FINANCIAL ACCOUNTING

Accrual Accounting - Recap

 SCHOOL OF BUSINESS AND SOCIAL SCIENCES

AARHUS UNIVERSITET
AGENDA

• Exercise on Value Added Tax (VAT)

• Accrual Accounting (continued)
• Categories of adjusting entries
• The adjusted trial balance

Stefan Schaper - Spring 2017

 SCHOOL OF BUSINESS AND SOCIAL SCIENCES

AARHUS UNIVERSITET
Stefan Schaper - Fall 2017
REFERENCES

​To prepare this lecture, you should read:

• HHTS* Chapter 3

*Harrison, W.T., Horngren, C.T., Thomas, C.W. & Suwardy, T. (2014): Financial Accounting: International
Financial Reporting Standards, 9th ed., Pearson (Global Edition)

** available on BlackBoard

 SCHOOL OF BUSINESS AND SOCIAL SCIENCES

AARHUS UNIVERSITET
 EXERCISE
AARHUS
UNIVERSITET

Journalise the following transactions

& make the VAT settlement:

§ 1) Company XXX have a sales of 6000 DKK (VAT rate 25% incl) .
Payment due in 30 days.

§ How has the bill to be registered by XXX?

§ 2) After 30 days the payment is recieved à how does XXX

register it?

§ 3) Company XXX buy goods for total price = 3000 DKK (VAT rate
25% included). Payment immediate in cash is received.

§ 4) VAT settlement? FINANCIAL ACCOUNTING 5

 AARHUS
UNIVERSITET

ACCRUAL ACCOUNTING
› It records both cash and non-cash transactions:
Cash transactions Non-cash transactions
Collecting payments from customers Sales on account
Receiving cash from interest earned Purchases of inventory on account
Paying salaries, rent, and other Accrual of expenses incurred but
expenses not yet paid
Borrowing money Depreciation expense
Paying off loans Usage of prepaid rent, insurance,
and supplies
Issuing shares Earning of revenue when cash
was collected in advance

FINANCIAL ACCOUNTING 6
 AARHUS
UNIVERSITET

THE ACCRUAL PRINCIPLE

à SPECIFIC ASPECTS REGARDING
RECOGNITION AND MEASUREMENT

› When are income/expenses to be recognised?

› How are income/expenses to be measured?

FINANCIAL ACCOUNTING 7
 AARHUS
UNIVERSITET

REVENUE - RECOGNITION
From IAS18*: For sale of goods, revenue is recognized
when:
› the seller has transferred to the buyer the significant
risks and rewards of ownership
› the seller retains neither continuing managerial
involvement over the goods sold
› the amount of revenue and/or costs incurred can be
measured reliably
› it is probable that the economic benefits associated
with the transaction will flow to the seller
FINANCIAL ACCOUNTING
 AARHUS
UNIVERSITET

REVENUE – RECOGNITION
à 2 CRITERIA
1. The critical event to achieve revenue must have occurred –
the enterprise has completed its performance.
If future insignificant "services" (e.g. warranty) -> make reliable
estimate of the cost.
2. The customer will probably pay and the amount of revenue
can be measured reliably (measurable). The company can
make an estimate of bad debt.

It is important that both criteria are fulfilled!

Recognition in the annual report at the earliest possible date when

both income criteria are fulfilled

FINANCIAL ACCOUNTING
 AARHUS
UNIVERSITET

REVENUE – RECOGNITION

› The income from most goods and related costs are recognised at
the date the goods are delivered

› If the goods sold are distributed via a forwarding agent, the date of
transfer of title (decided by the terms of delivery) from the seller to
the buyer is decisive for the date of registering the sale

› The amount of revenue to record is the fair value taking into

account the amount of any trade discounts and volume rebates
allowed by the entity.

