Chapter Four - Powerpoint

Chapter 4
The
Accounting
Cycle:
Accruals and
Deferrals
Copyright © 2021 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4-1
Introduction
In Chapter 3, you learned that we record
revenue when it is earned.
For example, when a hairdresser cuts a
customer’s hair, revenue is earned when the hair
is cut and the fee is collected.
Suppose the same passenger boards a Carnival
Corporation cruise ship to the Bahamas using a
ticket that was purchased six months in advance.
At what point should the cruise line recognize
that ticket revenue has been earned?
4-2
Introduction: Carnival Corporation
In a recent balance sheet, Carnival Corporation
reports a $3.96 billion liability account called
Customer Deposits. As passengers purchase
tickets in advance, Carnival Corporation credits
the Customer Deposits account for an amount
equal to the cash it receives. It is not until
passengers actually use their tickets that the
company reduces this liability account and records
Passenger Ticket Revenue in its income statement.
4-3
Timing Differences
For most companies, revenue is not always
earned as cash is received, nor is an expense
necessarily incurred as cash is disbursed.
Timing differences between cash flows and the
recognition of revenue and expenses are referred
to as accruals and deferrals.
In this chapter, we examine how accounting
information must be adjusted for accruals and
deferrals prior to the preparation of financial
statements.
4-4
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.
4-5
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.
4-6
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.
4-7
Introduction: Converting Assets to
Expenses
 A cash expenditure (or cost) that will benefit more than one
accounting period usually is recorded by debiting an asset
account and by crediting Cash.
 The asset account created actually represents the deferral (or
postponement) of an expense.
 In each future period that benefits from the use of this asset,
an adjusting entry is made to allocate a portion of the asset’s
cost from the balance sheet to the income statement as an
expense.
 This adjusting entry is recorded by debiting the appropriate
expense account and crediting the related asset account.
4-8
Introduction: Converting Liabilities to
Revenue
 A business may collect cash in advance for services to be
rendered in future accounting periods.
 Transactions of this nature are usually recorded by debiting
Cash and by crediting a liability account (typically called
Unearned Revenue or Customer Deposits). Here, the liability
account created represents the deferral (or postponement) of a
revenue.
 In the period that services are actually rendered (or that goods
are sold), an adjusting entry is made to allocate a portion of the
liability from the balance sheet to the income statement to
recognize the revenue earned during the period.
 The adjusting entry is recorded by debiting the liability
(Unearned Revenue or Customer Deposits) and by crediting
Revenue Earned (or a similar account) for the value of the
services.
4-9
Introduction: Accruing Unpaid
Expenses
 An expense may be incurred in the current accounting
period even though no cash payment will occur until a
future period.
 These accrued expenses are recorded by an adjusting
entry made at the end of each accounting period.
 The adjusting entry is recorded by debiting the
appropriate expense account (for example, Interest
Expense or Salary Expense) and by crediting the related
liability (for example, Interest Payable or Salaries
Payable).
4-10
Introduction: Accruing Uncollected
Revenue
 Revenue may be earned (or accrued) during the current
period, even though the collection of cash will not occur
until a future period.
 Unrecorded earned revenue, for which no cash has been
received, requires an adjusting entry at the end of the
accounting period.
 The adjusting entry is recorded by debiting the
appropriate asset (for example, Accounts Receivable or
Interest Receivable) and by crediting the appropriate
revenue account (for example, Service Revenue Earned
or Interest Earned).
4-11
Adjusting Entries and Timing
Differences
In an accrual accounting system, there are often
timing differences between cash flows and the
recognition of expenses or revenue.
A company can pay cash in advance of incurring
certain expenses or receive cash before revenue
has been earned.
Likewise, it can incur certain expenses before
paying any cash or it can earn revenue before
any cash is received.
4-12
Adjusting Entries and Timing
Differences (cont.)
 These timing differences, and the adjusting entries that
result from them, are summarized as follows.
◦ Adjusting entries to convert assets to expenses result
from cash being paid prior to an expense being
incurred.
◦ Adjusting entries to convert liabilities to revenue result
from cash being received prior to revenue being earned.
◦ Adjusting entries to accrue unpaid expenses result from
expenses being incurred before cash is paid.
◦ Adjusting entries to accrue uncollected revenue result
from revenue being earned before cash is received.
4-13
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)
4-14
Characteristics of Adjusting Entries
Every adjusting entry involves
recognition of either revenue or expenses.
Must be accompanied by a corresponding
change in assets or liabilities.
Every adjusting entry affects an income
statement account and a balance sheet
account.
4-15
Characteristics of Adjusting Entries
(cont.)
Adjusting entries are based on accrual
accounting, not month-end transactions.
Preparing adjusting entries requires a
greater understanding of accrual
accounting concepts.
Adjusting entries are usually prepared by
the controller or a professional
accountant.
4-16
Converting Assets to Expenses
An adjusting entry to convert an asset to
an expense requires a debit to an expense
account and a credit to an asset account.
Examples include prepaid expenses and
entries to record depreciation expense.
4-17
Converting Assets to Expenses: Shop
Supplies
The costs are expensed as they are
used to generate revenue.
4-18
Converting Assets to Expenses:
Insurance Policies (Original transaction)
4-19
Insurance Policies (Adjusting entry)
4-20
Insurance Policies (cont.)
4-21
Your Turn: Insurance
You as a Car Owner
Car owners typically pay insurance premiums six
months in advance. Assume that you recently
paid your six-month premium of $600 on
February 1 (for coverage through July 31). On
March 31, you decide to switch insurance
companies. You call your existing agent and ask
that your policy be canceled. Are you entitled to a
refund? If so, why, and how much will it be?
4-22
Recording Prepayments Directly in the
Expense Accounts
 In our text, payments for shop supplies and for
insurance covering more than one period are debited
to asset accounts.
 Some companies follow an alternative policy of
debiting prepayments directly to an expense
account, such as Supplies Expense.
 At the end of the period, the adjusting entry then
would be to debit Shop Supplies and credit Supplies
Expense for the cost of supplies that had not been
used.
 The results for both methods are the same.
4-23
The Concept of Depreciation
Depreciation is the systematic allocation of
the cost of a depreciable asset to expense.
4-24
Depreciation Is Only an Estimate
4-25
Case in Point
4-26
Depreciation of Overnight’s Building
Overnight Auto Service would make the

