Lecture 3 PDF

Financial Accounting
Eleventh Edition
Global Edition
Chapter 3
Accrual
Accounting
Copyright © 2018 Pearson Education, Inc. All Rights Reserved.

Course Overview
What is accounting? ✓
Why do we do accounting in the way that will be discussed
in this course? ✓
How do we do accounting?
➢The format: T-accounts & journal entries ✓
➢Accrual accounting: Adjusting entries (This Lecture)
➢Presenting Financial Statements (Lecture 4)
➢Details of common accounts and cash flow (Lecture 5-10)
How do we use accounting information? (Lecture 11)

Learning Objectives
3.1 Explain how accrual accounting differs from cash-basis
accounting
3.2 Apply the revenue and expense recognition principles
3.3 Adjust the accounts
3.4 Prepare updated financial statements
3.5 Close the books

Learning Objective 3.1
Explain how accrual accounting differs from cash-basis
accounting

What is Accrual Accounting (1 of 6)
Cash-Basis Accounting
• Records only cash transactions
– Cash receipts
– Cash payments
• Fails to capture the underlying economic phenomenon
• Results in incomplete financial statements
• Only used by businesses that do not follow accounting
standards

Cash-Basis Accounting
• Example:
– On 20 Sept, you have lunch at a restaurant for $100,
you pay by credit card
– On 16 Oct, you receive the credit card statement with
the lunch bill on it
– Finally, on 15 Nov, the payment due date for the credit
card bill, you transfer $100 to your credit card account
15 Nov Lunch Bill 100
Cash 100
– When do you “spend” the $100?
Accrual Accounting
• Records impact of transactions when they occur
– Income when earned
– Expenses when incurred

• Accrual accounting and Cash-basis accounting both
record cash transactions, such as:
– Collecting cash from customers
– Receiving cash from interest earned
– Paying salaries, rent, and other expenses
– Borrowing money
– Paying off loans
– Issuing shares

• Accrual accounting also records non-cash transactions,
such as:
– Sales on account
– Purchases of inventory on account
– Accrual of expenses incurred but not yet paid
– Depreciation expense
– Usage of prepaid rent, insurance, and supplies
– Earning of revenue when cash was collected in
advance

Accrual Accounting
• Example:
– On 20 Sept, you have lunch at a restaurant for $100,
you pay by credit card 20 Sept Lunch Bill 100
Accounts Payable 100
– On 16 Oct, you receive the credit card statement with
the lunch bill on it
– Finally, on 15 Nov, the payment due date for the credit
card bill, you transfer $100 to your credit card account
15 Nov Accounts Payable 100
Cash 100

Example from Lecture 2
(5) Performed services on account, $3,000
(9) Received $1,000 on account
Income recorded when earned, not when cash is received

The Time-Period Concept
• Accounting information is reported at regular intervals
• Basic accounting period is one year
• Companies also prepare financial statements for interim
periods (Usually, larger companies are required to prepare
more frequent reporting)

Apply the revenue and expense recognition principles

Revenue and Expense Recognition
Principles (1 of 4)
The Revenue Recognition Principle
• Deals with two issues:
– When to record (recognize) revenue
– What amount of revenue to record

Principles (2 of 4)
The Revenue Recognition Principle
The five steps of revenue recognition according to IFRS 15
(in Hong Kong HKFRS 15), effective 1 Jan 2018:
1. Identify the contracts with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance
obligations in the contract
5. Recognize revenue when (or as) the entity satisfies a
performance obligation

Principles (3 of 4)
The Expense Recognition Principle
• Expenses should be recognized by associating with
related revenues
• Subtract expenses from related revenues to compute net
income or net loss

Principles (4 of 4)
The Matching Concept explains the relationship between
expenses and revenues
Includes two steps:
– Identify all expenses incurred during the period
– Measure the expenses and recognize them in the
same period in which any related income is earned
• Example: when a company produces goods, it is
recognized as inventory. When the inventory is sold, cost
of goods sold is recognized.
• The change in assets and liabilities determines profit or
loss, not the application of a matching concept.
Adjust the accounts

What are Adjusting Entries
At the end of an accounting period, we need to make sure
that the income and expenses are recorded in the correct
accounting period.
Adjusting entries are journal entries which we make to adjust
the ending balance of various ledger accounts to allocate
income and expenses into the correct period which they
actually occurred.