FINANCIAL ACCOUNTING 10
 AARHUS
UNIVERSITET

REVENUE – RECOGNITION
DEFINITION: CRITICAL EVENT
› Typically an objective event that is decisive for when
income can be recognised for accounting purposes

à In practice, the date of sale is typically applied

time
(1) (2) (3) (4) (5) (6)
Requests Requests Sells the Obtains Receives Return and
raw materials manpower product/ a receivable payment warranty
buildings and and Invoicing from the period expires
operating produces customer
equipment finished
goods FINANCIAL ACCOUNTING 11
 AARHUS
UNIVERSITET

REVENUE – RECOGNITION
DEFINITION: MEASURABLE
› High reliability when measuring revenue, i.e. it must be
computed objectively and verifiably

› Revenue recognition is known as the most susceptible

area to fraud
› Recording fictitious revenue
› Recognition of revenue when product/service not delivered yet
› Delivery incomplete
› Deliver without costumer acceptance

FINANCIAL ACCOUNTING 12
 AARHUS
UNIVERSITET

MATCHING PRINCIPLE

Match
Identify
Measure the against
expenses
expenses revenues
incurred
earned

FINANCIAL ACCOUNTING 13
 AARHUS
UNIVERSITET

MATCHING PRINCIPLE
EXPENSES - RECOGNITION

Matching: direct association between the cost incurred

and the earning of specific items of income.

Expenses - Identified as:

› decrease in ASSET
› Expenses paid in cash
› Use of an asset (supplies)

› Increase in liability
› Expenses are incurred but not paid yet
(accrued liabilities)

FINANCIAL ACCOUNTING
 AARHUS
UNIVERSITET

Update the accounts:

adjusting process

FINANCIAL ACCOUNTING Dias 17

 AARHUS
UNIVERSITET

CLOSING THE FINANCIAL STATEMENTS

› Financial statements issued at end of period
› Several accounts on trial balance need to be brought up-to-date
(for example Accounts Receivable, Supplies, Prepaid Rent)

à Why? Because certain transactions have not yet been recorded.

FINANCIAL ACCOUNTING 18
 AARHUS
UNIVERSITET

CATEGORIES OF ADJUSTMENTS
Accounting adjustments fall into three basic categories: deferrals,
accruals, and depreciation.

1. Deferral: adjustment for an item that the business

› paid in advance
› received cash in advance
2. Accrual is the opposite of a deferral.
› expense recorded before paying cash
› Revenue recorded before collecting cash
3. Depreciation: allocates the cost of an item of PPE to expense
over the asset’s useful life
FINANCIAL ACCOUNTING 19
 AARHUS
UNIVERSITET

1 – DEFERRALS (=PREPAIDS)
› A Business has paid or received cash in advance

Prepaid expense Unearned revenue

• Recorded as an • Recorded as a
asset when liability when
purchased payment is received
• Expensed when • Recorded as
used or expired revenue when
earned

FINANCIAL ACCOUNTING
20
 AARHUS
UNIVERSITET

DEFERRALS: PREPAID RENT

§ Prepaid Rent, Prepaid Insurance, and all other prepaid expenses
require deferral adjustments.

Example: Suppose A company prepays three months of store rent

($3,000) on June 1.

FINANCIAL ACCOUNTING 21
AARHUS
UNIVERSITET
PREPAID RENT

FINANCIAL ACCOUNTING
22
 AARHUS
UNIVERSITET

DEFERRALS: SUPPLIES
§ A company purchases supplies for use in its operations.
During the period, some supplies are used up and become
expenses à at the end of the period, adjustment is needed
Example: On June 2, the company paid cash of $700 for cleaning
supplies. At the end of the month, $400 of supplies remain
unused.

FINANCIAL ACCOUNTING 23
AARHUS

SUPPLIES
UNIVERSITET

FINANCIAL ACCOUNTING
24
 AARHUS
UNIVERSITET

DEFERRALS
UNEARNED REVENUE

› There are also deferral adjustments for liabilities.

› Companies may collect cash from a customer in advance of earning
the revenue.

1) Receive cash before revenue is earned à Creates a liability

2) When revenue is earned à Liability is reduced & Revenue
increased

FINANCIAL ACCOUNTING 25
 AARHUS
UNIVERSITET UNEARNED REVENUE
› Example:
1) a company is engaged to wash delivery vehicles and is paid $400 month,
beginning immediately (Jun 15). The company collects the first amount on
June 15.

JOURNAL
Date Accounts and explanation Debit Credit
Jun 15 Cash 400
Unearned service revenue 400
Received cash for revenue in advance.

2) During the last 15 days of the month, the company will earn one-half of the
$400, or $200. On June 30, the company makes the following adjustment.
Date Accounts and explanation Debit Credit
Jun 30 Unearned revenue 200
Service revenue 200

FINANCIAL ACCOUNTING
26
 AARHUS
UNIVERSITET

2 - ACCRUALS
An accrual is the opposite of a deferral.

