Accrual Basis Accounting Under the accrual basis accounting, revenues and expenses are recognized as follows: Revenue

recognition: Revenue is recognized when both of the following conditions are met: a. Revenue is earned. b. Revenue is realized or realizable. Revenue is earned when products are delivered or services are provided. Realized means cash is received. Realizable means it is reasonable to expect that cash will be received in the future. Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle). Cash Basis Accounting Under the cash basis accounting, revenues and expenses are recognized as follows: Revenue recognition: Revenue is recognized when cash is received. Expense recognition: Expense is recognized when cash is paid. Timing differences in recognizing revenues and expenses There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting. Four types of timing differences a. b. c. d. Accrued Revenue: Revenue is recognized before cash is received. Accrued Expense: Expense is recognized before cash is paid. Deferred Revenue: Revenue is recognized after cash is received. Deferred Expense: Expense is recognized after cash is paid.

An Example of Accrued Revenue Example: Products are sold at $5,000 on May 1, 2010 and cash is received on May 10, 2010. May 1, 2010 Revenue is recognized. [Journal entry on May 1, 2010] Debit Accounts receivable Sales [Journal entry on May 10, 2010] 5,000 5,000 Credit May 10, 2010 Cash is received.

Debit Cash Accounts receivable 5,000

Credit

5,000

An Example of Accrued Expense Example: On May 1, 2010, Company A borrowed $100,000 from a bank and promised to pay 12% interest at the end of each quarter. May 31, 2010 Interest expense is recognized for May. [Journal entry on May 1, 2010] Debit Cash Borrowings from bank [Journal entry on May 31, 2010] Debit Interest expense Interest payable $100,000 x 12% x 1/12 = $1,000 for each month. Interest payable is a liability account. Credit side of interest payable (a liability account) represents an increase. [Journal entry on June 30, 2010] Debit Interest expense Interest payable 1,000 1,000 Credit 1,000 1,000 Credit 100,000 100,000 Credit June 30, 2010 Cash is paid at the end of the quarter.

Credit side of interest payable (a liability account) represents an increase. Debit Interest payable Cash 2,000 2,000 Credit

Company pays $2,000 as interests for May and June. Debit side of interest payable (a liability account) represents a decrease.

An Example of Deferred Revenue Example: On May 1, 2010, Company A had a new lease contract with a tenant and received $6,000 for two month rent. May 1, 2010 Cash is received. May 31 and June 30 2010 Revenue is recognized at the end of May and June.

Revenue is recognized when Company A provides service. In this example, service is provided when time passes. [Journal entry on May 1, 2010] Debit Cash Unearned rent revenue 3,000 3,000 Credit

Unearned rent revenue is a liability account. Credit side of unearned rent revenue (a liability account) represents an increase. "Unearned revenue" accounts represent the amount of cash received before services are provided. Since services have not been provided yet, it is not revenue. "Unearned revenue" accounts are liabilities of the company, because they should be paid back to the other party if service is not provided in the future. [Journal entry on May 31, 2010] Debit Unearned rent revenue 3,000 Credit

Rent revenue

3,000

Debit side of unearned rent revenue (a liability account) represents a decrease. Credit side of rent revenue (a revenue account) represents an increase. [Journal entry on June 30, 2010] Debit Unearned rent revenue Rent revenue 3,000 3,000 Credit

Debit side of unearned rent revenue (a liability account) represents a decrease. Credit side of rent revenue (a revenue account) represents an increase. An Example of Deferred Expense Example: Company A purchased an insurance for a period from May 1, 2010 to July 31, 2010 and paid $6,000 cash for three month insurance premium. May 1, 2010 Cash is paid. May 31, June 30, July 31, 2010 Expense is recognized at the end of May, June and July.

[Journal entry on May 1, 2010] Debit Prepaid insurance Cash 6,000 6,000 Credit

Prepaid insurance is an asset account. Debit side of prepaid insurance (an asset account) represents an increase. [Journal entry on May 31, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease.

[Journal entry on June 30, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease. [Journal entry on July 31, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease.

An Example of Deferred Revenue Example: On May 1, 2010, Company A had a new lease contract with a tenant and received $6,000 for two month rent. May 1, 2010 Cash is received. May 31 and June 30 2010 Revenue is recognized at the end of May and June.

