CH 04 SV

Chapter
4-1
Accrual Accounting
Concepts
Chapter
4-2 Financial Accounting, Fifth Edition
Study
Study Objectives
Objectives
1. Explain the revenue recognition principle and the matching
principle.
2. Differentiate between the cash basis and the accrual basis of
accounting.
3. Explain why adjusting entries are needed, and identify the major
types of adjusting entries.
4. Prepare adjusting entries for deferrals.
5. Prepare adjusting entries for accruals.
6. Describe the nature and purpose of the adjusted trial balance.
7. Explain the purpose of closing entries.
8. Describe the required steps in the accounting cycle.
9. Understand the causes of differences between net income and
cash provided by operating activities.
Chapter
4-3
Accrual
Accrual Accounting
Accounting Concepts
Concepts
The Adjusted
The Basics of
Trial Balance Closing the Quality of
Timing Issues Adjusting
and Financial Books Earnings
Entries
Statements
Revenue Types of Preparing the Preparing Earnings

recognition adjusting adjusted trial closing entries management
principle entries balance Preparing a Sarbanes-Oxley
Matching Adjusting Preparing post-closing
principle entries for financial trial balance
Accrual versus deferrals statements Summary of
cash basis of Adjusting the accounting
accounting entries for cycle
accruals
Summary of
basic
relationships
Chapter
4-4
Timing
Timing Issues
Issues
Accountants divide the economic life of a business

into artificial time periods (Time Period Assumption).
.....
Jan. Feb. Mar. Apr. Dec.
Generally a month, a quarter, or a year.

Fiscal year vs. calendar year
Chapter
4-5 SO 1 Explain the revenue recognition principle and the matching principle.
Timing
Timing Issues
Issues
Review Question
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.
b. expenses should be matched 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.
Chapter
Timing
Timing Issues
Issues
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
Timing
Timing Issues
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:
Chapter
Timing
Timing Issues
Issues
Chapter
Timing
Timing Issues
Issues
“Let the expenses follow the revenues.”
Chapter
Timing
Timing Issues
Issues
Chapter
Timing
Timing Issues
Issues
Chapter
Timing
Timing Issues
Issues
Accrual- vs. Cash-Basis Accounting

Accrual-Basis Accounting
Transactions recorded in the periods in which
the events occur
Revenues are recognized when earned, rather
than when cash is received.
Expenses are recognized when incurred, rather
than when paid.
Chapter SO 2 Differentiate between the cash basis and

4-13
the accrual basis of accounting.
Timing
Timing Issues
Issues
Accrual- vs. Cash-Basis Accounting

Cash-Basis Accounting
Revenues are recognized when cash is received.
Expenses are recognized when cash is paid.
Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).

4-14
Timing
Timing Issues
Issues
Illustration: Suppose that Fresh Colors paints a large

building in 2009. In 2009 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
2010. Illustration 4-2

4-15
Timing
Timing Issues
Issues
Review Question
One of the following statements about the accrual basis
of accounting is false. That statement is:
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.

4-16
Chapter
4-17
The
The Basics
Basics of
of Adjusting
Adjusting Entries
Entries
Revenues - recorded in the period in which they

are earned.
earned
Expenses - recognized in the period in which they
are incurred.
incurred
Adjusting entries - needed to ensure that the
revenue recognition and matching principles are
followed.
Chapter SO 3 Explain why adjusting entries are needed, and

4-18
identify the major types of adjusting entries
The
The Basics
Basics of
of Adjusting
Adjusting Entries
Entries
Adjusting entries make it possible to report

correct amounts on the balance sheet and on
the income statement.
A company must make adjusting entries every

time it prepares financial statements.
Every adjusting entry will include one income

statement account and one balance sheet
account.

4-19
The
The Basics
Basics of
of Adjusting
Adjusting Entries
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 recorded in the period in which
they are earned.
c. balance sheet and income statement accounts
have correct balances at the end of an
accounting period.
d. all of the above.
4-20
Types
Types of
of Adjusting
Adjusting Entries
Entries
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.

