C4 Accrual Accounting Concept

4
ACCRUAL ACCOUNTING CONCEPTS
4-1
Accounting, Fourth Edition
Study Objectives
1. 2. 3. 4. 5. 6. 7. 8. 9. Explain the revenue recognition principle and the expense recognition principle. Differentiate between the cash basis and the accrual basis of accounting. Explain why adjusting entries are needed, and identify the major types of adjusting entries. Prepare adjusting entries for deferrals. Prepare adjusting entries for accruals. Describe the nature and purpose of the adjusted trial balance. Explain the purpose of closing entries. Describe the required steps in the accounting cycle. Understand the causes of differences between net income and cash provided by operating activities.
4-2
Accrual Accounting Concepts
Timing Issues
The Basics of Adjusting Entries Types of adjusting entries Adjusting entries for deferrals Adjusting entries for accruals Summary of basic relationships
The Adjusted Trial Balance and Financial Statements Preparing the adjusted trial balance Preparing financial statements
Closing the Books
Quality of Earnings
Revenue recognition principle Expense recognition principle Accrual versus cash basis of accounting
Preparing closing entries Preparing a post-closing trial balance Summary of the accounting cycle
Earnings management Sarbanes-Oxley
4-3
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
4-4
SO 1 Explain the revenue recognition principle 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.

4-5
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.
4-6
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:
4-7
Timing Issues
Illustration 4-1 (Partial)
Let the expenses follow the revenues.

4-8
Timing Issues
Illustration 4-1 GAAP relationships in revenue and expense recognition
4-9
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.
4-10
SO 2 Differentiate between the cash basis 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).
4-11
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.
4-12
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.
4-13
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.
4-14
SO 3
Explain why adjusting entries are needed, and 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.
4-15
SO 3

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.
4-16
SO 3
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.
4-17
SO 3
Types of Adjusting Entries

Trial Balance Each account is analyzed to determine
whether it is complete and upto-date.
Illustration 4-4
4-18
SO 3
Adjusting Entries for Deferrals

Deferrals are either:
Prepaid expenses OR Unearned revenues.
4-19
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 supplies advertising
rent equipment buildings
4-20

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.
4-21

Adjusting entries for prepaid expenses
Illustration 4-5
Increases (debits) an expense account and

Decreases (credits) an asset account.
4-22

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 Supplies
($2,500 1,000 = $1,500)
1,500 1,500
4-23

Illustration: On October, 4 Sierra Corporation paid $600 for a oneyear 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 Prepaid Insurance 50 50
4-24

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 assets useful life. Depreciation does not attempt to report the actual change in the value of the asset.
4-25

Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month. Oct. 31 Depreciation Expense Accumulated Depreciation-Equipment 40 40
4-26

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
4-27

Summary
Illustration 4-10
4-28
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 airline tickets magazine subscriptions
customer deposits
4-29

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.
4-30

Adjusting entries for unearned revenues
Illustration 4-11
Decrease (a debit) to a liability account and Increase (a credit) to a revenue account.

4-31

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

Service Revenue
400
400
4-32

Summary
Illustration 4-13
4-33
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.
4-34
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
4-35

Accrued Revenues
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues earned.
4-36

Adjusting entries for accrued revenues
Illustration 4-14
Increases (debits) an asset account and Increases (credits) a revenue account.

4-37

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
4-38

Summary
Illustration 4-16
4-39
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 interest taxes salaries
4-40

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

(2) Recognizes the expenses.
4-41

Adjusting entries for accrued expenses
Illustration 4-17
Increases (debits) an expense account and Increases (credits) a liability account.

4-42

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
Interest Payable
50
50
4-43

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
4-44

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 Salaries Payable 1,200 1,200
Illustration 4-21
4-45

Summary
Illustration 4-22
4-46
Summary of Basic Relationships
4-47
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 balances 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.
4-48
SO 6 Describe the nature and purpose of the adjusted trial balance.
4-49
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.
4-50
Preparing Financial Statements

Financial statements are prepared directly from the Adjusted Trial Balance.
Income Statement
Retained Earnings Statement
Balance Sheet
4-51

Illustration 4-27
4-52
4-53
Illustration 4-28
Closing the Books

At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders equity accountRetained Earnings.
Illustration 4-29
4-54
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
4-55
Closing the Books

