Accrual Accounting Concepts

ACCRUAL
ACCOUNTING
CONCEPTS
4
!1
Preview of Chapter 4
!2
Timing Issues
Accountants divide the economic life of a business into

artificial time periods (Periodicity Assumption).
Jan. Feb. Mar. Apr.

..... Dec.
◆ Generally a month, a quarter, or a year.

◆ Fiscal year vs. calendar year
LO 1 Explain the revenue recognition principle and

!3 the expense recognition principle.
Timing Issues
Review Question
What is the periodicity assumption?
a. Companies should recognize revenue in the
accounting period in which it is earned.
b. Companies should match expenses with revenues.
c. The economic life of a business can be divided into
artificial time periods.
d. The fiscal year should correspond with the calendar
year.

Timing Issues
The Revenue Recognition Principle
Companies recognize revenue

in the accounting period in
which the performance
obligation is satisfied.

Timing Issues
Illustration: Assume Conrad Dry Cleaners cleans clothing on

June 30, but customers do not claim and pay for their clothes
until the first week of July. The journal entries for June and
July would be:

Timing Issues
Illustration 4-1 (Partial)
“Let the expenses follow the revenues.”

Timing Issues
Illustration 4-1 GAAP
relationships in revenue
and expense recognition

Timing Issues
Accrual versus Cash Basis of Accounting

Accrual-Basis Accounting
► Transactions recorded in the periods in which the
events occur.
► Revenues are recognized when services performed,

even if cash was not received.
► Expenses are recognized when incurred, even if cash

was not paid.
LO 2 Differentiate between the cash basis and

!9
the accrual basis of accounting.
Timing Issues
Accrual versus Cash Basis of Accounting

Cash-Basis Accounting
► Revenues are recognized only when cash is received.
► Expenses are recognized only when cash is paid.
► Prohibited under generally accepted accounting

principles (GAAP).

!10
Timing Issues
Illustration: Suppose that Fresh Colors paints a large building

in 2013. In 2013, it incurs and pays total expenses (salaries
and paint costs) of $50,000. It bills the customer $80,000, but
does not receive payment until 2014.
Illustration 4-2 (Partial)
2013 2014

!11
Timing Issues
Review Question
Which one of these statements about the accrual basis of accounting
is false?
a. Companies record events that change their financial statements
in the period in which events occur, even if cash was not
exchanged.
b. Companies recognize revenue in the period in which the
performance obligation is satisfied.
c. This basis is in accord with generally accepted accounting
principles.
d. Companies record revenue only when they receive cash, and
record expense only when they pay out cash.

!12
The Basics of Adjusting Entries
Adjusting entries
◆ ensure that the revenue recognition and expense
recognition principles are followed.
◆ are required every time a company prepares financial

statements.
◆ includes one income statement account and one

balance sheet account.
◆ never include cash.
LO 3 Explain why adjusting entries are needed, and

!13
identify the major types of adjusting entries
The Basics of Adjusting Entries
Review Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they are
incurred.
b. revenues are recognized in the period in which the
performance obligation is satisfied.
c. balance sheet and income statement accounts have
correct balances at the end of an accounting period.
d. All of the above.

!14
Types of Adjusting Entries
Illustration 4-3
Categories of adjusting entries
Deferrals:
1. Prepaid expenses: Expenses paid in cash and recorded as
assets before they are used or consumed.
2. Unearned revenues: Cash received before service are
performed.
Accruals:
1. Accrued revenues: Revenues for services performed but not
yet received in cash or recorded.
2. Accrued expenses: Expenses incurred but not yet paid in
cash or recorded.