4-21
Types
Types of
of Adjusting
Adjusting Entries
Entries
Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and up-
to-date.
Illustration 4-4

4-22
Adjusting
Adjusting Entries
Entries for
for Deferrals
Deferrals
Deferrals are either:

Prepaid expenses
OR
Unearned revenues.
Chapter
4-23 SO 4 Prepare adjusting entries for deferrals.
Adjusting
Adjusting Entries
Entries for
for “Prepaid
“Prepaid Expenses”
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 maintenance on equipment
advertising fixed assets (depreciation)
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
Prepaid Expenses
Costs that expire 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
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
Adjusting entries for prepaid expenses

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

Decreases (credits) an asset account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
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.
($2,500 – 1,000 = $1,500)
Oct. 31 Advertising supplies expense 1,500

Advertising supplies 1,500
Illustration 4-6
Chapter
Chapter
4-28
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
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
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
Depreciation
Buildings, equipment, and 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 (Matching
Principle).
Depreciation is the process of allocating the cost of an
asset to expense over its useful life
Chapter
4-30
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
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
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
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
Adjusting
Adjusting Entries
Entries for
for “Prepaid
Expenses”
Summary Illustration 4-10
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
“Unearned Revenues”
Revenues”
Receipt of cash that is recorded as a liability because

the revenue has not been earned.
Cash Receipt BEFORE Revenue Recorded
Unearned revenues often occur in regard to:

rent magazine subscriptions
airline tickets customer deposits
school tuition
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
Revenues”
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
Adjusting
Adjusting Entries
Entries for
for “Unearned
Revenues”
Adjusting entries for unearned revenues

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

Increase (a credit) to a revenue account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Unearned
Revenues”
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
Adjusting
Adjusting Entries
Entries for
for “Unearned
Revenues”
Summary
Illustration 4-13
Chapter
Chapter
4-39
The ledger of Hammond, Inc., on March 31, 2010,
includes these selected accounts before
adjusting entries are prepared.
Chapter
4-40
Adjusting
Adjusting Entries
Entries for
for Accruals
Accruals
Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not

been recognized through daily entries.
Chapter
4-41 SO 5 Prepare adjusting entries for accruals.
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Revenues”
Revenues”
Revenues earned 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
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Revenues”
Accrued Revenues
An adjusting entry serves two purposes:
(1) It shows the receivable that exists, and
(2) It records the revenues earned.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Revenues”
Adjusting entries for accrued revenues

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

Increases (credits) a revenue account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Revenues”
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
Adjusting
Adjusting Entries
Entries for
for “Accrued
Revenues”
Summary
Illustration 4-16
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
“Accrued Expenses”
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
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
Accrued Expenses
(1) It records the obligations, and
(2) It recognizes the expenses.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
Adjusting entries for accrued expenses

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

Increases (credits) a liability account.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
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
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
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 Salary expense 1,200

Salary payable 1,200
Illustration 4-21
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
Accrued Expenses
(1) It records the obligations, and
(2) it recognizes the expenses.
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
Summary
Illustration 4-22
Chapter
Adjusting
Adjusting Entries
Entries for
for “Accrued
Expenses”
Micro Computer Services Inc. began operations on August 1,
2010. At the end of August 2010, management attempted to
prepare monthly financial statements. The following
information relates to August.
Chapter
Summary
Summary of
of Basic
Basic Relationships
Relationships
Chapter
The
The Adjusted
Adjusted Trial
Trial Balance
Balance
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
4-56 SO 6 Describe the nature and purpose of the adjusted trial balance.
The
The Adjusted
Adjusted Trial
Trial Balance
Balance
Chapter
4-57
The
The Adjusted
Adjusted Trial
Trial Balance
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.
Chapter
Preparing
Preparing Financial
Financial Statements
Statements
Financial
Statements are
are prepared
prepared directly
directly from
from the
the
Adjusted
Adjusted Trial
Trial Balance.
Balance.
Retained
Balance Income
Earnings
Sheet Statement
Statement
Chapter
Preparing
Preparing Financial
Statements
Chapter
4-60
Preparing
Preparing Financial
Statements
Illustration 4-28
Chapter
4-61
Preparing
Preparing Financial
Statements
Skolnick Co. was organized on April 1, 2010. The company
prepares quarterly financial statements. The adjusted trial
balance amounts at June 30 are shown.
Chapter
4-62
Closing
Closing the
the Books
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
Chapter
4-63 SO 7 Explain the purpose of closing entries.
Closing
Closing the
the Books
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
Chapter
Closing
Closing the
the Books
Books
Illustration 4-31
Chapter
4-65
Closing
Closing the
the Books
Books
Chapter SO 7 Explain the purpose