following adjusting entry.
4-27
Computing Book Value for Assets
We will assume that Overnight did not record any
depreciation expense in January because it
operated for only a small part of the month.
December 31, 2018 Balance Sheet Presentation
Building $ 36,000
Less: Accum. depr. 1,650 34,350
Tool and Equipment $ 18,000
Less: Accum. depr. 2,200 15,800
Cost − Accumulated Depreciation = Book Value

4-28
Important Notes about Book Value
Book value (or carrying value) describes
the net valuation of an asset in a
company’s accounting records.
Book value is of significance primarily
for accounting purposes.
The computation of book value is based
upon an asset’s historical cost. Thus, book
value is not intended to represent an
asset’s current market value.
4-29
Depreciation of Overnight’s Tools and
Equipment
Overnight depreciates its $12,000 of tools
and equipment over 60 months. Calculate
monthly depreciation and make the journal
entry.
4-30
Important Notes about Depreciation
Depreciation is a noncash expense.
As depreciable assets expire, depreciation
expense is recorded, net income is reduced,
and owners’ equity declines, but there is no
corresponding cash outlay in the current
period.
Often it represents the largest difference
between net income and the cash flow from
business operations.
4-31
Converting Liabilities to Revenue
4-32
Unearned Rent Revenue—Harbor Cab
and Overnight
On December 1, Overnight received $3,000

in advance for a three-month rental contract.
4-33
Unearned Rent Revenue—Harbor Cab
and Overnight (cont.)
On December 1, Overnight received $3,000

in advance for a three-month rental contract.
4-34
Recording Advance Collections
Directly in the Revenue Accounts
 In our text, advance payments from customers are
credited to an unearned revenue account.
 Some companies follow an accounting policy of
crediting these advance collections directly to
revenue accounts.
 At the end of the period, the adjusting entry then
should consist of a debit to the revenue account and
a credit to the unearned revenue account for the
portion of the advance payments not yet earned.
 The results for both methods are the same.
4-35
Accruing Unpaid Expenses
A type of adjusting entry that recognizes
expenses that will be paid in future
transactions.
No cost has yet been recorded in the
accounting records.
These expenses are said to accrue over time,
that is, to grow or to accumulate.
Salaries of employees and interest on
borrowed money are common examples.
4-36
Accrual of Wages (or Salaries) Expense
4-37
Accrual of Wages (or Salaries) Expense
(cont.)
Let’s look at the entry for Jan. 3.