!15
Types of Adjusting Entries
Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.
Illustration 4-4

!16
Adjusting Entries for Deferrals
Deferrals are either:
◆ Prepaid expenses
OR
◆ Unearned revenues.
!17 LO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid Expenses”
Payment of cash, that is recorded as an asset because

service or benefit will be received in the future.
Cash Payment BEFORE Expense Recorded
Prepayments often occur in regard to:

◆ insurance ◆ rent
◆ supplies ◆ equipment
◆ advertising ◆ buildings

Prepaid Expenses
◆ Costs that expire either with the passage of time or
through use.
◆ Adjusting entry results in an increase (a debit) to an

expense account and a decrease (a credit) to an asset
account.

Adjusting entries for prepaid expenses

Illustration 4-5
◆ Increases (debits) an expense account and

◆ Decreases (credits) an asset account.

Illustration: Sierra Corporation purchased supplies costing $2,500 on

October 5. Sierra recorded the purchase by increasing (debiting) the
asset Supplies. This account shows a balance of $2,500 in the
October 31 trial balance. An inventory count at the close of business
on October 31 reveals that $1,000 of supplies are still on hand.
Oct. 31 Supplies Expense 1,500

Supplies 1,500
($2,500 – 1,000 = $1,500)

Illustration: On October 4, Sierra Corporation paid $600 for a one-year

fire insurance policy. Coverage began on October 1. Sierra recorded
the payment by increasing (debiting) Prepaid Insurance. This account
shows a balance of $600 in the October 31 trial balance. Insurance of
$50 ($600 ÷ 12) expires each month.
Oct. 31 Insurance Expense 50

Prepaid Insurance 50

Depreciation
◆ Buildings, equipment, and motor vehicles (long-lived
assets) are recorded as assets, rather than an expense,
in the year acquired.
◆ Companies report a portion of the cost of a long-lived

asset as an expense (depreciation) during each period of
the asset’s useful life.
◆ Depreciation does not attempt to report the actual change

in the value of the asset.

Illustration: For Sierra Corporation, assume that depreciation on

the office equipment is $480 a year, or $40 per month.
Oct. 31 Depreciation Expense 40

Accumulated Depreciation-Equipment 40

Summary
Illustration 4-10

Adjusting Entries for “Unearned Revenues”
Receipt of cash recorded as a liability before services are

performed.
Cash Receipt BEFORE Revenue Recorded
Unearned revenues often occur in regard to:

◆ rent ◆ magazine subscriptions
◆ airline tickets ◆ customer deposits

Unearned Revenues
◆ Adjusting entry to record the revenue that has been
earned and to show the liability that remains.
◆ Adjusting entry results in a decrease (a debit) to a liability

account and an increase (a credit) to a revenue account.

Adjusting entries for unearned revenues

Illustration 4-11
◆ Decrease (a debit) to a liability account and

◆ Increase (a credit) to a revenue account.

Illustration: Sierra Corporation received $1,200 on October 2 from R.

Knox for guide services for multi-day trips expected to be completed by
December 31. Unearned Service Revenue shows a balance of $1,200
in the October 31 trial balance. From an evaluation of the service
Sierra performed for Knox during October, the company determines
that it has earned $400 in October.
Oct. 31 Unearned Service Revenue 400

Service Revenue 400

Summary
Illustration 4-13
ACCOUNTING FOR UNEARNED REVENUES
Reason for Accounts Before Adjusting

Examples
Adjustment Adjustment Entry
Rent, magazine Unearned Revenues Liabilities overstated. Dr. Liabilities

subscriptions, recorded in liability Revenues understated. Cr. Revenues
customer deposits for accounts are now
future service recognized as
revenue for services
performed

!31
Adjusting Entries for Accruals
Made to record:
◆ Revenues earned and
OR
◆ Expenses incurred
in the current accounting period that have not been

recognized through daily entries.
!32 LO 5 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued Revenues”
Revenues for services performed but not yet received in cash or recorded.
Adjusting entry results in:
Revenue Recorded BEFORE Cash Receipt
Accrued revenues often occur in regard to:

◆ rent
◆ interest
◆ services performed

Accrued Revenues
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues for services performed.

