Chapter 4

The
Accounting
Cycle:
Accruals and
Deferrals

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4-1
 Step 4 in the Accounting Cycle
We covered the first three steps of the
accounting cycle in Chapter 3:
◦ Recording transactions
◦ Posting transactions
◦ Preparing a trial balance
KEY POINT
In this chapter, we focus solely upon the fourth step of the accounting
cycle—performing the end-of-period adjustments required to measure
business income.

4-2
The Need for Adjusting Entries
Certain transactions affect the revenue or
expenses of two or more accounting periods.
Adjusting entries are needed at the end of each
accounting period to make certain that
appropriate amounts or revenue and expense are
reported in the company’s income statement.

4-3
Categories of Adjusting Entries
Most adjusting entries fall into one of four general
categories:
1. Converting assets to expenses.
2. Converting liabilities to revenue.
3. Accruing unpaid expenses.
4. Accruing uncollected revenue.

4-4
Adjusting Entries

Adjusting Every
entries are adjusting
needed whenever entry involves a
revenue or expenses change in either a
affect more than one revenue or expense
accounting and an asset
period. or liability.

4-5
Converting Assets to Expenses
End of Current Period

Prior Periods Current Period Future Periods

Transaction Adjusting Entry

Pay cash in  Recognizes portion of
advance of asset consumed as
incurring expenses, and
expense  Reduces balance of
(creates an asset account
asset)

4-6
Example: Insurance Policy

$18,000 Insurance Policy

Coverage for 12 Months

$1,500 Monthly Insurance Expense

Mar. 1 Feb.28

On March 1, Overnight Auto Service

purchased a one-year insurance policy
for $18,000.
4-7
Insurance Policy: Initial Entry

Initially, costs that benefit more than one

accounting period are recorded as assets.

4-8
Insurance: Adjusting Entry

The costs are expensed as they are

used to generate revenue.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Monthly Adjusting Entry for Insurance
Mar. 31 Insurance Expense 1,500
Unexpired Insurance 1,500
Adjusting entry to record insurance expense for March.
4-9
Insurance: Financial Statement Impact

Balance Sheet Income Statement

Cost of assets Cost of assets
that benefit used this period to
future periods. generate revenue.

Unexpired Insurance Insurance Expense

3/1 18,000 3/31 1,500 3/31 1,500
Bal. 16,500

4-10
Converting Liabilities to Revenue
End of Current Period

Prior Periods Current Period Future Periods

Transaction Adjusting Entry

Collect cash in  Recognizes portion
advance of earned as revenue, and
earning revenue  Reduces balance of
(creates a liability account
liability)

4-11
 Example: Rental Revenue

$3,000 Rental Contract

Coverage for 3 Months

$1,000 Monthly Rental Revenue

Dec. 1 Feb. 28

On December 1, Overnight received $3,000

in advance for a three-month rental contract.
4-12
 Rental Revenue: Initial Entry

Initially, revenues that benefit more than one

accounting period are recorded as liabilities.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 1 Cash 3,000
Unearned Rent Revenue 3,000
Collected $3,000 in advance for rent.

4-13
Rental Revenue: Adjusting Entry

Over time, the revenue is recognized

as it is earned.

4-14
Rental Revenue: Financial Statement
Impact

Balance Sheet Income Statement

Liability for Revenue earned
future periods. this period.

Unearned Rental Revenue Rental Revenue

12/31 1,000 12/1 3,000 12/31 1,000
Bal. 2,000

4-15
Accruing Unpaid Expenses
End of Current Period

Prior Periods Current Period Future Periods

Adjusting Entry Transaction

 Recognizes expenses Pay cash in
incurred, and settlement of
 Records liability for liability.
future payment

4-16
Example: Wages Owed
Friday,
$1,950 Wages Jan. 3
Expense

Monday, Tuesday,
Dec. 30 Dec. 31

On Dec. 31, Overnight owes wages of

$1,950. Payday is Friday, Jan. 3.

4-17
Wages Owed: Initial Entry

Initially, an expense and a liability are

recorded.

4-18
Wages Owed: Financial Statement
Impact

Balance Sheet Income Statement

Liability to be Cost incurred this
paid in a future period to generate
period. revenue.

Wages Payable Wages Expense

12/31 3,000 12/31 1,950

4-19
Accruing Uncollected Revenue
End of Current Period

Prior Periods Current Period Future Periods

Adjusting Entry Transaction

 Recognizes revenue Collect cash in
earned but not yet settlement of
recorded, and receivable
 Records receivable

4-20
Example: Service Revenue
$750 Repair
Service
Revenue

Dec. 15 Dec. 31 Jan. 15

On Dec. 31, Airport Shuttle Service owes

Overnight half of its maintenance agreement.
The one-month fee of $1,500 is to be paid on
the 15th day of January.
4-21
Accrued Service Revenue Entry

Initially, the revenue is recognized and

a receivable is created.