FINANCIAL ACCOUNTING
27
 ACCRUED EXPENSES: ACCRUED SALARIES
AARHUS
UNIVERSITET

• Record expense before paying cash

• Most companies pay their employees at set times. Suppose the
company pays its employee a monthly salary of $1,800, half on the 15th
and half on the last day of the month.

the second half-month amount of $900 will be paid on Monday, July 1:

à Impact on June 30?
FINANCIAL ACCOUNTING
28
 ACCRUED SALARIES
AARHUS
UNIVERSITET

$900 $900
$1,800 month salary

Jun 1 Jun 15 Jun 30 Jul 1st

At June 30, therefore, the company adjusts for additional salary expense and
salary payable of $900 as above.

JOURNAL
Date Accounts and explanation Debit Credit
Jun 30 Salaries expense 900
Salary Payable 900
To accrue salary expense

FINANCIAL ACCOUNTING
29
 AARHUS
UNIVERSITET

ACCRUED REVENUE
› Revenue earned but not yet received

› Example: Suppose the company will be paid $600 monthly, with the
first payment on July 15. During June, the company will earn half a
month’s fee, $300, for work done June 15 through June 30. On June
30, the company makes the following adjusting entry:
JOURNAL
Date Accounts and explanation Debit Credit
Jun 30 Accounts receivable ($600 x ½) 300
Service revenue 300
To accrue service revenue.

FINANCIAL ACCOUNTING
30
 AARHUS
UNIVERSITET

PREPAIDS AND ACCRUALS

PREPAIDS –CASH FIRST
FIRST LATER
Prepaid Prepaid expense Expense
expenses Cash Prepaid expense
Unearned Cash Unearned revenue
revenues Unearned revenue Revenue
ACCRUALS – CASH LATER
FIRST LATER
Accrued Expense Payable
expenses Payable Cash
Accrued Receivable Cash
revenues Revenue Receivable

FINANCIAL ACCOUNTING
31
 AARHUS
UNIVERSITET

3 - DEPRECIATION
› Allocates cost of PPE to expense
over the s.c. useful live

› Represents wear-and-tear and obsolescence

› Accumulated depreciation account:

› Sum of all depreciation expense
› Increases over plant asset’s life

› Contra-asset
› Normal credit balance
› Always has a companion account

FINANCIAL ACCOUNTING
32
 AARHUS
UNIVERSITET

DEPRECIATION
Example: a company purchased equipment for $24,000.
Assume monthly depreciation=400$
JOURNAL
Date Accounts and explanation Debit Credit
Jun 2 Equipment 24,000
Cash 24,000

Jun 30 Depreciation expense 400

Accumulated depreciation 400

FINANCIAL ACCOUNTING
33
 AARHUS
UNIVERSITET

DEPRECIATION

Equipment Depreciation Expense

Jun 2 $24,000 Jun 30 $400

Balance
Sheet

Accumulated Depreciation Income

Statement
$400 Jun 30

FINANCIAL ACCOUNTING
34
 AARHUS
UNIVERSITET

BOOK VALUE
The net amount of a PPE (cost minus accumulated depreciation) is
called that asset’s book value (of a PPE), or carrying amount.

On the balance sheet, the PPE is shown at their book value – the
cost of the asset minus the accumulated depreciation.

Balance Sheet
December 31, 2010
Equipment $24,000
Less: Accumulated Depreciation (400)
Book value $23,600
FINANCIAL ACCOUNTING
35
 AARHUS
UNIVERSITET

SUMMARY OF ADJUSTING ENTRIES

Each category of adjustment has its own pattern. Notice that
each involves a balance sheet account and an income statement
account

Type of Account
Category of Adjustment Debit Credit
Prepaid expense Expense Asset
Depreciation Expense Contra asset
Accrued expense Expense Liability
Accrued revenue Asset Revenue
Unearned revenue Liability Revenue

FINANCIAL ACCOUNTING
36
 AARHUS
UNIVERSITET

CLOSING THE FINANCIAL STATEMENTS

› Basic form of a worksheet and the three steps for preparing it

Step 1. Prepare a trial balance on the worksheet

› Enter all ledger accounts with balances in the account name
space

Step 2: Enter the adjustments in the adjustment columns

Step 3: Extend trial balance and adjustments to appropriate

financial statements columns

FINANCIAL ACCOUNTING 37
AARHUS
CLOSING THE FINANCIAL STATEMENTS
UNIVERSITET

BACH excercise
38