now we look at the accruals. Wage expense, we are accruing the expense. Now this is a little bit
trickier because this number here, these two numbers, that is my adjusting entry. Notice there was no previous balance there. There was a zero balance, whereas with
the deferrals, we adjusted a number. We adjusting supplies from
20,000, 2800, whatever, to 980, and we adjusting unearned
revenue from 52 to 1260. Here, there’s nothing in
either one of these accounts, the adjusting entry puts something in there. To accrue is to recognize we did
something, something took place. We now have to account for it. We have to record it. So the adjusting entry debit wage
expense, credit wage payable. If I did not record this adjusting entry,
I would think wage payable was zero when, in fact, it should be 1500. It would be — liabilities would be undervalued,
and wage expense I would think was zero when it should be 1500, wage
expense would be undervalued. Let’s go to the income statement here. Wage expense is 1500; therefore,
net income is really 28,500. If I did not record this adjusting entry,
I’d think my total expenses were 40,000 and net income was 30,000. But the accurate, the true number, the correct
number, expenses are 41,500, net income 28-5. Okay, so here we go. Accounting equation, if I did
not record the adjusting entry, I would think liabilities were
zero, they would be too low. They should be 1500. Expenses I would think were zero;
they should be 15, expenses too low. If an expense is not recorded,
expenses are too low, net income will be too high, and here it is. Okay, so this is my actual
expenses, this is net income. Since net income was over stated, equity,
retained earnings will be overstated. Again, it would equal out in terms of the
accounting equation, but we would have a mistake on the balance sheet, and we’d have
a mistake on the income statement. Last example. This is accrued revenue. I did work for a customer and
they’re going to pay me next month, but since I did the work this
month, I still have to accrue it. So my adjusting entry to accrue revenue is
debit AR, accounts receivable, credit service revenue. Okay. Now, really you only have
one service revenue account. I simply wanted to show them side by side,
okay. If I did not record this
adjusting journal entry, I would think AR was zero
when, in fact, it’s 3890. Assets would be too low. Didn’t record service revenue, revenue
would be too low on the income statement. Service revenue, as a result of this
adjusting journal entry, 3890; therefore, here’s what revenue should
be and net income should be. If I did not record this adjusting entry,
I’d think revenue was 70, expenses were not involved
in this adjusting entry, so they’re unaffected. Net income I would think was 30. But really, the accurate number is revenue
is a total of 73,890 minus 40, net income is 33890. So, last, if I didn’t adjust to accrue
revenue, AR, assets would be too low, revenue would be too low, net income
would be too low, and therefore equity, retained earnings would be too low. Now, that is an awful lot to think about. This is a tricky area, and you’ve
got to take my advice on this one. You’re going to have it to read this a couple
of times and practice it because it’s considered to be a very important part
of financial accounting. This is an area where financial
statements can really be misstated. More importantly for you, I plan on testing
you on this material, so please take good, hard look at this, practice it, and
hopefully it’ll make some sense. Okay, and that’ll do it.

2 comments on “Lecture 3-Accrual Accounting Concepts”

  1. drae408 says:

    Awesome Teacher!!!

  2. Nana Wong says:

    Please upload another video. This video not working

Leave a Reply

Your email address will not be published. Required fields are marked *