ACCY901

Accounting Foundations for Professionals

Topic 3
Accrual Accounting and Adjusting Entries

Dr Andy Wang
BCom(Hons), MAccg, PhD, CPA
Topic 2 Review

• Accounting cycle:
– Analysing transactions
– Double entry accounting rules
• Each transaction has a dual effect on the accounting equation
• Each type of account (ie asset, liability, and equity) has a different normal
balance and therefore debit and credit entries will effect these accounts
differently
• Debit and credit rules?
– Journalizing
– Posting
– Trail balance

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Topic 2 Review
The recording process illustrated

1. Investment of cash by owner

1 September, Nala invests $30 000 cash in a

Transaction business, Mass Productions Ltd

Basic The asset Cash is increased $30 000, and

analysis owner’s equity, Nala, Capital is increased
$30 000

Debit-credit Debits increase assets: debit Cash $30 000.

analysis Credits increase owner’s equity: credit
Nala, Capital $30 000

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The recording process illustrated

Debit-credit Debits increase assets: debit Cash $30 000

analysis Credits increase owner’s equity: credit
Nala, Capital $30 000

1 Sep Cash 101 30 000

Journal entry Nala, Capital 301 30000
(Owner’s investment
of cash in business)

Cash 101 Nala, Capital 301

Posting 1 Sep 30 000 1 Sep 30 000

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Chapter 3 – Accrual accounting and adjusting entries

Learning objectives
1) Differentiate between the cash basis and the accrual basis of
accounting.
2) Explain criteria for revenue recognition and expense recognition.
3) Explain why adjusting entries are needed and identify the major
types of adjusting entries.
4) Prepare adjusting entries for prepayments and accruals.

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Expanded accounting cycle including adjusting entries

1. Recognise & record Source documents

transactions

2. Journalise transaction General journal

3. Post to ledger accounts General ledger

4. Prepare unadjusted trial Trial balance

balance of general ledger (unadjusted)

Continued Next Slide

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Expanded accounting cycle including adjusting entries

5. Determine adjusting entries General journal

and journalise

6. Post adjusting entries to General ledger

general ledger (Accounts Adjusted)

7. Prepare adjusted trial balance Trial balance

(Adjusted)

8. Prepare financial statements Work Financial Statements

sheet
The need for adjusting entries

• In many cases the period in which cash is paid or received does not
coincide with period in which expense and income are recognised

• Therefore, in order for our statements to reflect what has actually

happened, some accounts must be adjusted on the last day of the
accounting period to correctly recognise income and expenses not
reflected in cash receipts or payments

• matching principle!

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Accrual versus cash basis of accounting
§ The main difference between the accrual and cash bases of
accounting is the timing of when revenues and expenses are
recorded.
§ Cash Basis
• Income is recorded when cash is received
• Expenses are recorded when cash is paid
§ Accrual Basis
• Income recognised when the anticipated inflow of economic benefit can
be reliably measured
(earned: account receivable for revenue)
• Expenses recognised when the consumption of benefits can be reliably
measured
(incurred: account payable to suppliers)

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Timing issues

Period assumption
Economic life of business
can be divided into artificial
periods

Revenue recognition criteria Expense recognition criteria

Revenues recognised in the
period in which the increase in
assets or decrease in liabilities
become probable and can be
measured reliably
Expenses recognised in the
period when the reduction in
assets or increase in liabilities
become probable and can be
measured reliably

Revenue and expense criteria

Form part of generally
accepted accounting
principles (GAAP)

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 Example
- accrual versus cash basis of accounting

Year 1 Year 2
• Example:
Activity Paid $50,000 for purchased Received $80, 000 cash
paint and paid employees for work done in Year 1

Accrual Revenue $ Revenue $

basis Expense Expense
Profit $ Profit $

Cash Revenue $ Revenue $

basis Expense Expense
Loss $ Profit $

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 Example
- accrual versus cash basis of accounting

• Example: Year 1 Year 2

Activity Purchased paint, painted Received payment for work
building, paid employees done in Year 1

Accrual Revenue $ 80 000 Revenue $ -

basis Expense 50 000 Expense -
Profit $ 30 000 Profit $ -

Cash Revenue $ - Revenue $ 80 000

basis Expense 50 000 Expense -
Loss $(50 000) Profit $ 80 000

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Types of adjusting entries

Revenue received in advance

Prepaid Expense Amounts received from customers
Amounts paid in cash and recorded as a liability until
Prepayments and recorded as assets services performed or goods
until used. delivered.
(unearned revenue)

Accruals Accrued Expense Accrued Revenue

Expenses incurred but Revenue earned but not yet
(Unrecorded) not yet paid received

Provide a “true” picture of profit for the accounting period.

The rules of adjusting entries
o Attempting to account for the “timing difference” between
receipt/payment of cash, and recognition of income/expense
o One side of the entry affects an income statement account
o That is revenue or expense
o The other side of the entry affects an account reported in the
balance sheet
o That is asset or liability
o Cash is never adjusted!

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Adjusting entries for prepayments

Prepayments are either:

a. prepaid expenses
b. revenues received in advance (unearned revenue).

