4

Accrual Accounting Concepts

4-1
 LEARNING OBJECTIVES

Explain the accrual basis of accounting and the

1 reasons for adjusting entries.

2 Prepare adjusting entries for deferrals.

3 Prepare adjusting entries for accruals.

4 Prepare an adjusted trial balance and closing entries.

4-2
LEARNING Explain the accrual basis of accounting and
OBJECTIVE 1 the reasons for adjusting entries.

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.

4-3 LO 1
 Periodicity Assumption

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.

4-4 LO 1
 REVENUE RECOGNITION PRINCIPLE

Companies recognize
revenue in the accounting
period in which the
performance obligation is
satisfied.

4-5 LO 1
 REVENUE RECOGNITION PRINCIPLE

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:

4-6 LO 1
 EXPENSE RECOGNITION PRINCIPLE

ILLUSTRATION 4-1

“Let the expenses follow the revenues.”

4-7 LO 1
 EXPENSE RECOGNITION PRINCIPLE

4-8 LO 1
 ACCRUAL VERSUS CASH BASIS

Accrual-Basis Accounting

4-9 LO 1
 ACCRUAL VERSUS CASH BASIS

Cash-Basis Accounting

4-10 LO 1
 ACCRUAL VERSUS CASH BASIS

Illustration: Suppose that Fresh Colors paints a large

building in 2016. In 2016, 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 2017.

2016 2017

4-11 LO 1
 Periodicity Assumption

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.
4-12 LO 1
 THE NEED FOR ADJUSTING ENTRIES

Adjusting entries

4-13 LO 1
 THE NEED FOR 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.

4-14 LO 1
 TYPES OF ADJUSTING ENTRIES

Deferrals:
1. Prepaid expenses:
.
2. Unearned revenues:

Accruals:
1. Accrued revenues:
.
2. Accrued expenses:

4-15 LO 1
 TYPES OF ADJUSTING ENTRIES

Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and
up-to-date.

4-16
LO 1
 DO IT! 1 Timing Concepts

Below is a list of concepts in the left column, with descriptions of the

concepts in the right column. There are more descriptions provided than
concepts. Match the description of the concept to the concept.

1. ____ Accrual-basis accounting. (a) Monthly and quarterly time

2. ____ Calendar year. periods.
3. ____ Periodicity assumption. (b) Efforts (expenses) should
4. ____ Expense recognition principle. be matched with results
(revenues).
(c) Accountants divide the economic life of a business into time periods.
(d) Companies record revenues when they receive cash and record
expenses when they pay out cash.
(e) An accounting time period that starts on January 1 and ends on
December 31.
(f) Companies record transactions in the period in which the events occur.
4-17 LO 1
LEARNING Prepare adjusting entries for
OBJECTIVE 2 deferrals.

To defer means to postpone or delay.

Journalize
Analyze
Trial and Post
business Journalize Post
Balance Adjusting
transactions
Entries

Adjusted
Financial Closing Post-Closing
Trial
Statements Entries Trial Balance
Balance

4-18 LO 2
 Deferrals

Deferrals are either:

◆ Prepaid expenses

OR

◆ Unearned revenues.

4-19 LO 2
 PREPAID EXPENSES

Expenses paid in cash before they are used or consumed.

Cash Payment Expense Recorded

Prepayments often occur in regard to:

4-20 LO 2
 PREPAID EXPENSES

Prepaid Expenses

4-21 LO 2
 PREPAID EXPENSES

Adjusting entries for prepaid expenses

4-22 LO 2
 Supplies

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

4-23 LO 2
 Insurance

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

4-24 LO 2
 Depreciation

◆ Buildings, equipment, and motor vehicles (long-lived

assets) are recorded as assets, rather than an
expense, in the year acquired.

◆ Depreciation is the process of allocating the cost of

an asset to expense (depreciation) over its useful life.

◆ Depreciation does not attempt to report the actual

change in the value of the asset.

4-25 LO 2
 Depreciation

Illustration: For Sierra Corporation, assume that depreciation on

the office equipment is $480 a year, or $40 per month.

Oct. 31

ILLUSTRATION 4-8

4-26 LO 2
 Depreciation

Statement Presentation
◆ Accumulated Depreciation-
Equipment is a contra asset
account.

◆ Appears just after the account it

offsets (Equipment) on the
balance sheet.

4-27 LO 2
 PREPAID EXPENSES

4-28 LO 2
 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:

4-29 LO 2
 UNEARNED REVENUES

4-30 LO 2
 UNEARNED REVENUES

Adjusting entries for unearned revenues

ILLUSTRATION 4-11

◆ Decrease (a debit) to a liability account.

◆ Increase (a credit) to a revenue account.

4-31 LO 2
 UNEARNED REVENUES

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

4-32 LO 2
 UNEARNED REVENUES

ACCOUNTING FOR UNEARNED REVENUES

Reason for Accounts Before Adjusting

Examples Adjustment Adjustment Entry

4-33 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for $4,000 of the unearned
service revenue reported.
Prepare the adjusting entries for the month of March.
4-34 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
1. Insurance expires at the rate of $100 per month.

SOLUTION

4-35 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
2. Supplies on hand total $800.

SOLUTION

4-36 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
3. The equipment depreciates $200 a month.

SOLUTION

4-37 LO 2
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment $5,000
Unearned Service Revenue 9,200
Prepare the adjusting entries for the month of March.
4. During March, services were performed for $4,000 of the unearned
service revenue reported.

SOLUTION

4-38 LO 2
LEARNING Prepare adjusting entries for
OBJECTIVE 3 accruals.