Adjusting entries for accrued revenues

Illustration 4-14
◆ Increases (debits) an asset account and

◆ Increases (credits) a revenue account.

Illustration: In October, Sierra Corporation performed guide

services for $200 that were not billed to clients before October
31.
Oct. 31 Accounts Receivable 200
Service Revenue 200

Summary
Illustration
Illustration 4-16
4-16
ACCOUNTING FOR ACCRUED REVENUES
Reason for Accounts Before Adjusting

Examples
Adjustment Adjustment Entry
Interest, rent, services Services performed Assets understated. Dr. Assets
performed but not but not yet received in Revenues understated. Cr. Revenues
collected cash or recorded

Adjusting Entries for “Accrued Expenses”
Expenses incurred but not yet paid in cash or recorded.
Adjusting entry results in:
Expense Recorded BEFORE Cash Payment
Accrued expenses often occur in regard to:
◆ rent ◆ taxes
◆ interest ◆ salaries

Accrued Expenses
An adjusting entry serves two purposes:
(1) Records the obligations, and
(2) Recognizes the expenses.

Adjusting entries for accrued expenses

Illustration 4-17
◆ Increases (debits) an expense account and

◆ Increases (credits) a liability account.

Illustration: Sierra Corporation signed a three-month note

payable in the amount of $5,000 on October 1. The note
requires Sierra to pay interest at an annual rate of 12%.
Oct. 31 Interest Expense 50

Interest Payable 50

!42
Illustration: Sierra Corporation last paid salaries on October 26; the

next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 × 3 days).
Illustration 4-20

Illustration: Sierra Corporation last paid salaries on October 26; the

next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 x 3 days).
Oct. 31 Salaries and Wages Expense 1,200

Salaries and Wages Payable 1,200

Summary
Illustration 4-22

Summary of Basic Relationships
Illustration 4-23
Summary of adjusting
entries

The Adjusted Trial Balance
After all adjusting entries are journalized and posted the

company prepares another trial balance from the ledger
accounts (Adjusted Trial Balance).
The adjusted trial balance’s purpose is to prove the equality of

debit balances and credit balances in the ledger.
The adjusted trial balance is the primary basis for the

preparation of the financial statements.
!47 LO 6 Describe the nature and purpose of the adjusted trial balance.
Illustration 4-26
Adjusted trial balance
!48 LO 6
Review Question
Which of the following statements is incorrect concerning the
adjusted trial balance?
a. An adjusted trial balance proves the equality of the total debit
balances and the total credit balances in the ledger after all
adjustments are made.
b. The adjusted trial balance provides the primary basis for the
preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting
entries have been journalized and posted.
Preparing Financial Statements
Financial statements are prepared directly from the

Adjusted Trial Balance.
Retained
Income Balance
Earnings
Statement Sheet
Statement
Illustration 4-27
!51
Illustration 4-28
!52
Closing the Books
At the end of the accounting period, companies transfer the

temporary account balances to the permanent stockholders’
equity account—Retained Earnings.
Illustration 4-29
!53 LO 7 Explain the purpose of closing entries.

Closing the Books
In addition to updating Retained Earnings to its correct ending

balance, closing entries produce a zero balance in each
temporary account.
Illustration 4-30

Closing the Books
2014
Illustration 4-31
!55
Closing the Books
Illustration 4-32
Posting of closing
entries

Preparing a Post-Closing Trial Balance
The purpose of the post-closing trial balance is to prove the

equality of the permanent account balances that the
company carries forward into the next accounting period.
All temporary accounts will have zero balances.

Summary of the Accounting Cycle
Illustration 4-33
1. Analyze business transactions Required steps in the
accounting cycle
9. Prepare a post-closing trial

2. Journalize the transactions
balance
8. Journalize and post closing

3. Post to ledger accounts
entries
7. Prepare financial statements 4. Prepare a trial balance
6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries:
Deferrals/Accruals
!58 LO 8 Describe the required steps in the accounting cycle.