Revenue is recognized when Company A provides service. In this example, service is provided when time passes. [Journal entry on May 1, 2010] Debit Cash Unearned rent revenue 3,000 3,000 Credit

Unearned rent revenue is a liability account. Credit side of unearned rent revenue (a liability account) represents an increase. "Unearned revenue" accounts represent the amount of cash received before services are provided. Since services

have not been provided yet, it is not revenue. "Unearned revenue" accounts are liabilities of the company, because they should be paid back to the other party if service is not provided in the future. [Journal entry on May 31, 2010] Debit Unearned rent revenue Rent revenue 3,000 3,000 Credit

Debit side of unearned rent revenue (a liability account) represents a decrease. Credit side of rent revenue (a revenue account) represents an increase. [Journal entry on June 30, 2010] Debit Unearned rent revenue Rent revenue 3,000 3,000 Credit

Debit side of unearned rent revenue (a liability account) represents a decrease. Credit side of rent revenue (a revenue account) represents an increase. An Example of Deferred Expense Example: Company A purchased an insurance for a period from May 1, 2010 to July 31, 2010 and paid $6,000 cash for three month insurance premium. May 1, 2010 Cash is paid. May 31, June 30, July 31, 2010 Expense is recognized at the end of May, June and July.

[Journal entry on May 1, 2010] Debit Prepaid insurance Cash 6,000 6,000 Credit

Prepaid insurance is an asset account. Debit side of prepaid insurance (an asset account) represents an increase.

[Journal entry on May 31, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease. [Journal entry on June 30, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease. [Journal entry on July 31, 2010] Debit Insurance expense Prepaid insurance 2,000 2,000 Credit

Credit side of prepaid insurance (an asset account) represents a decrease.

Example 1: Financing Activities

Owner invested $10,000 in the company. Analysis of Transaction Steps 1 Increase in Assets (Cash) by $10,000 2 Increase in Owner's Equity by $10,000 Journal Entry Cash Owner's Equity Description of Journal Entry Owner invested $10,000 in the company. Debit 10,000 Credit 10,000

Debit or Credit ? Debit Credit

Results of Journal Entry Cash balance increases by $10,000. --> Increase in Assets Owner's Equity balance increases by $10,000. --> Increase in Owner's Equity

Example 2: Financing Activities

The company borrowed $20,000 from a bank. Analysis of Transaction Steps 1 Increase in Assets (Cash) by $20,000 2 Increase in Liabilities (Borrowings) by $20,000 Journal Entry Cash Borrowings Description of Journal Entry Borrowed $20,000. Results of Journal Entry Cash balance increases by $20,000. --> Increase in Assets Borrowings balance increases by $10,000. --> Increase in Liabilities Debit 20,000 Credit 20,000

Debit or Credit ? Debit Credit

Example 3: Investing Activities

The company purchased $12,000 equipment and paid in cash. Analysis of Transaction Steps 1 Increase in Assets (Equipment) by $12,000 Decrease in Assets (Cash) by $12,000 2 Journal Entry
Equipment

Debit or Credit ? Debit Credit

Debit 12,000

Credit 12,000

Cash Description of Journal Entry Purchased $12,000 equipment in cash. Results of Journal Entry Equipment balance increases by $12,000. --> Increase in Assets Cash balance decreases by $12,000. --> Decrease in Assets Example 4: Operating Activities

The company purchased $6,000 merchandise (600 units) on credit. Analysis of Transaction Steps 1 Increase in Assets (Merchandise) by $6,000 2 Increase in Liabilities (Accounts Payable) by $6,000 Journal Entry
Merchandise

Debit or Credit ? Debit Credit

Debit 6,000

Credit 6,000

Accounts Payable Description of Journal Entry Purchased $6,000 merchandise on credit. Results of Journal Entry Merchandise balance increases by $6,000. --> Increase in Assets Accounts Payable balance increases by $6,000. --> Increase in Liabilities

Example 5: Operating Activities

The company sold 500 units of merchandise at the price of $11,000. Customer paid $9,000 in cash at the time of sale. Analysis of Transaction Note: This transaction includes both "REVENUE" and "EXPENSE" components. (1) REVENUE side Steps 1 Increase in Assets (Cash) by $9,000 2 Increase in Assets (Accounts Receivable) by $2,000 3 Increase in Revenue (Sales) by $11,000 (2) EXPENSE side Steps 1 Increase in Expenses (Cost of Merchandise Sold) by $5,000 ($6,000 / 600 units = $10 per unit) ($10 per unit X 500 units sold = $5,000 cost) 2 Decrease in Assets (Merchandise) by $5,000

Debit or Credit ? Debit Debit Credit

Debit or Credit ? Debit

Debit

(1) REVENUE Journal Entry Cash Accounts Receivable Sales Revenue Description of Journal Entry Debit 9,000 9,000 Credit