4-66 of closing entries.
Preparing
Preparing aa Post-Closing
Post-Closing Trial
Trial Balance
Balance
The purpose of this 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.
Chapter
Closing
Closing the
the Books
Books
After making entries to close its revenue and expense
accounts to Income Summary, Hancock Company has the
following balances.
Chapter SO 7 Explain the purpose

4-68 of closing entries.
Summary
Summary of
of the
the Accounting
Accounting Cycle
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
Chapter
4-69 SO 8 Describe the required steps in the accounting cycle.
Quality
Quality of
of Earnings
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.
inflate 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.
Chapter
4-70 SO 8 Describe the required steps in the accounting cycle.
Keep
Keep an
an Eye
Eye on
on Cash
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.
Chapter SO 9 Understand the causes of differences between net

4-71
income and cash provided by operating activities.
Keep
Keep an
an Eye
Eye on
on Cash
Cash
Sierra Corporation’s income statement shows net income
of $2,860. Net income and net cash provided by
operating activities often differ.
Chapter
4-72
Keep
Keep an
an Eye
Eye on
on Cash
Cash
The difference for Sierra is $2,840 ($5,700 - $2,860).
The following summary shows the causes of this
difference of $2,840.
Chapter
4-73
Adjusting
Adjusting Entries
Entries –– Using
Using aa Worksheet
Worksheet (Appendix)
(Appendix)
Illustration 4A-1
Form and
procedure for a
worksheet
SO 10 Describe
the purpose and the
basic form of a
worksheet.
Chapter
4-74
Copyright
Copyright
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without the express written permission of the copyright owner
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use only and not for distribution or resale. The Publisher
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caused by the use of these programs or from the use of the
information contained herein.”
Chapter
4-75

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Chapter

Revenue Types of Preparing the Preparing Earnings

Accountants divide the economic life of a business

Generally a month, a quarter, or a year.

Revenue Recognition Principle

Illustration: Assume Conrad Dry Cleaners cleans

“Let the expenses follow the revenues.”

Accrual- vs. Cash-Basis Accounting

Chapter SO 2 Differentiate between the cash basis and

Accrual- vs. Cash-Basis Accounting

Chapter SO 2 Differentiate between the cash basis and

Illustration: Suppose that Fresh Colors paints a large

Chapter SO 2 Differentiate between the cash basis and

Chapter SO 2 Differentiate between the cash basis and

Revenues - recorded in the period in which they

Chapter SO 3 Explain why adjusting entries are needed, and

Adjusting entries make it possible to report

A company must make adjusting entries every

Every adjusting entry will include one income

Chapter SO 3 Explain why adjusting entries are needed, and

2. Unearned Revenues. 4. Accrued Expenses.

Chapter SO 3 Explain why adjusting entries are needed, and

Chapter SO 3 Explain why adjusting entries are needed, and

Deferrals are either:

Payment of cash, that is recorded as an asset because

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

Adjusting entries (1) to record the expenses that

Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Oct. 31 Advertising supplies expense 1,500

Oct. 31 Insurance expense 50

Oct. 31 Depreciation expense 40

Depreciation (Statement Presentation)

Summary Illustration 4-10

Receipt of cash that is recorded as a liability because

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

The adjusting entry for unearned revenues results

Adjusting entries for unearned revenues

Decrease (a debit) to a liability account and

Oct. 31 Unearned service revenue 400

in the current accounting period that have not

Adjusting entry results in:

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

(1) It shows the receivable that exists, and

(2) It records the revenues earned.

Adjusting entries for accrued revenues

Increases (debits) an asset account and

Illustration: In October Sierra Corporation earned $200

Oct. 31 Accounts Receivable 200

Adjusting entry results in:

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

(1) It records the obligations, and

(2) It recognizes the expenses.

Adjusting entries for accrued expenses

Increases (debits) an expense account and

Oct. 31 Interest expense 50

Oct. 31 Salary expense 1,200

(1) It records the obligations, and

(2) it recognizes the expenses.