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4
ACCRUAL ACCOUNTING
CONCEPTS
4-1
Financial Accounting, Sixth Edition
Study Objectives
4-2
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.
Accrual Accounting Concepts
Timing Issues
The Basics of
Adjusting
Entries
Revenue
recognition
principle
Types of
adjusting
entries
Preparing the
adjusted trial
balance
Expense
recognition
principle
Adjusting
entries for
deferrals
Preparing
financial
statements
Accrual versus
cash basis of
accounting
Adjusting
entries for
accruals
Summary of
basic
relationships
4-3
The Adjusted
Trial Balance
and Financial
Statements
Closing the
Books
Quality of
Earnings
Preparing
closing entries
Earnings
management
Preparing a
post-closing
trial balance
Sarbanes-Oxley
Summary of
the accounting
cycle
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
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.
4-5
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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:
4-6
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
Timing Issues
Illustration 4-1 (Partial)
“Let the expenses follow the revenues.”
This is commonly referred to as the “Matching
Principle”.
4-7
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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.
4-8
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).
4-9
SO 2 Differentiate between the cash basis
and the accrual basis of accounting.
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.
Illustration 4-2 (Partial)
4-10
SO 2 Differentiate between the cash basis
and the accrual basis of accounting.
The Basics of Adjusting Entries
Adjusting entries are necessary for accounts to reflect
“Economic Reality” at the financial statement date.
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.
4-11
SO 3
Explain why adjusting entries are needed, and
identify the major types of adjusting entries
The Basics 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
(Matching) principles are followed.
4-12
SO 3
Explain why adjusting entries are needed, and
identify the major types of adjusting entries
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.
4-13
SO 3
Explain why adjusting entries are needed, and
identify the major types of adjusting entries
Types of Adjusting Entries
Trial Balance –
Each account is
analyzed to
determine
whether it is
complete and upto-date. Does it
reflect Economic
Reality?
Illustration 4-4
4-14
SO 3
Explain why adjusting entries are needed, and
identify the major types of adjusting entries
Adjusting Entries for Deferrals
Deferrals are either:
Prepaid expenses
OR
Unearned revenues.
4-15
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
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.
4-16
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
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
1,500
1,500
($2,500 – 1,000 = $1,500)
Illustration 4-6 (Partial)
4-17
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
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
50
Prepaid Insurance
50
Illustration 4-7 (Partial)
4-18
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
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.
4-19
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
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
Illustration 4-8 (Partial)
4-20
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Prepaid Expenses”
Statement Presentation
Accumulated Depreciation-Equipment is a contra asset
account.
Appears just after the account it offsets (Equipment) on
the balance sheet.
4-21
Illustration 4-9
SO 4 Prepare adjusting entries for deferrals.
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:
4-22
rent
magazine subscriptions
airline tickets
customer deposits
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
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.
4-23
SO 4 Prepare adjusting entries for deferrals.
Adjusting Entries for “Unearned Revenues”
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
Illustration 4-12 (Partial)
4-24
SO 4 Prepare adjusting entries for deferrals.
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 (routine) entries.
4-25
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Accrued Revenues
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues earned.
4-26
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Revenues”
Illustration: In October, Sierra Corporation earned $200 for
guide services that were not billed to clients before October 31.
Oct. 31
Accounts Receivable
Service Revenue
200
200
Illustration 4-15
4-27
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
Accrued Expenses
An adjusting entry serves two purposes:
(1) Records the obligations, and
(2) Recognizes the expenses.
4-28
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
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
Illustration 4-19 (Partial)
4-29
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
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
4-30
SO 5 Prepare adjusting entries for accruals.
Adjusting Entries for “Accrued Expenses”
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
4-31
SO 5 Prepare adjusting entries for accruals.
Summary of Basic Relationships
4-32
SO 5 Prepare adjusting entries for accruals.
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.
4-33
SO 6 Describe the nature and purpose of the adjusted trial balance.
The Adjusted Trial Balance
4-34
SO 6
Preparing Financial Statements
Financial statements are prepared directly from the
Adjusted Trial Balance.
Income
Statement
4-35
Retained
Earnings
Statement
Balance
Sheet
SO 6 Describe the nature and purpose of the adjusted trial balance.
Preparing Financial Statements
Illustration 4-27
4-36
Preparing Financial Statements
4-37
Illustration 4-28
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
4-38
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
4-39
SO 7 Explain the purpose of closing entries.
Closing the Books

1.
2.
3.
4.
There are 4 Closing Entries
Close all revenue accounts to income
summary.
Close all expense accounts to income
summary.
Close income summary to R.E.
Close dividends to R.E.
That’s all there is to it!
4-40
Closing the Books
2012
Illustration 4-31
4-41
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.
4-42
SO 7 Explain the purpose of closing entries.
Summary of the Accounting Cycle
1. Analyze business transactions
4-43
Illustration 4-33
Required steps in the
accounting cycle
9. Prepare a post-closing
trial balance
2. Journalize the
transactions
8. Journalize and post
closing entries
3. Post to ledger accounts
7. Prepare financial
statements
4. Prepare a trial balance
6. Prepare an adjusted trial
balance
5. Journalize and post
adjusting entries:
Deferrals/Accruals
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.
4-44
SO 8 Describe the required steps in the accounting cycle.