Accrual Accounting

Concepts

Chapter 5
 Study Objectives
1. Explain the revenue recognition
principle and the matching principle.
2. Differentiate between the cash basis
and the accrual basis of accounting.
3. Explain why adjusting entries are
needed and identify the major types of
adjusting entries.
4. Prepare adjusting entries for
prepayments.
 Study Objectives
5. Prepare adjusting entries for accruals.
6. Describe the nature and purpose of the
adjusted trial balance
7. Explain the purpose of closing entries.
8. Describe the required steps in the
accounting cycle.
Recall: Time Period Assumption

 Divides life of business into artificial time

periods: monthly, quarterly, yearly
 #
1 Revenue Recognition
Principle
 Dictates that revenue be recognized
in the accounting period in which it
is earned.
 Considered earned when the service
has been provided or when the
goods are delivered.
#
1 Revenue Recognition
Principle
 #
1 Matching Principle
 Requires that expenses be
recorded in the same period
in which the revenues they
helped produce are recorded.
 Differentiate
Cash Basis from
Accrual Basis of Accounting
 Cash Basis

Revenue recorded only when cash is received.

Expenses recorded only when cash is paid.

Cash Basis is not GAAP

GA
AP
 What is GAAP?
 Generally Accepted Accounting
Principles (GAAP) defines the standards
by which accounting should be
performed.
 Includes the standards, conventions,
and rules accountants follow in
recording and summarizing
transactions, and in the preparation of
financial statements.
 Accrual Basis Accounting

• Follows both . . .

• Revenue Recognition Principle

• Matching Principle
 Accrual Basis is GAAP
Revenue Realization Principle states that..
• Revenue is recorded only when
earned not when cash is received

Matching Principle states that…

• Expense is recorded only when
incurred not when cash paid
Why is this so important?
Possible conclusions from the Cash Method?
 Let’s Review

Which principle dictates that efforts (expenses)

be recorded with accomplishments (revenues)?

a. Cost principle.
b. Matching principle.
c. Periodicity principle.
d. Revenue recognition principle.
 Let’s Review

Which principle dictates that efforts (expenses)

be recorded with accomplishments (revenues)?

a. Cost principle.

b. Matching principle.

c. Periodicity principle.

d. Revenue recognition principle.

 Let’s Review
When would revenue be recorded for
the following scenario . . .
Ad agency is hired for a project in
May, does work in June and is paid
in July?

The answer is June!

 Let’s Review
When would expenses be recorded for
this companion scenario . . .
The Ad agency on this project incurs
Php1,500 of expenses in May,
Php3,000 in June, and none in July?

The answer is June! Matching says

the expenses should follow the
revenue.
 Let’s Review
When would revenue be recorded for the
following scenario . . .

Sell plane ticket on September 1 for a

flight on October 15?

The answer is October – when the

service is provided!
 Let’s Review
When would expenses be recorded for the
following scenario . . .
The airline pays pilot salaries on
October 7th for the week ended
September 30th?
The answer is September – the pilots
provided labor services for September
flights during that month.
 Now let’s discuss how
accounting makes this happen
...
 Explain Why Adjusting
Entries are Needed
and
Identify the Major Types of
Adjusting Entries
 Adjusting Entries
 Trial balance is not up to date.
 To produce accurate financial
statements, we record adjusting
entries . . .
 Revenues are recognized (recorded)
when they are earned.
 Expenses are recognized (recorded)
when they are incurred (used up).
 Adjusting Entries

Adjusting entries ensure that

Revenue Recognition and
Matching Principles are
followed!
 Types of Adjusting Entries
Prepayments:
 Prepaid expenses: Expenses paid in cash
and recorded as assets before they are
used or consumed. (cash paid in
advance)