4-38
Accruing Uncollected Revenue
A business may earn revenue during the current
accounting period but not bill the customer until
a future accounting period.
Any revenue that has been earned but not
recorded during the current accounting period
should be recorded at the end of the period by
means of an adjusting entry.
This adjusting entry consists of a debit to an
account receivable and a credit to the
appropriate revenue account.
4-39
Accruing Uncollected Revenue
4-40
Accruing Uncollected Revenue (cont.)
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.
4-41
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.
4-42
International Case in Point
4-43
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.
4-44
Matching Costs
Costs are matched with revenue in one of two ways.
1. Direct association of costs with specific revenue
transactions. The ideal method of matching revenue
with expenses is to determine the actual amount of
expense associated with specific revenue transactions.
However, this approach works only for those costs and
expenses that can be directly associated with specific
revenue transactions. Commissions paid to salespeople
are an example of costs that can be directly associated
with the revenue of a specific accounting period.
4-45
Matching Costs (cont.)
2. Systematic allocation of costs over the useful life of the
expenditure. Many expenditures contribute to the
earning of revenue for a number of accounting periods
but cannot be directly associated with specific revenue
transactions. Examples include the costs of insurance
policies and depreciable assets. In these cases,
accountants attempt to match revenue and expenses by
systematically allocating the cost to expense over its
useful life. Straight-line depreciation is an example of
a systematic technique used to match the cost of an
asset with the related revenue that it helps to earn over
its useful life.
4-46
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.
4-47
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.
4-48
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.
4-49
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.
4-50
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.
4-51
Your Turn: Materiality
You as Overnight Auto’s Service Department Manager
You just found out that Betty, one of the best mechanics
that you supervise for Overnight Auto, has taken home
small items from the company’s supplies, such as a
screwdriver and a couple of cans of oil. When you talk to
Betty, she suggests that these items are immaterial to
Overnight Auto because they are not recorded in the
inventory and they are expensed when they are purchased.
How should you respond to Betty?
4-52
Effects of the Adjusting Entries
4-53
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).
4-54
Ethics, Fraud, & Corporate Governance
Improper accounting for operating costs has often resulted
in the SEC bringing action against companies for
fraudulent financial reporting. Expenditures that are
expected only to benefit the year in which they are made
should be expensed (deducted from revenue in the
determination of net income for the current period).
Companies that engage in fraud will often defer these
expenditures by capitalizing them (they debit an asset
account reported in the balance sheet instead of an expense
account reported in the income statement).
4-55
(cont. 1)
Prior to Enron and WorldCom, one of the largest
financial scandals in U.S. history occurred at Waste
Management. Waste Management was the world’s largest
waste services company. The improper accounting at
Waste Management lasted for approximately five years
and resulted in an overstatement of earnings during this
time period of $1.7 billion. Investors lost over $6 billion
when Waste Management’s improper accounting was
revealed.
4-56
(cont. 2)
Waste Management’s scheme for overstating earnings was
simple. The company deferred recognizing normal
operating expenditures as expenses until future periods.
These improper deferrals were accomplished in a number
of different ways, many of which involved improper
accounting for long-term assets. For example, Waste
Management incurred costs in buying and developing land
to be used as landfills (i.e., garbage dumps).
4-57
(cont. 3)
Capitalizing these costs—treating them as long-term assets
—was proper accounting. However, in certain cases, the
company was not able to secure the necessary
governmental permits and approvals to use the purchased
land as intended. In these cases, the costs that had been
capitalized and reported as landfills in the balance sheet
should have been expensed immediately, thereby reducing
net income for the year in which the company’s failure to
obtain government permits and approvals occurred.
4-58
Learning Objective Summary LO4-1
