Accrual Accounting

Concepts &
Adjustments
Chapter
4-1 Financial Accounting, Fifth Edition
 Accountants divide the economic life of a business
into time periods (Time Period Assumption).
.....
Jan. Feb. Mar. Apr. Dec.

Generally a month, a quarter, or a year.

Fiscal year vs. calendar year

Chapter
4-2
 Revenue Recognition Principle
Companies recognize
revenue in the accounting
period in which it is
earned.
In a service enterprise,
revenue is considered to
be earned at the time the
service is performed.

Chapter
4-3
 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:

Chapter
4-4
 “Let the expenses follow the revenues.”

Chapter
4-5
Chapter
4-6
The Matching Principle

3-7
The Matching Principle

Expense
Incurred
AND
Cash
Paid

Expense (+E) xxx

Cash (-A) xxx

3-8
 The Matching Principle

Cash paid after expense is incurred -

Expense
Incurred

Expense (+E) xxx

Payable (+L) xxx

3-9
 The Matching Principle

Cash paid after expense is incurred -

Expense Cash
Incurred Paid

Expense (+E) xxx

Payable (+L) xxx

Cash will be paid.

3-10
 The main purpose is to measure the
profitability of the economic
activities conducted during the
accounting period.
The most important concept
involved in accrual accounting is the
matching principle.

Chapter
4-11
Chapter
4-12
Accounting Cycle
Start of Period
During the period: l Close revenues,
l Analyze transactions.
gains, expenses, and
l Record journal entries.
losses to Retained
l Post amounts to general
Earnings.
ledger.

l Prepare financial
At the end of the period: statements.
l Adjust revenues and l broadcast
expenses. statements to
users.

4-13
Adjustment Entries: introduction

Many transactions affect the revenue or

expenses of two or more accounting periods.

For example: a business may purchase

equipment that will last for many years. Or
supplies that last for several months.

Initially, the cost of such items recorded as

, because it will benefit the business in
the future accounting periods.

3- 14
Adjustment Entries: introduction

Overtime, these assets are , and their

become expenses of the periods in which the
goods or services are used.

The question is: how do business allocate the

costs of such assets to expense over a span of
several accounting periods?

The answer is by adjusting entries at the end

of each accounting periods.

3- 15
Purpose of Adjustments

Revenues are Expenses are

recorded when recorded when
earned. incurred.

4-16
 .

Chapter
4-17
 Illustration 4-3
Categories of adjusting entries

Deferrals Accruals
1. Prepaid Expenses. 3. Accrued Revenues.
Expenses paid in cash and Revenues earned but not
recorded as assets before yet received in cash or
they are used or consumed. recorded.

2. Unearned Revenues. 4. Accrued Expenses.

Cash received and Expenses incurred but not
recorded as liabilities yet paid in cash or
before revenue is earned. recorded.

Chapter
4-18
 Deferrals are either:
Prepaid expenses

OR

Unearned revenues.

Chapter
4-19
 Cash Payment BEFORE Expense Recorded

Chapter
4-20
 Prepaid Expenses
Costs that either with the passage of time
or through use.

Adjusting entries (1) to record the expenses that

apply to the current accounting period, and

(2) to show the unexpired costs in the asset

accounts.

Chapter
4-21
 Adjusting entries for prepaid expenses
Illustration 4-5

Increases (debits) an expense account and

Decreases (credits) an asset account.

Chapter
4-22
Prepaid Expenses
End of
accounting period.

Cash paid. Expense incurred.

4-23
Prepaid Expenses

4-24
Prepaid Expenses
After we post the entry to the T-accounts, the account
balances look like this:

Prepaid
Insurance Expense Insurance Expense
1/1 36,000 12/31 12,000 12/31 12,000

Bal. 24,000 Bal. 12,000

4-25
 Illustration: Sierra Corporation purchased advertising supplies
costing $2,500 on October 5. Sierra recorded the payment by
increasing (debiting) the asset Advertising 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 Advertising supplies expense 1,500

Advertising supplies 1,500
Illustration 4-6

Chapter
4-26
 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
Illustration 4-7

Chapter
4-27
 Depreciable assets are Physical objects which
retain their size and shape, but eventually wear out
or become obsolete.
They are not physically consumed but their
economic usefulness is “used up” over time.
Examples of include buildings,
and all types of equipments.
LAND is NOT viewed as depreciable asset, as it has
an UNLIMITED useful life.

Chapter
4-28
 Each period, a portion of depreciable asset’s
expire.
Therefore, a of its cost is
recognized as

Chapter
4-29
 In accounting, the term depreciation means
the
over the
asset’s useful life.
The rationale for depreciation lies in the

Our goal is to a reasonable portion of

the asset’s cost revenue in each
period of the asset’s useful life.
Chapter
4-30
 Depreciation expense is paid in advance
when the asset is originally purchased.
Therefore, adjusting entries are needed at
the end of each accounting period to
transfer an appropriate amount of the
asset’s cost to depreciation expense.
The “appropriate amount” of depreciation
expense is only an estimate.

