Financial Accounting:

Tools for Business Decision Making, 4th Ed.

Kimmel, Weygandt, Kieso

CHAPTER 4
Prepared by

Ellen L. Sweatt
Georgia Perimeter College

Chapter 4

ACCRUAL
ACCOUNTING
CONCEPTS
2

Chapter 4
Accrual Accounting Concepts

Explain the revenue recognition principle

and the matching 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 prepayments.
3

Chapter 4
Accrual Accounting Concepts

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.

1
11

Time Period Assumption...

Divides the economic life of a
business into artificial time
periods

WHY?
to provide immediate
feedback on how the
business is doing.
5

Time Period Assumption...

Generally a month, a quarter, or a
year.

An accounting time period that is one

year long is called a fiscal year.
An accounting time period that starts on January 1
and ends December 31 is called a calendar year.

Revenue Recognition
Principle...
Dictates that revenue be recognized
in the accounting period in which it is
earned.
Is considered earned

when the service has been provided or

when the goods are delivered.
7

Matching Principle...
Requires that expenses be
recorded in the same period
in which the revenues they
helped produce are recorded.

Accounting Principles for Measuring Income

Revenue Principle
Record revenue for the
cash value when
earned (Customer
receives product or
service for the
agreed-upon price)

Matching Principle
Record expenses when
incurred to earn revenue
(Business uses resources
to make product or
provide service)

Cardinal Computer Service Center

Income Statement
For the year ended March 31, 20X8
Revenue:
Service revenue
Expenses:
Salary expense
Rent expense
Interest expense
Utilities expense
Total expenses
Net Income

7,600

5,100
2,500

3,000
1,500
400
200

Time Period Concept

Prepare financial
statements often for the
same length of time
(Financial statements
for one year ending on
the same date each
year)

10

Review
Which principle dictates that efforts (expenses)
be recorded with accomplishments (revenues)?
a. Cost Principle.
b. Matching Principle
c. Periodicity Principle
d. Revenue Recognition Principle
11

Review
Which principle dictates that efforts (expenses)
be recorded with accomplishments (revenues)?
a. Cost Principle.
b. Matching Principle
c. Periodicity Principle
d. Revenue Recognition Principle
12

Review
When would revenue be recorded for the
following scenario . . .
Ad agency is hired for a project in May,
does the work in June and is paid in
July?

June
13

Review
When would expenses be recorded for this
companion scenario ?
The Ad agency on this project incurs
$1,500 of expenses in May, $3,000 in June,
and none in July?

The answer is June! Matching

says the expenses should follow
the revenue.

14

Review
When would revenue be recorded for the
following scenario . . .
Sell plane ticket on September 1 for a
flight on October 15?
The answer is October when the
service is provided!
15

Review
When would expenses be recorded for the
following scenario . . .
The airline pays pilot salaries on October 7 th
for the week ended September 30th?
The answer is September the pilots
provided labor services for September
flights during that month.
16

2
11

Cash Basis
A
GA
P
Revenue recorded only when cash is received.
Expense recorded only when cash is paid.
17

Accrual Basis Accounting

Adheres to the:
Revenue Recognition
Principle
Revenue
recorded only when earned,
not when cash is received
Matching Principle
Expense recorded only
when incurred, not when cash
paid
18

Accrual Basis adheres to...

Generally
Accepted
Accounting
Principles
19

20

Types of Adjusting Entries

Prepayments:
Prepaid expenses: Expenses paid in cash and
recorded as assets before they are used or
consumed.
Unearned Revenues: Cash received and
recorded as liabilities before revenue is earned.
Accruals:
Accrued revenues: Revenues earned but not yet
received in cash or recorded.
Accrued expenses: Expenses incurred but not
yet paid in cash or recorded.
21

Prepaids
Exhibit Prepaids
3-2 Deferrals

Pay cash before

asset is used or
expended
Cash
paid

Asset
Cash

Dr
XX

Expense incurred
Cr
Expense
Asset

XX

Dr
XX

Expense incurred
Dr
XX

Cr
XX

Revenue earned

Cash
received
Cash
Liablity

YearEnd
Adjustment

Revenue earned
Liability
Revenue

Cr
XX

Receive cash
before service
is provided

Dr
XX

Cr
XX

Exhibit Accruals
3-3 Accruals

YearEnd
Adjustment

Pay cash after

asset is used
or expended
Cash
paid

Expense incurred

Expense incurred
Expense
Liability

Dr
XX

Cr
XX

Revenue earned

Revenue earned
Asset
Revenue

Dr
XX

Cash
received

Cr
XX

Receive cash after

service is provided
or goods are sold

Prepaid Rent
Prepaid Insurance
Supplies

Rent Expense
Insurance Expense
Supplies Expense
Adjusting entries

PrepaidsCash transaction comes first.

Prepaid
Expenses

First
Pay cash and record an asset:

Prepaid Rent
XXX
Cash
Unearned Receive cash and record a
Revenues liability:
Cash
XXX
Unearned Service Revenue

XXX

XXX

Later
Record an expense and
decrease the asset:
Rent Expense
XXX
Prepaid Rent
Record a revenue and
decrease the liability:
Unearned Service Revenue XXX
Service Revenue

XXX

XXX

AccrualsCash transaction comes later.