LO4-1: Explain the purpose of adjusting entries.
The purpose of adjusting entries is to allocate revenue
and expenses among accounting periods in accordance
with the realization and matching principles. These
end-of-period entries are necessary because revenue
may be earned and expenses may be incurred in
periods other than the period in which related cash
flows are recorded.
4-59
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.
4-60
LO4-3: Prepare adjusting entries to convert assets
to expenses. When an expenditure is made that will
benefit more than one accounting period, an asset
account is debited and cash is credited. The asset
account is used to defer (or postpone) expense
recognition until a later date. At the end of each period
benefiting from this expenditure, an adjusting entry is
made to transfer an appropriate amount from the asset
account to an expense account. This adjustment
reflects the fact that part of the asset’s cost has been
matched against revenue in the measurement of
income for the current period.
4-61
LO4-4: Prepare adjusting entries to convert liabilities to
revenue. Customers sometimes pay in advance for services to be
rendered in later accounting periods. For accounting purposes, the
cash received does not represent revenue until it has been earned.
Thus, the recognition of revenue must be deferred until it is
earned. Advance collections from customers are recorded by
debiting Cash and by crediting a liability account for unearned
revenue. This liability is sometimes called Customer Deposits,
Advance Sales, or Deferred Revenue. As unearned revenue
becomes earned, an adjusting entry is made at the end of each
period to transfer an appropriate amount from the liability
account to a revenue account. This adjustment reflects the fact
that all or part of the company’s obligation to its customers has
been fulfilled and that revenue has been realized.
4-62
LO4-5: Prepare adjusting entries to accrue unpaid
expenses. Some expenses accumulate (or accrue) in the
current period but are not paid until a future period. These
accrued expenses are recorded as part of the adjusting process at
the end of each period by debiting the appropriate expense (e.g.,
Salary Expense, Interest Expense, or Income Taxes Expense),
and by crediting a liability account (e.g., Salaries Payable,
Interest Payable, or Income Taxes Payable). In future periods, as
cash is disbursed in settlement of these liabilities, the
appropriate liability account is debited and Cash is credited.
Note: Recording the accrued expense in the current period is the
adjusting entry. Recording the disbursement of cash in a future
period is not considered an adjusting entry.
4-63
LO4-6: Prepare adjusting entries to accrue
uncollected revenue. Some revenues are earned (or
accrued) in the current period but are not collected until a future
period. These revenues are normally recorded as part of the
adjusting process at the end of each period by debiting an asset
account called Accounts Receivable, and by crediting the
appropriate revenue account. In future periods, as cash is
collected in settlement of outstanding receivables, Cash is
debited and Accounts Receivable is credited. Note: Recording
the accrued revenue in the current period is the adjusting entry.
Recording the receipt of cash in a future period is not considered
an adjusting entry.
4-64
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.
4-65
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.
4-66
LO4-9: Prepare an adjusted trial balance and
describe its purpose. The adjusted trial balance reports all
of the balances in the general ledger after the end-of-period
adjusting entries have been made and posted. Generally, all
of a company’s balance sheet accounts are listed, followed by
the statement of retained earnings accounts and, finally, the
income statement accounts. The amounts shown in the
adjusted trial balance are carried forward directly to the
financial statements. The adjusted trial balance is not
considered one of the four general-purpose financial
statements introduced in Chapter 2. Rather, it is simply a
schedule (or worksheet) used in preparing the financial
statements.
4-67
End of Chapter 4
4-68

Chapter Four - Powerpoint

Uploaded by

Document Information

Original Title

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

Chapter Four - Powerpoint

Uploaded by

Copyright:

Available Formats

Chapter 4

Prior Periods Current Period Future Periods

Transaction Adjusting Entry

Overnight Auto Service would make the

December 31, 2018 Balance Sheet Presentation

Cost − Accumulated Depreciation = Book Value

On December 1, Overnight received $3,000

On December 1, Overnight received $3,000

Let’s look at the entry for Jan. 3.

On Dec. 31, Airport Shuttle Service owes

You might also like