 Unearned Revenues: Cash

received and recorded as
liabilities before revenue is
earned. (cash received in
advance)
 Types of Adjusting Entries
Accruals:
 Accrued revenues: Revenues
earned but not yet received in cash
or recorded (someone owes us).
 Accrued expenses: Expenses incurred
but not yet paid in cash or recorded (we
owe someone else).
 Prepare Adjusting Entries for
Prepayments – Prepaid Expenses

• Expenses paid in cash and recorded as

assets before they are used or consumed.
(paid in advance)
• Prepaid expenses expire with the passage
of time OR they are consumed (used)
• Time: rent, insurance
• Consumed: supplies
 Prepaid Expenses

Amount equals cost of goods or services used up or expired

If not adjusted, expenses would be

understated and assets overstated
 Prepare Adjusting Entries for
Prepayments – Prepaid Expenses

• Start with the trial balance to find

information to adjust prepayments

• Let’s use the Sierra Corporation

examples in the book . . .
Prepaid Expenses - Supplies

What is the entry when you

purchase supplies?
 Prepaid Expenses - Supplies

Supplies
Cash Supplies Expense
Oct 5 2,500 Oct 5 2,500

GENERAL JOURNAL Debit Credit

Oct 5 Supplies 2,500
Cash 2,500
Purchased Advertising Supplies
Prepaid Expenses - Supplies
Oct. 31: Take inventory and it shows
$1,000 of supplies still on hand

What is the adjusting entry?

 Prepaid Expenses - Supplies

Supplies
Cash Supplies Expense
Oct 5 2,500 Oct 5 2,500 Oct 31 1,500 Oct 31 1,500

Oct 31 1,000

GENERAL JOURNAL Debit Credit

Oct 31 Supplies Expense 1,500
Supplies
1,500
To record supplies used
 Supplies Expense
October November December January
$1,500 $1,800 $1,410 $1,425

February March April May

$1,601 $1,435 $1,530 $1,592

June July August September

$1,622 $1,652 $1,427 $1,557

Expense varies each month with usage

Prepaid Expenses - Insurance

What is the entry when you

purchase the insurance policy?
 Prepaid Expenses - Insurance

Prepaid Insurance
Cash Insurance Expense
Oct 4 600 Oct 4 600

GENERAL JOURNAL Debit Credit

Oct 4 Prepaid Insurance 600
Cash 600
Purchased one-year fire insurance policy.
Prepaid Expenses - Insurance
Oct. 31: You are at the end of the
month. How much of the insurance
policy has expired?

$600 / 12 months = $50 per month

What is the adjusting entry?

 Prepaid Expenses - Insurance

Prepaid Insurance
Cash Insurance Expense
Oct 4 600 Oct 4 600 Oct 31 50 Oct 31 50

Oct 31 550

GENERAL JOURNAL Debit Credit

Oct 31 Insurance Expense 50
Prepaid Insurance 50
To record expired insurance coverage
 Insurance Expense
October Novembe Decembe January
$50 r r $50
$50 $50
February March April May
$50 $50 $50 $50

June July August Septemb

$50 $50 $50 er
$50

Policy Expense is the same each month

 Depreciation Expense
October Novembe Decembe January
$40 r r $40
$40 $40
February March April May
$40 $40 $40 $40

June July August Septemb

$40 $40 $40 er
$40

Let’s say expense is estimated at $480 per year

 Depreciation

Office Depreciation Accumulated

Equipment Expense Depreciation
Oct 2 5,000 Oct 31 40 Oct 31 40

GENERAL JOURNAL Debit Credit

Oct 31 Depreciation Expense 40
Accumulated Depreciation 40
To record monthly depreciation of annual $480 estimate
 Adjustment for Depreciation

CONTRA-ASSET EXPENSE
ACCOUNT ACCOUNT
Accumulated Depreciation Depreciation Expense

Adjusting Adjusting
Entry Entry
Credit Debit

Amount equals cost

of asset allocated
to accounting period
 Balance Sheet Presentation
Office equipment $ 5,000
Less: accumulated depreciation 40