Exhibit 3-3 Unadjusted Trial Balance

Categories of Adjusting Entries
• Deferrals
– An adjustment for an item for which payment of or
receipt of cash is made in advance.
– Cash transaction before income/expense recognition
• Accruals
– The opposite of a deferral.
– Cash transaction after income/expense recognition
• Depreciation
– Allocates the cost of Property, Plant and Equipment
(PPE) to expense over the asset’s useful life.

Categories of Adjusting Entries
• Deferrals
– Prepaid Expenses
– Unearned Revenues
• Accruals
– Accrued Expenses
– Accrued Revenues
• Depreciation

Adjust the Accounts (1 of 6)
Deferrals
1. Prepaid Expenses (Prepayments)
An expense paid in advance. Prepaid expenses are assets
because they provide a future benefit for the owner.

Prepaid Expenses (1 of 4)
Prepaid Rent: Suppose the company prepays three months’
store rent ($3,000) on June 1.
Step 1: Record cash transaction (included in trial balance)

Prepaid Rent. At June 30 (period end), an adjusting entry is
required to transfer $1,000 ($3,000 ÷ 3) from Prepaid Rent to Rent
Expense.
Step 2: Recognize the expense in the appropriate period

Supplies. On June 2, the company paid cash of $700 for
supplies. (e.g. stationaries, paper, light bulbs)
Step 1: Record cash transaction

Supplies. A count at June 30 indicates that $400 of supplies
remain on hand.

Deferrals
2. Unearned Revenues (Deferred income)
Receipt of cash before earning the revenue. Unearned
revenues are liabilities because the owner is obliged to
deliver goods / perform services in the future.

Unearned Revenues (1 of 2)
Suppose another hotel chain engages the company, paying us
$400 of commissions in advance on June 15 to make 10
bookings.

Unearned Revenues (2 of 2)
During the last 15 days of the month, the company books 5 clients
into the hotel to earn ½ of the $400.
Step 2: Recognized the revenue when earned

Accruals
1. Accrued Expenses
• A liability that arises from an expense that has not yet been
paid
• Not recorded daily or weekly, but rather at the end of the
period as an adjusting entry

Accrued Expenses (1 of 4)
Accrued Salary Expense. 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 following calendar for June has the
paydays circled:
Assume that if a payday falls on a Sunday, the comapny pays the

employee on the following Monday.
During June, the company paid its employee the first half-month
salary of $900.
Cash transaction coincides with expense recognition, no accrual
is needed

The second half-month amount of $900 should be paid on June
30. However, cash payment is delayed to Monday, July 1.
Therefore, at June 30 the company records the adjusting entry.

At 1 July, the company pay its employee the second half-month
salary for June of $900.
Jul 1 Salary Payable 900

Cash 900
To pay salary
Salary Payable Cash

Opening Bal. 900 Jul. 1 900
Jul. 1 900
Bal. 0

Accruals
2. Accrued Revenues
• A revenue that has been earned but not yet collected.

Accrued Revenues (1 of 2)
Assume that on June 15 a hotel agrees to pay the company a
commission of $30 per booking into its hotel. At the end of June,
record shows that the company has booked 10 clients in June and
has earned $300 for the work.
Step 1: Recognize revenue when earned

Accrued Revenues (2 of 2)
Later in July 15, the client makes payment to the company
Jul 15 Cash 300

Accounts Receivable 300
Collected cash on account
Accounts Receivable Cash

Opening Bal. 300 Jul. 15 300
Jul. 15 300
Bal. 0

Exhibit 3-4 Prepaid and Accrual
Adjustments

Depreciation of Property, Plant and Equipment
• Plant assets are long-lived tangible assets, such as land,
buildings, furniture, and equipment.
• Depreciation is the process of allocating cost to expense
for a long-term plant asset.
– Decline in usefulness
– Spread the cost of the plant asset over its useful life
– Exception: Land – does not decline in usefulness
– Process is identical to deferrals
• To be discussed in detail in lecture 7
Additional: Income Tax Accrual
The company would make an additional adjusting entry to
accrue (estimated) income tax expense of $600 and the
related income tax payable as the final adjusting entry of the
period.
Identical to other accrued expenses.

