ch04 Accrual Accounting Concepts

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4
ACCRUAL ACCOUNTING
CONCEPTS
Financial Accounting, Sixth Edition

4-2
Study Objectives
1. Explain the revenue recognition principle and the expense recognition
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.
4-3
Accrual Accounting 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
Expense Adjusting Preparing post-closing
recognition entries for financial trial balance
principle deferrals statements Summary of
Accrual versus Adjusting the accounting
cash basis of entries for cycle
accounting accruals
Summary of
basic
relationships
4-4
Timing Issues
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
SO 1 Explain the revenue recognition principle

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and the expense recognition principle.
Timing Issues
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.

4-6
Timing Issues
The 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.

4-7
Timing 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:

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Timing Issues
Illustration 4-1 (Partial)
“Let the expenses follow the revenues.”

4-9
Timing Issues
Illustration 4-1 GAAP
relationships in revenue
and expense recognition

4-10
4-11 Discussion on notes page.
Timing Issues
Accrual versus Cash Basis of Accounting

Accrual-Basis Accounting
► Transactions recorded in the periods in which the
events occur.
► Revenues are recognized when earned, even if cash

was not received.
► Expenses are recognized when incurred, even if cash

was not paid.
SO 2 Differentiate between the cash basis

4-12
and the accrual basis of accounting.
Timing Issues
Accrual versus Cash Basis of Accounting

Cash-Basis Accounting
► Revenues are recognized only when cash is received.
► Expenses are recognized only when cash is paid.
► Prohibited under generally accepted accounting

principles (GAAP).

4-13
Timing Issues
Illustration: Suppose that Fresh Colors paints a large

building in 2011. In 2011, 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 2012.

4-14
Timing Issues
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 it is
earned.
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.

4-15
4-16
The Basics of Adjusting 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.
Includes one income statement account and one

balance sheet account.
SO 3 Explain why adjusting entries are needed, and

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identify the major types of adjusting entries
Revenues - recorded in the period in which they are

earned.
Expenses - recognized in the period in which they

are incurred.
Adjusting entries - needed to ensure that the

revenue recognition and expense recognition
principles are followed.

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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.

4-19
Types of Adjusting Entries
Illustration 4-3
Categories of adjusting entries
Deferrals:
1. Prepaid expenses: Expenses paid in cash
and recorded as assets before they are used or
consumed.
2. Unearned revenues: Cash received and
reported as liabilities before revenue is earned.
Accruals:
1. Accrued revenues: Revenues earned but
not yet received in cash or recorded.
2. Accrued expenses: Expenses incurred
but not yet paid in cash or recorded.
4-20
Types of Adjusting Entries
Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and up-
to-date.
Illustration 4-4

4-21
Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
4-22 SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for “Prepaid 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 equipment
advertising buildings

Prepaid Expenses
Costs that expire either with the passage of time or
through use.
Adjusting entry results in an increase (a debit) to an

expense account and a decrease (a credit) to an asset
account.

Adjusting entries for prepaid expenses

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

Decreases (credits) an asset account.

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 Supplies Expense 1,500

Supplies 1,500
($2,500 – 1,000 = $1,500)

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

Depreciation
Buildings, equipment, and motor 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.
Depreciation does not attempt to report the actual

change in the value of the asset.

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-Equipment 40

Statement Presentation
Accumulated Depreciation-Equipment is a contra asset
account.
Appears just after the account it offsets (Equipment) on

the balance sheet.
Illustration 4-9

Summary
Illustration 4-10

Adjusting Entries for “Unearned 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

Unearned Revenues
Adjusting entry to record the revenue that has been
earned and to show the liability that remains.
Adjusting entry results in a decrease (a debit) to a

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

Adjusting entries for unearned revenues

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

Increase (a credit) to a revenue account.

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 Unearned Service Revenue 400

Service Revenue 400

Summary
Illustration 4-13

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Adjusting Entries for Accruals
Made to record:
Revenues earned and
OR
Expenses incurred
in the current accounting period that have not been

recognized through daily entries.
4-38 SO 5 Prepare adjusting entries for accruals.

Adjusting Entries for “Accrued 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

Accrued Revenues
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues earned.

Adjusting entries for accrued revenues

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

Increases (credits) a revenue account.

Illustration: In October, Sierra Corporation earned $200 for

guide services that were not billed to clients before October 31.
Oct. 31 Accounts Receivable 200

Service Revenue 200
Illustration 4-15

Summary
Illustration 4-16

Adjusting Entries for “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:
rent taxes
interest salaries

Accrued Expenses
An adjusting entry serves two purposes:
(1) Records the obligations, and
(2) Recognizes the expenses.

Adjusting entries for accrued expenses

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

Increases (credits) a liability account.