$4,960
Accumulated depreciation
is a contra asset account,
an offset against the fixed
asset account. Book Value
#
4 Prepare Adjusting Entries for
Prepayments – Unearned
Revenues
 Cash received and recorded as
liabilities before revenue is
earned. (cash received in
advance)
 Earned when services are
provided
 Rent, magazine subscriptions,
customer deposits
 Unearned Revenues

Amount equals price of services performed or goods delivered

If not adjusted, revenues would be

understated and liabilities overstated
 Unearned Revenues

What is the entry when you are

paid in advance for services?
 Unearned Revenues

Unearned
Cash Revenue Revenue
Oct 2 1,200 Oct 2 1,200 Oct 3 10,000

GENERAL JOURNAL Debit Credit

Oct 2 Cash 1,200
Unearned Revenue
1,200
To record customer payment received in advance of services
 Unearned Revenues
Oct. 31: Some of the work has been
performed, $400 has been earned

What is the adjusting entry?

 Unearned Revenues

Unearned
Cash Revenue Revenue
Oct 2 1,200 Oct 31 400 Oct 2 1,200 Oct 3 10,000
Oct 31 400
Oct 31 800
Oct 31 10,400

GENERAL JOURNAL Debit Credit

Oct 31 Unearned Revenue 400
Revenue 400
To record revenue earned
#
5 Prepare Adjusting Entries for
Accruals – Accrued Revenues
 Accrued revenues: revenues earned but not yet
received in cash or recorded at the statement date

 Adjusting entry is required to show the receivable that

exists at the balance sheet date
 Accrued Revenues

Amount equals price of services performed

If not adjusted, revenues would be

understated and assets understated
 Accrued Revenues

What is the adjusting entry for

$200 of services performed but
not billed before October 31?
 Accrued Revenues

Accounts Service
Receivable Revenue
Oct 31 200 Oct 3 10,000
Oct 31 400
Oct 31 200
Oct 31 10,600

GENERAL JOURNAL Debit Credit

Oct 31 Accounts Receivable 200
Service Revenue 200
To record revenue earned but not billed
#
5 Prepare Adjusting Entries for
Accruals – Accrued Expenses
 Accrued expenses: expenses incurred but not yet
paid in cash or recorded at the statement date

 Adjusting entry is required to show the payable that

exists at the balance sheet date
 Accrued Expenses

Amount equals cost of expense incurred

If not adjusted, expenses would be
understated and liabilities understated
 Where is the
interest expense
for this note?

Interest expense has

not been recorded yet
for this period, so we
need an adjustment!
Accrued Expenses - Interest
Oct. 31: Signed $5,000 note on Oct. 1st
with annual interest rate of 12%
Use formula to calculate interest:

What is the adjusting entry?

 Accrued Interest

Interest Interest
Expense Payable
Oct 31 50 Oct 31 50

GENERAL JOURNAL Debit Credit

Oct 31 Interest Expense 50
Interest Payable 50
To record interest on notes payable
 Accrued Expenses - Salaries
Oct. 31: Employees are paid every two weeks.
There are 3 days of October that will not be paid
until November. Wages are $2,000 for 5 days

What is the adjusting entry?

 Accrued Salaries

Salaries Salaries
Expense Payable
Bal. 4,000 Oct 31 1,200
Oct 31 1,200

Oct 31 5,200

GENERAL JOURNAL Debit Credit

Oct 31 Salaries Expense 1,200
Salaries Payable 1,200
To record accrued salaries ( $400 a day times 3 days )
Summary of Adjusting Entries

Note that each adjusting entry affects at least one

balance sheet account and at least one income
statement account!
 #
6 Describe the nature and
purpose of the Adjusted Trial
 Balance
Prepared after adjusting
entries journalized and
posted
 Shows balances of all
accounts
 See the adjusting journal
entry changes on next
slide. . .
 Adjusted Trial Balance
 Purpose is to prove the equality of
total debit balances and total credit
balances after the adjusting entries
have been made.
 Financial statements are prepared

from the adjusted trial balance

 #
7 Explain the Purpose of
Closing Entries
 Closing entries transfer the
temporary accounting
balances to the permanent
stockholders’ equity account
– Retained Earnings.
Close Temporary Accounts
Only

Zero balance
after closing
entries!