11,000

Sold merchandise at $11,000 price and received $9,000 in cash. Results of Journal Entry Cash balance increases by $9,000. --> Increase in Assets Accounts Receivable balance increases by $2,000. --> Increase in Assets Sales Revenue account balance increases by $11,000. --> Increase in Revenue (2) EXPENSE Journal Entry Cost of Merchandise Sold Merchandise Description of Journal Entry To record the cost of merchandise sold. Results of Journal Entry Merchandise balance decreases by $5,000. --> Decrease in Assets Cost of Merchandise Sold account balance increases by $5,000. --> Increase in Expense Debit 5,000 Credit 5,000

Example 6: Operating Activities

The company paid $3,500 salaries. Analysis of Transaction Steps 1 Increase in Expenses (Salaries Expense) by $3,500 Decrease in Assets (Cash) by $3,500 2 Journal Entry Salaries Expense Cash Description of Journal Entry Paid $3,500 salaries. Results of Journal Entry Cash balance decreases by $3,500. --> Decrease in Assets Salaries Expense account balance increases by $3,500. --> Increase in Expenses Debit 3,500 Credit 3,500

Debit or Credit ? Debit Credit

Example 7: Operating Activities

The company paid $1,500 rent. Analysis of Transaction Steps 1 Increase in Expenses (Rent Expense) by $1,500

Debit or Credit ? Debit

Decrease in Assets (Cash) by $1,500

Credit

Journal Entry Rent Expense Cash Description of Journal Entry Paid $1,500 rent. Results of Journal Entry Cash balance decreases by $1,500. --> Decrease in Assets Rent Expense account balance increases by $1,500. --> Increase in Expenses Debit 1,500 Credit 1,500

Summary of Transactions from previous file. No. (1) (2) (3) (4) (5) (6) (7) Date May 1 May 3 May 6 May 8 May 15 May 25 May 26 Transactions Owner invested $20,000 in the company. Borrowed $10,000 from a bank. Purchased $15,000 equipment in cash. Purchased $9,000 merchandise (900 units) on credit. Sold 500 units of merchandise at the price of $11,000. Customer paid $8,000 in cash at the time of sale. Paid $2,500 salaries. Paid $1,500 rent.

Summary of Journal Entries from previous file. No. (1) (1) Journal Entries Cash Owner's Equity Owner invested $10,000 in the company. Cash Borrowings Borrowed $20,000. Equipment Cash Purchased $12,000 equipment in cash. Merchandise Accounts Payable Purchased $6,000 merchandise on credit. Cash 12,000 12,000 20,000 20,000 Debit 10,000 10,000 Credit

(2) (2)

(3) (3)

(4) (4)

6,000 6,000

(5)-1

9,000

(5)-1 (5)-1

Accounts Receivable Sales Sold merchandise at $11,000 price and received $9,000 in cash. Cost of Goods Sold Merchandise To record the cost of goods sold ($5,000 merchandise). Salaries Expense Cash Paid $2,500 salaries. Rent Expense Cash Paid $1,500 rent.

2,000 11,000

(5)-2 (5)-2

5,000 5,000

(6) (6)

2,500 3,500

(7) (7)

1,500 1,500

Calculating Accounting Balances Cash Debit (1) (2) (5)-1 Balance 10,000 20,000 9,000 23,000 (3) (6) (7) Credit 12,000 2,500 1,500

Accounts Receivable Debit (5)-1 Balance 2,000 2,000 Credit

Merchandise Debit (4) Balance 6,000 1,000 (5)-2 Credit 5,000

Equipment Debit (3) Balance 12,000 12,000 Credit

Accounts Payable Debit (4) Balance Credit 6,000 6,000

Sales Debit (5)-1 Balance Credit 11,000 11,000

Cost of Goods Sold Debit (5)-2 Balance 5,000 5,000 Credit

Salaries Expense Debit (6) Balance 2,500 2,500 Credit

Rent Expense Debit (7) Balance 1,500 1,500 Credit

Balance Sheet and Income Statement Balance Sheet As of May 31, 20XX Assets Cash Accounts Receivable Merchandise Equipment Total Assets $ 23,000 2,000 1,000 12,000 $ 38,000 Liabilities and Owner's Equity Accounts Payable $ 6,000 Borrowings 20,000 Owner's Equity Total Liabilities and Owner's Equity 12,000 (*1) $ 38,000

Income Statement For the Period from May 1 to May 31, 20XX Revenue Sales Total Revenue Expenses Cost of Goods Sold Salaries Expense Rent Expense Total Expenses Net Income (*1) Owner's Equity=Investment by Owner+Net Income=$10,000+$2,000=$12,000 (*2) Net Income = Total Revenue - Total Expenses = $11,000 - $9,000 = $2,000 $ 11,000 $ 11,000

$ 5,000 2,500 1,500 9,000 $ 2,000 (*2)