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

4-48
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

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 Salaries Expense 1,200

Salaries Payable 1,200
Illustration 4-21

Summary
Illustration 4-22

Summary of Basic Relationships

The 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.
4-53 SO 6 Describe the nature and purpose of the adjusted trial balance.
4-54 SO 6
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.
Preparing Financial Statements
Financial statements are prepared directly from the

Adjusted Trial Balance.
Retained
Income Balance
Earnings
Statement Sheet
Statement
Illustration 4-27
4-57
Illustration 4-28
4-58
Closing the 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
4-59 SO 7 Explain the purpose of closing entries.

Closing the 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

Closing the Books
2012
Illustration 4-31
4-61
Closing the Books
SO 7 Explain the purpose

4-62 of closing entries.
Preparing a Post-Closing Trial 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.

Summary of the Accounting Cycle
Illustration 4-33
1. Analyze business transactions Required steps in the
accounting cycle
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
4-64 SO 8 Describe the required steps in the accounting cycle.

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.

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.
4-65 SO 8 Describe the required steps in the accounting cycle.

Keep an Eye on 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.
Illustration 4-27
SO 9 Understand the causes of differences between net

4-66
income and cash provided by operating activities.
Keep an Eye on Cash
The difference for Sierra is $2,840 ($5,700 - $2,860). The

following summary shows the causes of this difference.
4-67
SO 9
Adjusting Entries in an Automated World—
Using a Worksheet (Appendix)
Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and up-
to-date.
Illustration 4-4
4-68
SO 10
Adjusting Entries in an Automated World—
Using a Worksheet (Appendix)
SO 10 Describe the purpose and the

4-69
basic form of a worksheet.
1. Prepare a Trial Balance on the Worksheet
Adjusted Income
Trial Balance Adjustments Trial Balance Statement Balance Sheet
Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Retained Earnings -
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000

Rent 900
Totals 28,700 28,700
Trial balance amounts come

directly from ledger accounts.
Include all accounts
with balances.
4-70 SO 10 Describe the purpose and the basic form of a worksheet.

Using a Worksheet
Illustration 4-24
General journal
showing adjusting
entries 2012
Adjusting
Journal
Entries
4-71
2. Enter the Adjustments in Adjustments Columns
Adjusted Income
Cash 15,200
Supplies 2,500 (a) 1,500
Prepaid Insurance 600 (b) 50
Equipment 5,000
Adjustments Key:
Notes Payable 5,000 (a) Supplies Used.
Accounts Payable 2,500
Unearned Service Revenue 1,200 (d) 400 (b) Insurance Expired.
Common Stock 10,000 (c) Depreciation Expensed.
Retained Earnings -
Dividends 500 (d) Service Revenue Earned.
Service Revenue 10,000 (d) 400
(e) 200
(e) Service Revenue Accrued.
Salaries Expense 4,000 (g) 1,200 (f) Interest Accrued.
Rent 900
Totals 28,700 28,700 (g) Salaries Accrued.
Supplies Expense (a) 1,500
Insurance Expense (b) 50
Accumulated
Depreciation- Enter adjustment amounts, total
Equipment (c) 40
(c)
adjustments columns, and check
Depreciation Expense 40
Interest Expense (f) 50 for equality.
Accounts Receivable (e) 200
Interest Payable (f) 50
Salaries Payable (g) 1,200
Totals 3,440 3,440
Net income
Totals Add additional accounts as needed.
4-72 SO 10
3. Complete the Adjusted Trial Balance Columns
Adjusted Income
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800
Common Stock 10,000 10,000
Retained Earnings -
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200
Rent 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500
Insurance Expense (b) 50 50
Accumulated
Depreciation-
Equipment (c) 40 40
Depreciation Expense (c) 40 40
Interest Expense (f) 50 50
Accounts Receivable (e) 200 200
Interest Payable (f) 50 50
Salaries Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190
Net income
Totals Total
the adjusted trial balance
4-73 columns and check for equality. SO 10
4. Extend Amounts to Financial Statement Columns
Adjusted Income
Cash 15,200 15,200
Supplies 2,500 (a) 1,500 1,000
Prepaid Insurance 600 (b) 50 550
Equipment 5,000 5,000
Notes Payable 5,000 5,000
Accounts Payable 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800
Common Stock 10,000 10,000
Retained Earnings -
Dividends 500 500
Service Revenue 10,000 (d) 400 10,600 10,600
(e) 200
Salaries Expense 4,000 (g) 1,200 5,200 5,200
Rent 900 900 900
Totals 28,700 28,700
Supplies Expense (a) 1,500 1,500 1,500
Insurance Expense (b) 50 50 50
Accumulated
Depreciation-
Equipment (c) 40 40
Depreciation Expense (c) 40 40 40
Interest Expense (f) 50 50 50
Accounts Receivable (e) 200 200
Interest Payable (f) 50 50
Salaries Payable (g) 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600
Net income
Totals Extend
all revenue and expense account
4-74 balances to the income statement columns. SO 10
4. Extend Amounts to Financial Statement Columns
Adjusted Income
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800 800
Common Stock 10,000 10,000 10,000
Retained Earnings -
Dividends 500 500 500
(e) 200
Rent 900 900 900
Totals 28,700 28,700
Accumulated
Depreciation-
Equipment (c) 40 40 40
Accounts Receivable (e) 200 200 200
Interest Payable (f) 50 50 50
Salaries Payable (g) 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net income
Totals Extendall asset, liability, and equity account
4-75 balances to the balance sheet columns. SO 10
5. Total Columns, Compute Net Income (Loss)
Adjusted Income
Cash 15,200 15,200 15,200
Supplies 2,500 (a) 1,500 1,000 1,000
Prepaid Insurance 600 (b) 50 550 550
Equipment 5,000 5,000 5,000
Notes Payable 5,000 5,000 5,000
Accounts Payable 2,500 2,500 2,500
Unearned Service Revenue 1,200 (d) 400 800 800
Common Stock 10,000 10,000 10,000
Retained Earnings -
Dividends 500 500 500
(e) 200
Rent 900 900 900
Totals 28,700 28,700
Accumulated
Depreciation-
Equipment (c) 40 40 40
Accounts Receivable (e) 200 200 200
Interest Payable (f) 50 50 50
Salaries Payable (g) 1,200 1,200 1,200
Totals 3,440 3,440 30,190 30,190 7,740 10,600 22,450 19,590
Net income 2,860 2,860
Totals Compute Net Income or Net Loss. 10,600 10,600 22,450 22,450
4-76
SO 10
Copyright
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Request for further information should be addressed to the
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programs or from the use of the information contained herein.”
4-77