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prepaid expenses
• Cash paid before benefits are consumed/expire
– Initially recorded as an asset when paid
– At the end of the period the amount consumed/expired is expensed.

ASSET ACCOUNT EXPENSE ACCOUNT

Prepaid Expense
Initial Cost Adjusting Entry Adjusting Entry
Debit Credit Debit

Costs consumed or expired

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Example 1. prepaid rent
• On 1 June the following entry was made to record rent covering
the a period of 3 months:

General Journal
Jun 5 Prepaid Rent asset 1 200
Cash at Bank 1 200
(Payment of rent for 3 months)

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Example 1. prepaid rent
• On 30 June only one month of rent has expired
($1,200 ÷ 3 months = $400)

Adjusting entry General Journal

Jun 30 Rent Expense 400
Prepaid Rent 400
(Adjusting entry for rent)

Prepaid Rent Rent Expense

Initial Entry Adjusting Entry Adjusting Entry
1 200 400 400

Costs expired and allocated to current period

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Example 2. prepaid insurance

– Insurance paid for 1 year in advance: $600.

– Insurance for October $600/12 = $50.

– Journal entry:

– General ledger:

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Example 3. Depreciation
– Allocation of the cost of the asset to expense over its useful life.
– Depreciation of office equipment: $480 p.a. or $40 monthly.
– Journal entry:

– General Ledger:

– Statement of Financial Position:

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 Example 4. Supplies
– Supplies at the beginning of October: $12,500
– Supplies on hand 31 October: $5,000
– Supplies expense $7,500
– Journal entry:

Oct. 31 Supplies Expense 7,500

Supplies 7,500
(To record supplies used for Oct.)

– General Ledger:

Supplies Supplies Expense

Oct. 4 12,500 Oct. 31 Adj. 7,500 Oct. 31 Adj. 7,500

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Revenues received in advance: unearned revenue
• Cash received in advance for services that are to be preformed
in the future
– Initially recorded as liability when received
– Recognised as revenue as earned-Accrual basis!

LIABILITY ACCOUNT INCOME ACCOUNT

Unearned Revenue
Adjusting Entry Cash Receipt Adjusting Entry
Debit Credit

Revenue earned during the current period

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 Revenues received in advance: unearned revenue
• Example:
– $1200 received 2 October for advertising services to be
completed 31 December. Services worth $400 were performed
in October.

– Journal entry:

– General Ledger:

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Adjusting entries for accruals
• Accruals may be either:
a. accrued revenues
b. accrued expenses.

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 Adjusting entries for accruals: accrued revenues
• Accrued revenues are revenues earned from providing goods or services that
have not as yet been recorded.
• Revenue and receivable are recorded for revenue not received and not
recorded.
• Once cash is received, receivable is reduced.

• Example:
– Commission Revenue earned, but not yet received or recorded – $200.
– Journal entry:

– General Ledger:

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One more example: market services

• On 1 June an agreement was signed to provide marketing services for a

monthly fee of $800. On 30 June cash is yet to be received and no
invoice has been issued.

General Journal

Jun 30 Accounts Receivable 800

Marketing Services Revenue 800

(Marketing services fee receivable for June)

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Adjusting entries for accruals: accrued expenses

• Expenses that have been consumed but payment has not yet been made
• Expense must be recognised along with a liability for future payment

LIABILITY ACCOUNT EXPENSE ACCOUNT

Expense Payable
Adjusting Entry Adjusting Entry
Credit Debit

Expenses Incurred

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Example: accrued salaries

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Example: accrued salaries
• On 30 June an adjusting entry is required to correctly determine June’s
expenses.

General Journal

Jun 30 Salaries Expense 3 980

Salaries Payable 3 980

(Adjusting entry for salaries payable)

Salaries Payable Salaries Expense

Adjusting Entry Adjusting Entry
3 980 3 980

Expenses Incurred

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 Example: accrued salaries
• The liability is eliminated on 6 July when the next payment is made to
employees.

General Journal
Jul 6 Salaries Payable 3 980
Salaries Expense 3 420
Cash at Bank 7 400
(Payment of salaries earned 23 June
to 6 July)

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 Accrued interest (liability)
• On 2 June, Intellectual Management Services financed a portion of the land
and building purchase with a 20-year, $240 000, 8% mortgage.

Adjusting entry
To record the interest expense incurred in June:

$240 000 × 8% × 1/12= $1 600

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 Accrued electricity (liability)
• Assume that ABC Ltd. makes an estimate of $420 for electricity used in
June.

Adjusting entry To record the electricity expense incurred in June:

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Summary of adjusting entry scenarios

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Summary of basic relationships

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Lecture Question

Prepare year-end adjustments for the following transactions.

Omit explanations.

1. Accrued interest on notes receivable, $135.

2. Revenues received in advance now earned, $3,500.
3. Three years rent, totalling $24,000, was paid in advance at the
beginning of the year.
4. Services totalling $8,100 had been performed but not yet invoiced
at the end of the year.
5. Depreciation on equipment totalled $1,500 for the year.
6. Supplies for use totalled $750. By year end, only $95 in supplies
remained.
7. Salaries owed to employees at the end of the year total $535.

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