Summary of the Adjusting Process
• Two purposes of the adjusting process are to
1. measure income
2. update the balance sheet
• Therefore, every adjusting entry affects both of the
following:
– Revenue or expense—to measure income
– Asset or liability—to update the balance sheet
• Every adjusting entry does not affect the cash account
since they are accrual in nature.

Exhibit 3-7 Summary of Adjusting
Entries

Exhibit 3-8 The Adjusting Process(1 of 2)

Exhibit 3-8 The Adjusting Process(2 of 2)

The Adjusted Trial Balance
Summarizes all accounts and their final balances after all
adjusting entries have been journalized and posted

Exhibit 3-9 Adjusted Trial Balance

Prepare updated financial statements

Construct the Financial Statements
The June financial statements of the company can be
prepared from the adjusted trial balance.

Exhibit 3-10 Income Statement

Exhibit 3-11 Statement of Changes in
Equity

Exhibit 3-12 Balance Sheet

Close the books

Close the Books (1 of 3)
• Prepares the accounts for the next period
• Close temporary accounts: accounts related to a period
of time
– Income
– Expenses
– Dividends
• Do NOT close permanent accounts
– Assets
– Liabilities
– Shareholders’ equity
Exhibit 2-6 Expansion of the
Accounting Equation
Balance Sheet Statement of Changes in Equity

Normal Balance:

Steps to close the books:
1. Debit each income for the amount of its credit balance.
Credit Retained Earnings for the sum of all revenues.
2. Credit each expense account for the amount of its debit
balance. Debit Retained Earnings for the sum of all
expenses.
3. Credit the dividends account for the amount of its debit
balance. Debit Retained Earnings for the same amount.
All accounts are closed into Retained Earnings!

Exhibit 3-13 Journalizing and Posting
the Closing Entries (1 of 2)

Exhibit 3-13 Journalizing and Posting
the Closing Entries (2 of 2)


Chapter Summary
• In contrast to Cash-basis accounting which only records
cash transactions, Accrual accounting records the impact
of transactions when they occur: income when earned,
expenses when incurred
• The income (revenue) is recorded according to the
Revenue Recognition Principle, and the expenses
according to the Matching Concept
• At the end of an accounting period, we need to make sure
that transactions are recorded in the correct period. We
achieve this by doing adjusting entries

Chapter Summary
• Adjusting entries:

Chapter Summary
• After journalizing and posting the adjusting entries, the
Trial Balance is updated to the Adjusted Trial Balance, and
the financial statements can be prepared
• Finally, we close the temporary accounts (Income,
Expenses, Dividends) into Retained Earnings by doing the
Closing Entries. This process is called “Closing the Book”,
and it prepares the temporary accounts for next year by
resetting their balance to zero

Course Overview
What is accounting? ✓
Why do we do accounting in the way that will be discussed
in this course? ✓
How do we do accounting?
➢The format: T-accounts & journal entries ✓
➢Accrual accounting: Adjusting entries ✓
➢Presenting Financial Statements (Next Lecture)
➢Details of common accounts and cash flow (Lecture 5-10)
How do we use accounting information? (Lecture 11)

Homework Assignments
• S3-15; E3-31B
• Due 8 Oct, 11:59pm
• Upload to Blackboard
• Late submission is not accepted
• Next week is holiday, next lecture is at 9 Oct

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Financial Accounting

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(9) Received $1,000 on account

Income recorded when earned, not when cash is received

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Assume that if a payday falls on a Sunday, the comapny pays the

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Jul 1 Salary Payable 900

Salary Payable Cash

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Jul 15 Cash 300

Accounts Receivable Cash

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Close the Books (2 of 3)

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