2012
Illustration 4-31
4-56
Closing the Books
4-57
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.
4-58
Summary of the Accounting Cycle

1. Analyze business transactions
Illustration 4-33 Required steps in the accounting cycle
9. Prepare a post-closing trial balance 8. Journalize and post closing entries 7. Prepare financial statements 6. Prepare an adjusted trial balance
2. Journalize the transactions
3. Post to ledger accounts
4. Prepare a trial balance 5. Journalize and post adjusting entries: Deferrals/Accruals
4-59
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.
4-60
SO 8 Describe the required steps in the accounting cycle.
Keep an Eye on Cash

Sierra Corporations 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
4-61
SO 9
Understand the causes of differences between net 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.
4-62
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 upto-date.
Illustration 4-4
4-63
SO 10
Adjusting Entries in an Automated World Using a Worksheet (Appendix)
4-64
SO 10 Describe the purpose and the basic form of a worksheet.
1. Prepare a Trial Balance on the Worksheet

Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Trial Balance Dr. Cr. 15,200 2,500 600 5,000 5,000 2,500 1,200 10,000 500 10,000 4,000 900 28,700 Adjustments Dr. Cr. Adjusted Trial Balance Dr. Cr. Income Statement Dr. Cr. Balance Sheet Dr. Cr.
28,700
Trial balance amounts come directly from ledger accounts. Include all accounts with balances.
4-65
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
4-66
2. Enter the Adjustments in Adjustments Columns

Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Supplies Expense Insurance Expense Accumulated DepreciationEquipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries Payable Totals Net income Add Totals Trial Balance Adjustments Dr. Cr. Dr. Cr. 15,200 (a) 1,500 2,500 (b) 600 50 5,000 5,000 2,500 1,200 (d) 400 10,000 500 10,000 (d) 400 (e) 200 (g) 1,200 4,000 900 28,700 28,700 (a) 1,500 (b) 50 Adjusted Trial Balance Dr. Cr. Income Statement Dr. Cr. Balance Sheet Dr. Cr.
Adjustments Key: (a) Supplies Used. (b) Insurance Expired. (c) Depreciation Expensed. (d) Service Revenue Earned. (e) Service Revenue Accrued. (f) Interest Accrued. (g) Salaries Accrued.
(c)
(c) 40 (f) 50 (e) 200
40
Enter adjustment amounts, total adjustments columns, and check for equality.
(f) 50 (g) 1,200 3,440 3,440
additional accounts as needed. SO 10
4-67
3. Complete the Adjusted Trial Balance Columns

Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Supplies Expense Insurance Expense Accumulated DepreciationEquipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries Payable Totals Net income Total Totals Trial Balance Adjustments Dr. Cr. Dr. Cr. 15,200 (a) 1,500 2,500 (b) 600 50 5,000 5,000 2,500 1,200 (d) 400 10,000 500 10,000 (d) 400 (e) 200 (g) 1,200 4,000 900 28,700 28,700 (a) 1,500 (b) 50 Adjusted Trial Balance Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500 10,600 5,200 900 1,500 50 Income Statement Dr. Cr. Balance Sheet Dr. Cr.
(c)
(c) 40 (f) 50 (e) 200
40 40 50 200
40
(f) 50 (g) 1,200 3,440 3,440
30,190
50 1,200 30,190
4-68
the adjusted trial balance columns and check for equality.
SO 10
4. Extend Amounts to Financial Statement Columns

Trial Balance Adjustments Dr. Cr. Dr. Cr. 15,200 (a) 1,500 2,500 (b) 50 600 5,000 5,000 2,500 1,200 (d) 400 10,000 500 10,000 (d) 400 (e) 200 (g) 1,200 4,000 900 28,700 28,700 (a) 1,500 (b) 50 Adjusted Trial Balance Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500 10,600 5,200 900 1,500 50 5,200 900 1,500 50 10,600 Income Statement Dr. Cr. Balance Sheet Dr. Cr.
Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Supplies Expense Insurance Expense Accumulated DepreciationEquipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries Payable Totals Net income Extend Totals
(c)
(c) (f) (e)
40 40 50 200
40 40 50 50 1,200 30,190
40 50 200
(f) 50 (g) 1,200
3,440
3,440
30,190
7,740
10,600
4-69
all revenue and expense account balances to the income statement columns.
SO 10
4. Extend Amounts to Financial Statement Columns