First
Accrued Accrue an expense and the
Expenses related payable:
Notice that in each adjusting
entry,
Salary Expense
XXX
Salaryand
Payable
one balance sheet account
Accrued Accrue a revenue and the
one income statement
Revenues account
related receivable:
XXX
are affected Interest Receivable
Interest Revenue

XXX

XXX

Pay cash and decr

payable:
Salary Payable
Cash
Receive
cash
decrease the recei
Cash
Interest Receiva

Adjusting entries

PrepaidsCash transaction comes first.

et:

Interest
Salaries
XXX

XXX

d a

ue

XXX
XXX

Later
Record an expense and
decrease the asset:
Expense/Interest
Payable
Rent Expense
XXX
Expense/Salaries
Payable
Prepaid Rent
XXX
Record a revenue and
decrease the liability:
Unearned Service Revenue XXX
Service Revenue
XXX

Notice that in each

adjusting entry,
one balance sheet
account and
one income statement
account
are affected

AccrualsCash transaction comes later.

First
Accrued Accrue an expense and the
Expenses related payable:
Salary Expense
XXX
Salary Payable
Accrued Accrue a revenue and the
Revenues related receivable:
Interest Receivable
XXX
Interest Revenue

XXX

XXX

Later
Pay cash and decrease the
payable:
Salary Payable
XXX
Cash
Receive
cash
and
decrease the receivable:
Cash
XXX
Interest Receivable

Interest Receivable/ Interest

Income
Accounts Receivable/ Sales
Revenue

XXX

XXX

Prepayments
PREPAID EXPENSES - Costs that
expire either with the passage of
time or through use.
UNEARNED REVENUES- money has
been received before the goods or
services are provided.

26

You can start with the trial

balance to find information to
adjust prepayments.

27

Sierra Corporation
Trial Balance
October 31, 2007
Cash
Advertising Supplies
Prepaid Insurance
Office Equipment
Notes Payable
Accounts Payable
Unearned Service Revenue
Common Stock
Dividends
Service Revenue
Salaries Expense
Rent Expense

Debit Credit
$15,200
2,500
600
5,000
$ 5,000
2,500
1,200
10,000
500
10,000
4,000
900
$28,700 $28,700

Prepaid Expenses

Amount equals cost of goods or

services used up or expired
If not adjusted, expenses would be
understated and assets overstated
29

Supplies
On October 5 the company paid
$2,500 for advertising supplies.
Advertising
Cash
Oct 5 2,500

Advertising
Supplies
Oct 5

2,500

GENERAL JOURNAL
Oct 5

Supplies
Expense

Supplies
Cash
Purchased advertising supplies

Debit

Credit

2,500
2,500

Supplies

An inventory on October 31 reveals that $1,000 of

supplies remain on hand; therefore $1,500 of
supplies have been used. ($2,500 - $1,000) =$
Advertising
1,500
Advertising
Supplies
Expense
Cash
Supplies
Oct 5 2,500 Oct 5 2,500 Oct 31 1,500

Oct 31 1,500

Bal. 1,000
GENERAL JOURNAL
Oct 5

Supplies Expense
Supplies

1,500
To record advertising supplies consumed

Debit
1,500

Credit

Supplies Expense
Oct
$1,500

Nov
$1,800

Dec
$1,410

Jan
$1,425

Feb
$1,601

Mar
$1,435

Apr
$1,510

May
$1,592

June
$1,652

July
$1,621

Aug
$1,427

Sept
$1,555

Supplies expense is based on usage... so

different amounts appear each month
32

Prepaid Expenses

On October 1 the company paid $600 for a 1-year

insurance policy. Coverage began October 1.

Cash
Oct 1

Insurance
Expense

Prepaid
Insurance
600 Oct 1

600

GENERAL JOURNAL

Debit

Oct 1

600

Prepaid Insurance
Cash
Purchased one-year policy effective October 1

Credit
600

Insurance Policy
Oct
$50

Nov
$50

Dec
$50

Jan
$50

Feb
$50

Mar
$50

Apr
$50

May
$50

June
$50

July
$50

Aug
$50

Sept
$50

1 Year $ 600
34

Prepaid Expenses
On October 31st, $50 ($600/12
months) of the insurance was used-up
or expired.
Insurance
Prepaid
Cash
Expense
Insurance
Oct 1

600 Oct 1

600 Oct 31 50

Oct 31

50

550

GENERAL JOURNAL
Oct 31

Insurance Expense
Prepaid Insurance

50
Record insurance expense for the month

Debit
50

Credit

Depreciation
How do you apply the Matching
Principle to the cost of a long lived
asset ?