Keep an Eye on Cash
Sierra Corporation’s income statement shows net income of
$2,860. Net income and net cash provided by operating activities
often differ.
✓ Net income on a cash basis is

referred to as “Net cash
provided by operating activities.”
✓ The statement of cash flows,

reports net cash provided by
operating activities.
Illustration 4-27
LO 9 Understand the causes of differences between net

!59
income and cash provided by operating activities.
Keep an Eye on Cash
The difference for Sierra is $2,840 ($5,700 - $2,860). The
following summary shows the causes of this difference.
!60
LO 9
Appendix 4A
Adjusting Entries in an Automated World— Using a
Worksheet
Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.
Illustration 4-4
!61
Steps in Preparing a Worksheet
1. Prepare a Trial Balance on the Worksheet Illustration 4A-1
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Dividends 500
Service Revenue 10,000
Salaries & Wages Exp. 4,000

Rent Expense 900
Totals 28,700 28,700
!62 LO 10 Describe the purpose and the basic form of a worksheet.

1. Prepare a Trial Balance on the Worksheet Illustration 4A-1
Adjusted Income
Cash 15,200
Supplies 2,500
Equipment 5,000
Notes Payable 5,000
Unearned Service Revenue 1,200
Common Stock 10,000
Dividends 500
Service Revenue 10,000
Salaries & Wages Exp. 4,000

Rent Expense 900
Totals 28,700 28,700
Trial balance amounts come

directly from ledger accounts.
Include all accounts
with balances.
!63 LO 10 Describe the purpose and the basic form of a worksheet.

Using a Worksheet
Illustration 4-24
General journal
showing adjusting
entries 2012
Adjusting
Journal
Entries
!64
2. Enter the Adjustments in the Adjustments Columns
Adjusted Income
Cash 15,200
Supplies 2,500 (a) 1,500
Prepaid Insurance 600 (b) 50
Equipment 5,000
Adjustments Key:
Notes Payable 5,000 (a) Supplies Used.
Unearned Service Revenue 1,200 (d) 400 (b) Insurance Expired.
Common Stock 10,000 (c) Depreciation Expensed.
Dividends 500
Service Revenue 10,000 (d) 400 (d) Service Revenue Earned.
(e) 200 (e) Service Revenue Accrued.
Salaries & Wages Exp. 4,000 (g) 1,200
Rent Expense 900
(f) Interest Accrued.
Totals 28,700 28,700 (g) Salaries Accrued.
Supplies Expense (a) 1,500
(b)
Insurance Expense 50
Accumulated Depreciation (c) 40
Depreciation Expense (c) 40
(e)
Accounts Receivable 200
Interest Expense
(f)
50
Enter adjustment amounts, total
Interest Payable (f) 50 adjustments columns,
(g)
Salaries and Wages Payable 1,200 and check for equality.
Totals 3,440 3,440
Add additional accounts as needed. LO 10 Describe the purpose and the

!65 basic form of a worksheet.
3. Complete the Adjusted Trial Balance Columns
Adjusted Income
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800
Common Stock 10,000 10,000
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600
(e) 200
Salaries & Wages Exp. 4,000 (g) 1,200 5,200
Rent Expense 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500
(b)
Insurance Expense 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40
(e)
Accounts Receivable 200 200
(f)
Interest Expense 50 50
Interest Payable (f) 50 50
(g)
Salaries and Wages Payable 1,200 1,200
Totals 3,440 3,440 30,190 30,190
Total the adjusted trial balance

columns and check for equality. LO 10 Describe the purpose and the
!66 basic form of a worksheet.
4. Extend Amounts to Financial Statement Columns
Adjusted Income
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800
Common Stock 10,000 10,000
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries & Wages Exp. 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
(b)
Insurance Expense 50 50 50
Accumulated Depreciation (c) 40 40
Depreciation Expense (c) 40 40 40
(e)
Accounts Receivable 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50
(g)
Salaries and Wages Payable 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600
Extend all revenue and expense account