Increase both a balance sheet and an income statement

account.
Journalize
Analyze
Trial and Post
business Journalize Post
Balance Adjusting
transactions
Entries

Adjusted
Financial Closing Post-Closing
Trial
Statements Entries Trial Balance
Balance

4-39 LO 3
 Adjusting Entries for Accruals

Made to record:

◆ Revenues for services performed and

OR

◆ Expenses incurred

in the current accounting period that have not been

recognized through daily entries.

4-40 LO 3
 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:

4-41 LO 3
 ACCRUED REVENUES

Accrued Revenues
An adjusting entry serves two purposes:

4-42 LO 3
 ACCRUED REVENUES

Adjusting entries for accrued revenues

ILLUSTRATION 4-14

4-43 LO 3
 ACCRUED REVENUES

Illustration: In October, Sierra Corporation performed guide

services for $200 that were not billed to clients before October
31.

Oct. 31

4-44 LO 3
 ACCRUED REVENUES

ACCOUNTING FOR ACCRUED REVENUES

Reason for Accounts Before Adjusting

Examples Adjustment Adjustment Entry

4-45 LO 3
 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:

4-46 LO 3
 ACCRUED EXPENSES

An adjusting entry serves two purposes:

4-47 LO 3
 ACCRUED EXPENSES

Adjusting entries for accrued expenses

ILLUSTRATION 4-17

4-48 LO 3
 Accrued Interest

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%.

$5,000 x 12% x 1/12 = $50

Oct. 31

ILLUSTRATION 4-19

4-49 LO 3
 Accrued Salaries

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

4-50 LO 3
 Accrued Salaries

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).

Oct. 31

4-51 LO 3
 ACCRUED EXPENSES

4-52 LO 3
 SUMMARY OF BASIC RELATIONSHIPS

4-53 LO 3
 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. The following information relates to
August.
1. At August 31, the company owed its employees $800 in
salaries that will be paid on September 1.
2. On August 1, the company borrowed $30,000 from a bank on a
15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August
totaled $1,100.
Prepare the adjusting entries needed at August 31, 2017.
4-54 LO 3
 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
1. At August 31, the company owed its employees $800 in
salaries that will be paid on September 1.

SOLUTION

4-55 LO 3
 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
2. On August 1, the company borrowed $30,000 from a bank
on a 15-year mortgage. The annual interest rate is 10%.

SOLUTION

4-56 LO 3
 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
3. Revenue for services performed but unrecorded for
August totaled $1,100.

SOLUTION

4-57 LO 3
LEARNING Prepare an adjusted trial balance
OBJECTIVE 4 and closing entries.

Analyze
Trial Adjusting
business Journalize Post
Balance Entries
transactions

Journalize
Adjusted Prepare Prepare a
and post
trial financial post-closing
closing
balance statements trial balance
entries

4-58 LO 4
 PREPARE 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.

4-59 LO 4
4-60 LO 4
 PREPARE ADJUSTED TRIAL BALANCE

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.
4-61 LO 4
 PREPARING FINANCIAL STATEMENTS

Financial statements are prepared directly from the

Adjusted Trial Balance.

Retained
Income Balance
Earnings
Statement Sheet
Statement

4-62 LO 4
4-68
4-63
4-64 LO 4
 QUALITY OF EARNINGS

Quality of Earnings – company provides full and

transparent information.
Earnings Management - the planned timing of revenues,
expenses, gains, and losses to smooth out bumps in net
income. Companies may manage earnings by:
◆ one-time items to prop up earnings numbers.
◆ inflating revenue numbers in the short-run.
◆ improper adjusting entries.

As a result of the Sarbanes-Oxley Act, many companies are trying

to improve the quality of their financial reporting.

4-65 LO 4
 DO IT! 4a Trial Balance

4-66 LO 4
 DO IT! 4a Trial Balance

(a) Determine the net income for the quarter April 1 to June 30.

4-67 LO 4
 DO IT! 4a Trial Balance

(b) Determine the total assets and total liabilities at June 30,
2017.

4-68 LO 4
 DO IT! 4a Trial Balance

(c) Determine the balance in Retained Earnings at June 30,

2017.

4-69 LO 4
 CLOSING THE BOOKS

At the end of the accounting period, companies transfer the

temporary account balances to the permanent stockholders’
equity account—Retained Earnings.

4-70 LO 4
 Preparing Closing Entries

In addition to updating Retained Earnings to its correct

ending balance, closing entries produce a zero balance in
each temporary account.
ILLUSTRATION 4-30
The closing process

4-71 LO 4
4-72 ILLUSTRATION 4-31 LO 4
 Preparing Closing Entries

Illustration 4-32
Posting of closing entries

4-73 LO 4
 Preparing a Post-Closing Trail 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.

4-74 LO 4
 SUMMARY OF THE ACCOUNTING CYCLE

1. Analyze business transactions

9. Prepare a post-closing 2. Journalize the

trial balance transactions

8. Journalize and post

3. Post to ledger accounts
closing entries

7. Prepare financial
4. Prepare a trial balance
statements

6. Prepare an adjusted trial 5. Journalize and post

balance adjusting entries:
Deferrals/Accruals

ILLUSTRATION 4-33
Required steps in the accounting cycle
4-75 LO 4
 DO IT! 4b Closing Entries

Hancock Company has the following balances in selected accounts of its

adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close the revenue and expense accounts.
SOLUTION

4-76 LO 4
 DO IT! 4b Closing Entries

Hancock Company has the following balances in selected accounts of its

adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close income summary and dividends.
SOLUTION

4-77 LO 4