4-22
Accrued Revenue: Financial Statement
Impact

Balance Sheet
Income Statement
Receivable to
Revenue earned
be collected in a
this period.
future period.

Accounts Receivable Repair Service Revenue

12/31 750 12/31 750

4-23
Accruing Income Taxes Expense: The
Final Adjusting Entry
As a corporation earns taxable income, it
incurs income taxes expense, and also a
liability to governmental tax authorities.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Income Taxes Expense 4,020
Income Taxes Payable 4,020
Adjusting entry to record income taxes accrued in December.

4-24
Supporting the Matching Principle
The matching principle underlies such
accounting practices as:
◦ Depreciating plant assets.
◦ Measuring the cost of supplies used.
◦ Amortizing the cost of unexpired insurance
policies.
All end-of-the-period adjusting entries involving
expense recognition are applications of the
matching principle.

4-25
Materiality Concept
Materiality refers to the relative importance of
an item or an event.
An item is considered material if knowledge of
the item might reasonably influence the
decisions of users of financial statements.
Accountants must be sure that all material items
are properly reported in financial statements.

4-26
Materiality Concept (cont.)
Immaterial items are those of little or no
consequence to decision makers.
◦ The financial reporting process should be cost-
effective—that is, the value of the information
should exceed the cost of its preparation.
◦ Immaterial items may be handled in the easiest
and most convenient manner.

4-27
Materiality and Adjusting Entries
The concept of materiality enables accountants to shorten
and simplify the process of making adjusting entries in
several ways. For example:
1. Businesses purchase many assets that have a very low
cost or that will be consumed quickly in business
operations. Examples include wastebaskets,
lightbulbs, and janitorial supplies. The materiality
concept permits charging such purchases directly to
expense accounts, rather than to asset accounts. This
treatment conveniently eliminates the need to prepare
adjusting entries to depreciate these items.

4-28
Materiality and Adjusting Entries (cont.)
2. Some expenses, such as telephone bills and utility
bills, may be charged to expenses as the bills are paid,
rather than as the services are used. Technically this
treatment violates the matching principle. However,
accounting for utility bills on a cash basis is very
convenient, as the monthly cost of utility service is not
even known until the utility bill is received. Under this
cash basis approach, the amount of utility expense
recorded each month is actually based on the prior
month’s bill.
3. Adjusting entries to accrue unrecorded expenses or
unrecorded revenue may actually be ignored if the
dollar amounts are immaterial.

4-29
Materiality and Professional Judgment
Whether a specific item or event is material is a
matter of professional judgment. In making these
judgments, accountants consider several factors:
1. The size of the organization.
2. The cumulative effect of numerous
immaterial events.
3. Nature of the item.
4. Dollar amount of the item.

4-30
 Effects of the Adjusting Entries
Income Statement Balance Sheet
Net Owners'
Adjustment Revenue Expenses Income Assets Liabilities Equity
Type I
Converting Assets to Expenses No effect Increase Decrease Decrease No effect Decrease
Type II
Converting Liabilities to Revenue Increase No effect Increase No effect Decrease Increase
Type III
Accruing Unpaid Expenses No effect Increase Decrease No effect Increase Decrease
Type IV
Accruing Uncollected Revenue Increase No effect Increase Increase No effect Increase

4-31
Overnight’s Adjusted Trial Balance
 After these
adjustments are
posted to the
ledger,
Overnight’s ledger
accounts will be
up-to-date (except
for the balance in
the Retained
Earnings account).

4-32
Learning Objective Summary LO4-2
LO4-2: Describe and prepare the four basic types of
adjusting entries. The four basic types of adjusting
entries are made to (1) convert assets to expenses, (2)
convert liabilities to revenue, (3) accrue unpaid
expenses, and (4) accrue uncollected revenue. Often a
transaction affects the revenue or expenses of two or
more accounting periods. The related cash inflow or
outflow does not always coincide with the period in
which these revenue or expense items are recorded.
Thus, the need for adjusting entries results from timing
differences between the receipt or disbursement of cash
and the recording of revenue or expenses.

4-33
Learning Objective Summary LO4-7
LO4-7: Explain how the principles of realization
and matching relate to adjusting entries.
Adjusting entries are the tools by which accountants
apply the realization and matching principles.
Through these entries, revenues are recognized as
they are earned, and expenses are recognized as
resources are used or consumed in producing the
related revenue.

4-34
Learning Objective Summary LO4-8
LO4-8: Explain the concept of materiality. The
concept of materiality allows accountants to use
estimated amounts and to ignore certain accounting
principles if these actions will not have a material
effect on the financial statements. A material effect is
one that might reasonably be expected to influence
the decisions made by the users of financial
statements. Thus, accountants may account for
immaterial items and events in the easiest and most
convenient manner.

4-35
Exercise 4.2

4-36
4-37
End of Chapter 4

4-38