balances to the income statement columns.
!67 LO 10
5. Total Columns, Compute Net Income (Loss)
Adjusted Income
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800 800
Common Stock 10,000 10,000 10,000
Dividends 500 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries & Wages Exp. 4,000 (g) 1,200 5,200 5,200
Rent Expense 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
(b)
Insurance Expense 50 50 50
Accumulated Depreciation (c) 40 40 40
Depreciation Expense (c) 40 40 40
(e)
Accounts Receivable 200 200 200
(f)
Interest Expense 50 50 50
Interest Payable (f) 50 50 50
(g)
Salaries and Wages Payable 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net Income 2,860 2,860
Totals 10,600 10,600 22,450 22,450
Compute Net Income or Net Loss.
!68 LO 10

Accrual Accounting Concepts

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Accrual Accounting Concepts

Uploaded by

Copyright:

Available Formats

ACCRUAL

Accountants divide the economic life of a business into

Jan. Feb. Mar. Apr.

◆ Generally a month, a quarter, or a year.

LO 1 Explain the revenue recognition principle and

LO 1 Explain the revenue recognition principle and

The Revenue Recognition Principle

Companies recognize revenue

LO 1 Explain the revenue recognition principle and

Illustration: Assume Conrad Dry Cleaners cleans clothing on

LO 1 Explain the revenue recognition principle and

Illustration 4-1 (Partial)

“Let the expenses follow the revenues.”

LO 1 Explain the revenue recognition principle and

LO 1 Explain the revenue recognition principle and

Accrual versus Cash Basis of Accounting

► Revenues are recognized when services performed,

► Expenses are recognized when incurred, even if cash

LO 2 Differentiate between the cash basis and

Accrual versus Cash Basis of Accounting

► Expenses are recognized only when cash is paid.

► Prohibited under generally accepted accounting

LO 2 Differentiate between the cash basis and

Illustration: Suppose that Fresh Colors paints a large building

LO 2 Differentiate between the cash basis and

LO 2 Differentiate between the cash basis and

◆ are required every time a company prepares financial

◆ includes one income statement account and one

◆ never include cash.

LO 3 Explain why adjusting entries are needed, and

LO 3 Explain why adjusting entries are needed, and

LO 3 Explain why adjusting entries are needed, and

LO 3 Explain why adjusting entries are needed, and

Deferrals are either:

!17 LO 4 Prepare adjusting entries for deferrals.

Payment of cash, that is recorded as an asset because

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

!18 LO 4 Prepare adjusting entries for deferrals.

◆ Adjusting entry results in an increase (a debit) to an

!19 LO 4 Prepare adjusting entries for deferrals.

Adjusting entries for prepaid expenses

◆ Increases (debits) an expense account and

!20 LO 4 Prepare adjusting entries for deferrals.

Illustration: Sierra Corporation purchased supplies costing $2,500 on

Oct. 31 Supplies Expense 1,500

!21 LO 4 Prepare adjusting entries for deferrals.

Illustration: On October 4, Sierra Corporation paid $600 for a one-year

Oct. 31 Insurance Expense 50

!22 LO 4 Prepare adjusting entries for deferrals.

◆ Companies report a portion of the cost of a long-lived

◆ Depreciation does not attempt to report the actual change

!23 LO 4 Prepare adjusting entries for deferrals.

Illustration: For Sierra Corporation, assume that depreciation on

Oct. 31 Depreciation Expense 40

!24 LO 4 Prepare adjusting entries for deferrals.

!25 LO 4 Prepare adjusting entries for deferrals.

Receipt of cash recorded as a liability before services are

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

!26 LO 4 Prepare adjusting entries for deferrals.

◆ Adjusting entry results in a decrease (a debit) to a liability

!27 LO 4 Prepare adjusting entries for deferrals.

Adjusting entries for unearned revenues