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4-1

Financial Accounting, Sixth Edition

Revenue Types of Preparing the Preparing Earnings

Accountants divide the economic life of a business into

Generally a month, a quarter, or a year.

SO 1 Explain the revenue recognition principle

SO 1 Explain the revenue recognition principle

The Revenue Recognition Principle

SO 1 Explain the revenue recognition principle

Illustration: Assume Conrad Dry Cleaners cleans

SO 1 Explain the revenue recognition principle

Illustration 4-1 (Partial)

“Let the expenses follow the revenues.”

SO 1 Explain the revenue recognition principle

SO 1 Explain the revenue recognition principle

Accrual versus Cash Basis of Accounting

► Revenues are recognized when earned, even if cash

► Expenses are recognized when incurred, even if cash

SO 2 Differentiate between the cash basis

Accrual versus Cash Basis of Accounting

► Expenses are recognized only when cash is paid.

► Prohibited under generally accepted accounting

SO 2 Differentiate between the cash basis

Illustration: Suppose that Fresh Colors paints a large

SO 2 Differentiate between the cash basis

SO 2 Differentiate between the cash basis

Adjusting entries make it possible to report correct

A company must make adjusting entries every time

Includes one income statement account and one

SO 3 Explain why adjusting entries are needed, and

Revenues - recorded in the period in which they are

Expenses - recognized in the period in which they

Adjusting entries - needed to ensure that the

SO 3 Explain why adjusting entries are needed, and

SO 3 Explain why adjusting entries are needed, and

SO 3 Explain why adjusting entries are needed, and

Deferrals are either:

4-22 SO 4 Prepare adjusting entries for deferrals.

Payment of cash, that is recorded as an asset because

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

4-23 SO 4 Prepare adjusting entries for deferrals.

Adjusting entry results in an increase (a debit) to an

4-24 SO 4 Prepare adjusting entries for deferrals.

Adjusting entries for prepaid expenses

Increases (debits) an expense account and

4-25 SO 4 Prepare adjusting entries for deferrals.

Illustration: Sierra Corporation purchased supplies costing $2,500

Oct. 31 Supplies Expense 1,500

4-26 SO 4 Prepare adjusting entries for deferrals.

Illustration: On October, 4 Sierra Corporation paid $600 for a one-

Oct. 31 Insurance Expense 50

Illustration 4-7 (Partial)

4-27 SO 4 Prepare adjusting entries for deferrals.

Companies report a portion of the cost of a long-lived

Depreciation does not attempt to report the actual

4-28 SO 4 Prepare adjusting entries for deferrals.

Illustration: For Sierra Corporation, assume that depreciation on

Oct. 31 Depreciation Expense 40

Illustration 4-8 (Partial)

4-29 SO 4 Prepare adjusting entries for deferrals.

Appears just after the account it offsets (Equipment) on

4-30 SO 4 Prepare adjusting entries for deferrals.