Do not close!
 Closing Entries

At the start of the next period, temporary account

balances are zero so you can accumulate data
separately from data in prior periods.
#
8 Describe the required steps in the
Accounting Cycle

 Steps are performed in

sequence and are repeated in
each accounting period . . .
 Let’s Review

Which is not a temporary account?

a. Salaries expense.
b. Service revenue.
c. Accounts receivable.
d. Dividends.
 Let’s Review

Which is not a temporary account?

a. Salaries expense.
b. Service revenue
c. Accounts receivable.
d. Dividends.
 Let’s Review

Which account will have a zero balance

after closing entries?

a. Service Revenue.
b. Advertising Supplies.
c. Prepaid Insurance.
d. Accumulated Depreciation.
 Let’s Review

Which account will have a zero balance

after closing entries?

a. Service Revenue.
b. Advertising Supplies.
c. Prepaid Insurance.
d. Accumulated Depreciation.
 Let’s Review

Which types of accounts will appear in the

post-closing trial balance?

a. Permanent accounts.
b. Temporary accounts.
c. Accounts shown in income statement.
d. None of the above.
 Let’s Review

Which types of accounts will appear in the

post-closing trial balance?

a. Permanent accounts.
b. Temporary accounts.
c. Accounts shown in income statement.
d. None of the above.
•Some of
the
amounts on
the trial
balance are
out of date.
 Adjusting entries
1. Actual amount of repair supplies
showed a balance of P850.

Repair Supplies

1,500
Adjusting entries
Repair Supplies

1,500

What the balance

850 
should be

 What the balance “should be” is determined from

someone counting the supplies that remain in the
business at the end of the year
Adjusting entries
Repair Supplies

1,500

650
850

The required adjustment

Adjusting entries
Repair Supplies Used

What the balance should

650 be

 What the balance “should be” is the amount

of supplies “used up” during the year
 Adjusting entries

1. Repair supplies used (Dr) 650

Repair supplies (Cr) 650
 Depreciation

What is the entry when you

purchase equipment?
 Depreciation
 Following the matching principle, the
cost of assets with long lives must be
allocated over their useful lives
 As we use the asset, we recognize a
portion of its cost as expense:
depreciation
 Depreciation expense is an estimate
 It is an allocation of cost, NOT
valuation
 Adjusting entries

2. Repair tools are depreciated at 10%

per annum.

P1200 x .10 = 120

(Original cost x depreciation p.a.)
 Adjusting entries

2. Depreciation-tools 120
Accumulated Depreciation 120
Adjusting entries

Straight-Line Method of Depreciation

D=(Cost - Salvage Value) / number of

year
Where:
D= depreciation
Cost = original cost
Salvage value = scrap value (the amount wherein the asset
can be sold after its useful life)
No. of Yrs = estimated number of useful life
 Adjusting entries
3. Given:
n=5 yrs (F&F); 10yrs (service truck)
c=6,500 (F&F); 20,000(service truck)

F&F:
6,500/5yrs = P1,300 per yr
1,300 x 4/12 = P433

a. Depreciation-F&F (Dr) 433

Accum. Dep.-F&F (Cr) 433
 Adjusting entries

Service truck:
20,000 / 10 = P2,000 p.a.
2,000 x 4/12 = P666

b. Depreciation-Service Truck (Dr) 666

Accum. Dep.-Servie Truck (Cr) 666
 Depreciation

Office Depreciation
Cash Equipment Expense
Oct 2 5,000 Oct 2 5,000

GENERAL JOURNAL Debit Credit

Oct 2 Office Equipment 5,000
Cash 5,000
To record purchase of office equipment
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