36

Depreciation
Allocates the cost of an asset to expense
over its useful life MATCHING
PRINCIPLE
Is an estimate
Depreciation is ALLOCATION of costnot VALUATION(Current Replacement
Cost)
Were not attempting to reflect the actual
change in value of an asset!
37

Office Equipment
Oct
$40

Nov
$40

Dec
$40

Jan
$40

Feb
$40

Mar
$40

Apr
$40

May
$40

June
$40

July
$40

Aug
$40

Sept
$40

Depreciation= $480/year
38

Office Equipment

Accumulated
DepreciationOffice Equipment

Oct 2 5,000

Oct 31

40

GENERAL JOURNAL
Oct 31 Depreciation Expense
Accumulated Depreciation-Office Equip

Depreciation
Expense
Oct 31

40

Debit

Credit

40
40

To record monthly depreciation

Accumulated depreciation is a
contra asset account - an offset
against the fixed asset account.

39

Balance Sheet Presentation

Office equipment
Less : accumulated depreciation

$ 5,000
40
$4,960

Book Value or
Carrying Value
40

5
11

Unearned Revenues

Received on Oct. 2 $1,200 for advertising

services expected to be completed by
Dec 31.
Unearned Service
Service
Revenue
Revenue
Cash
Oct 2 1,200

Oct 2

1,200

GENERAL JOURNAL

Debit

Oct 2

1,200

Cash
Unearned Service Revenue
Collected money for work to be
performed by Dec 31.

Credit

1,200

Unearned Revenues
During October $400 of the revenue was
earned.
Unearned Service
Revenue

Cash
Oct 2 1,200

Oct. 31 400 Oct 2

1,200

Bal

800

GENERAL JOURNAL
Oct 31 Unearned Service Revenue
Service Revenue
To record revenue earned

Service
Revenue
Oct. 31 400

Debit

Credit

400
400

5
11

Accruals
Revenue has been earned, but not
collected.
Expenses have been incurred, but
not yet paid.

43

Accrued Revenues
Revenues earned but not yet
received in cash or recorded at the
statement date.

44

Accrued Revenues
Earned $200 for advertising services to
clients in October, but they were not
billed until after October 31st.
Accounts
Receivable
Oct 31

200

GENERAL JOURNAL
Oct 31 Accounts Receivable
Service Revenue

Service
Revenue
Oct 31

Debit

200

Credit

200
200

Accrued Expenses
Expenses incurred but not yet paid
or recorded at the statement date.

46

Interest expense is the cost a

company incurs to use money:
Information needed to compute interest expense:
face value of note
interest rate (always expressed in annual rate)
the length of time note is outstanding

Accrued Interest
Interest Expense
Oct 31 50

Interest Payable
Oct 31

GENERAL JOURNAL
Oct 31 Interest Expense
Interest Payable
Accrue interest expense for the month

Debit

50

Credit

50
50

Accrued Salaries - Salaries Paid for

after the Service Has Been Performed.

Accrued Salaries
Salaries Expense
Oct 31 1,200

Salaries Payable
Oct 31 1,200

GENERAL JOURNAL

Debit

Oct 31 Salaries Expense

1,200

Salaries Payable
Accrue salary expense for the month

Credit

1,200

Adjusting Entries affect

one balance sheet
and one income statement
account

Balance Sheet
Account

Prepayments
Revenue now (at year end);
Cash collected earlier

Liability
decreases

Prepayments
Expense now (at year end);
Cash paid earlier

Asset
decreases

Accruals
Revenue now (at year end);
Collect cash later (in next year)
Accruals
Expense now (at year end);
Pay cash later (in next year)

Asset
increases

Liability
increases

Income Statement
Account

Revenue
increases

Expense
increases

Revenue
increases

Expense
increases

6
11

Adjusted Trial Balance

The adjusted trial balance is used to
prove the equity of total debit balances
and total credit balances after the
adjusting entries have been made.
Financial statements (except Cash Flow
Statement) can be easily prepared from
the adjusted trial balance.
52

53

7
11

Closing the Books

Closing entries transfer the temporary
account balances to the stockholders
equity account...
and reduce the balances in the
temporary accounts to zero.

56

Temporary

Permanent

All revenues accounts

All asset accounts

All expense accounts

All liability accounts

Dividends

Stockholders equity
accounts

Close Temporary Accounts

Only
Zero balance
after closing
entries!

Do not close!
58

The Closing Process

8
11

The Accounting Cycle

63

Required
Steps in
the
Accountin
g Cycle

64

Review
Which is not a temporary account?

a.Salaries expense
b.Service revenue
c.Accounts Receivable
d.Dividends
65

Review
Which is not a temporary account?

a.Salaries expense
b.Service revenue
c.Accounts Receivable
d.Dividends
66

Review
Which account will have a zero
balance after closing entries?
a.Service Revenue
b.Advertising Supplies
c.Prepaid Insurance
d.Accumulated Depreciation
67

Review
Which account will have a zero
balance after closing entries?
a.Service Revenue
b.Advertising Supplies
c.Prepaid Insurance
d.Accumulated Depreciation
68

Review
Which types of accounts will appear
in the post-closing trial balance?
a.Temporary accounts
b.Accounts shown in the income statement
c.Permanent accounts
d.All of the above
69

Review
Which types of accounts will appear
in the post-closing trial balance?
a.Temporary accounts
b.Accounts shown in the income statement
c.Permanent accounts
d.All of the above
70

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