Trial Balance Adjustments Dr. Cr. Dr. Cr. 15,200 (a) 1,500 2,500 (b) 600 50 5,000 5,000 2,500 1,200 (d) 400 10,000 500 10,000 (d) 400 (e) 200 (g) 1,200 4,000 900 28,700 28,700 (a) 1,500 (b) 50 Adjusted Trial Balance Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500 10,600 5,200 900 1,500 50 5,200 900 1,500 50 10,600 Income Statement Dr. Cr. Balance Sheet Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500
Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Supplies Expense Insurance Expense Accumulated DepreciationEquipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries Payable Totals Net income Extend Totals
(c)
(c) (f) (e)
40 40 50 200
40 40 50 200 50 1,200 30,190
40
40 50 200
(f) 50 (g) 1,200 3,440 3,440
30,190
7,740
10,600
22,450
50 1,200 19,590
4-70
all asset, liability, and equity account balances to the balance sheet columns.
SO 10
5. Total Columns, Compute Net Income (Loss)

Account Titles Cash Supplies Prepaid Insurance Equipment Notes Payable Accounts Payable Unearned Service Revenue Common Stock Retained Earnings Dividends Service Revenue Salaries Expense Rent Totals Supplies Expense Insurance Expense Accumulated DepreciationEquipment Depreciation Expense Interest Expense Accounts Receivable Interest Payable Salaries Payable Totals Net income Totals Trial Balance Adjustments Dr. Cr. Dr. Cr. 15,200 (a) 1,500 2,500 (b) 600 50 5,000 5,000 2,500 1,200 (d) 400 10,000 500 10,000 (d) 400 (e) 200 (g) 1,200 4,000 900 28,700 28,700 (a) 1,500 (b) 50 Adjusted Trial Balance Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500 10,600 5,200 900 1,500 50 5,200 900 1,500 50 10,600 Income Statement Dr. Cr. Balance Sheet Dr. Cr. 15,200 1,000 550 5,000 5,000 2,500 800 10,000 500
(c)
(c) (f) (e)
40 40 50 200
40 40 50 200 50 1,200 30,190
40
40 50 200
(f) 50 (g) 1,200 3,440 3,440
30,190
Compute Net Income or Net Loss.
7,740 2,860 10,600
10,600 10,600
22,450 22,450
50 1,200 19,590 2,860 22,450
4-71
SO 10
Exercise P4-2A (page 209)
4-72

C4 Accrual Accounting Concept

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4

ACCRUAL ACCOUNTING CONCEPTS

Accounting, Fourth Edition

Accrual Accounting Concepts

Closing the Books

Earnings management Sarbanes-Oxley

Generally a month, a quarter, or a year. Fiscal year vs. calendar year

b. Companies should match expenses with revenues.

d. The fiscal year should correspond with the calendar year.

Let the expenses follow the revenues.

was not received.

was not paid.

The Basics of Adjusting Entries

amounts on the balance sheet and on the income statement.

it prepares financial statements.

The Basics of Adjusting Entries

The Basics of Adjusting Entries

b. revenues are recorded in the period in which they are earned.

Types of Adjusting Entries

Types of Adjusting Entries

whether it is complete and upto-date.

Adjusting Entries for Deferrals

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

Prepayments often occur in regard to:

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

Increases (debits) an expense account and

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

Illustration 4-8 (Partial)

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

Appears just after the account it offsets (Equipment) on

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Prepaid Expenses

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Unearned Revenues

Unearned revenues often occur in regard to:

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Unearned Revenues

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Unearned Revenues

Decrease (a debit) to a liability account and Increase (a credit) to a revenue account.

Adjusting Entries for Unearned Revenues

Unearned Service Revenue

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Unearned Revenues

SO 4 Prepare adjusting entries for deferrals.

Adjusting Entries for Accruals

SO 5 Prepare adjusting entries for accruals.

Adjusting Entries for Accrued Revenues

Accrued revenues often occur in regard to:

SO 5 Prepare adjusting entries for accruals.

Adjusting Entries for Accrued Revenues