Chapter
4-31
 Depreciation Formula:

Deprecation Cost of the Asset

= Estimated useful life
expense

•The use of an estimated useful life is the major reason

why depreciation expense is only estimate.
•In most cases, management does not know in advance
exactly how long the asset will remain in use.

Chapter
4-32
 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 40
Illustration 4-8

Chapter
4-33
 Depreciation (Statement Presentation)
Accumulated Depreciation is a contra asset account.
Appears just after the account it offsets
(Equipment) on the balance sheet.
Illustration 4-9

Chapter
4-34
 Summary Illustration 4-10

Chapter
4-35
 Cash Receipt BEFORE Revenue Recorded

Chapter
4-36
 Unearned Revenues
Company makes an adjusting entry to record the
revenue that has been earned and to show the
liability that remains.

The adjusting entry for unearned revenues results

in a decrease (a debit) to a liability account and an
increase (a credit) to a revenue account.

Chapter
4-37
 Adjusting entries for unearned revenues
Illustration 4-11

Decrease (a debit) to a liability account and

Increase (a credit) to a revenue account.

Chapter
4-38
Unearned Revenues
End of
accounting period.

Cash received. Revenues earned.

4-39
Unearned Revenues
On December 1, 2019, Tom’s Rentals received a check for
$3,000, for the first four months’ rent from a new tenant.
The adjustment on December 31, 2019, to reduce the liability
and record the revenue earned would be:

$3,000 × 1/4 = $750 per month.

4-40
Unearned Revenues

Unearned Rent
Revenue Rent Revenue
12/31 750 12/1 3000 12/31 750

Bal. 2,250 Bal. 750

4-41
 Illustration: Sierra Corporation received $1,200 on October 2
from R. Knox for advertising services 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 work 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
Illustration 4-12

Chapter
4-42
 Summary
Illustration 4-13

Chapter
4-43
 Made to record:
Revenues earned and

OR

Expenses incurred

in the current accounting period that have not

been recognized through daily entries.

Chapter
4-44
 Revenue Recorded BEFORE Cash Receipt

Chapter
4-45
 Accrued Revenues
An adjusting entry serves two purposes:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.

Chapter
4-46
 Adjusting entries for accrued revenues
Illustration 4-14

Increases (debits) an asset account and

Increases (credits) a revenue account.

Chapter
4-47
Accrued Revenue
End of
accounting period.

Revenues earned Cash received

Example includes interest earned

during the period (accrued revenue).

4-48
Accrued Revenue
At December 31st, Matrix, Inc. earned, but has not
received, interest on its money market account of
$150. The adjustment is made to debit Interest
Receivable and credit Interest Revenue.

Interest Receivable Interest Revenue

12/31 150 12/31 150

Bal. 150 Bal. 150

4-49
 Illustration: In October Sierra Corporation earned $200
for advertising services that were not billed to clients
before October 31.

Oct. 31 Accounts Receivable 200

Service Revenue 200

Illustration 4-15

Chapter
4-50
 Summary
Illustration 4-16

Chapter
4-51
 Expense Recorded BEFORE Cash Payment

Chapter
4-52
 Accrued Expenses
An adjusting entry serves two purposes:

(1) It records the obligations, and

(2) It recognizes the expenses.

Chapter
4-53
 Adjusting entries for accrued expenses
Illustration 4-17

Increases (debits) an expense account and

Increases (credits) a liability account.

Chapter
4-54
Accrued Expenses
End of
accounting period.

Expense incurred. Expense paid.

4-55
Accrued Expenses

4-56
 Accrued Expenses

After we post the entry to the T-accounts, the account

balances look like this:

Wages Expense Wages Payable

As of
12/27 $1,900,000 12/31 50,000
12/31 50,000 Bal. 50,000
Bal. $1,950,000

4-57
 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%.
Illustration 4-18

Oct. 31 Interest expense 50

Interest payable 50
Illustration 4-19

Chapter
4-58
 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 $4,000 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 Salary expense 1,200

Salary payable 1,200
Illustration 4-21

Chapter
4-59
 Summary
Illustration 4-22

Chapter
4-60
Chapter
4-61
 After all adjusting entries are journalized and posted
the company prepares another trial balance from the
ledger accounts (Adjusted Trial Balance).

Its purpose is to prove the equality of debit balances

and credit balances in the ledger.

Chapter
4-62
 2019

Chapter
4-63
 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
segregateed by assets and liabilities.
d. The adjusted trial balance is prepared after the
adjusting entries have been journalized and posted.
Chapter
4-64
 Financial Statements are prepared directly from the
Adjusted Trial Balance.

Retained
Balance Income
Earnings
Sheet Statement
Statement

Chapter
4-65
Chapter
4-66
 Illustration 4-28

Chapter
4-67