accrual accounting concepts

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ACCRUAL ACCOUNTING CONCEPTS

Financial Accounting, Sixth Edition

4

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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.

Study ObjectivesStudy ObjectivesStudy ObjectivesStudy Objectives

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Types of adjusting entries

Adjusting entries for deferrals

Adjusting entries for accruals

Summary of basic relationships

Timing IssuesTiming IssuesTiming IssuesTiming IssuesThe Basics of The Basics of

Adjusting Adjusting EntriesEntries

The Basics of The Basics of Adjusting Adjusting

EntriesEntries

The Adjusted The Adjusted Trial Balance Trial Balance and Financial and Financial StatementsStatements

The Adjusted The Adjusted Trial Balance Trial Balance and Financial and Financial StatementsStatements

Closing the Closing the BooksBooks

Closing the Closing the BooksBooks

Quality of Quality of EarningsEarningsQuality of Quality of EarningsEarnings

Revenue recognition principle

Expense recognition principle

Accrual versus cash basis of accounting

Preparing the adjusted trial balance

Preparing financial statements

Preparing closing entries

Preparing a post-closing trial balance

Summary of the accounting cycle

Earnings management

Sarbanes-Oxley

Accrual Accounting ConceptsAccrual Accounting ConceptsAccrual Accounting ConceptsAccrual Accounting Concepts

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Generally a month, a quarter, or a year.

Fiscal year vs. calendar year

Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption).

SO 1 Explain the revenue recognition principle SO 1 Explain the revenue recognition principle and the expense recognition principle.and the expense recognition principle.

Jan. Feb. Mar. Apr. Dec.. . . . .

Timing IssuesTiming IssuesTiming IssuesTiming Issues

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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.


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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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“Let the expenses follow the revenues.”

This is commonly referred to as the “Matching Principle”.


Illustration 4-1 (Partial)

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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.


Accrual versus Cash Basis of Accounting

SO 2 Differentiate between the cash basis SO 2 Differentiate between the cash basis and the accrual basis of accounting.and the accrual basis of accounting.

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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).



Accrual versus Cash Basis of Accounting

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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.



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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.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries

SO 3 SO 3 Explain why adjusting entries are needed, and Explain why adjusting entries are needed, and identify the major types of adjusting entriesidentify the major types of adjusting entries

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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.

The Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting EntriesThe Basics of Adjusting Entries


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Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries

Illustration 4-3Categories 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.

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Trial BalanceTrial Balance –

Each account is

analyzed to

determine

whether it is

complete and up-

to-date. Does it

reflect Economic

Reality?

Types of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting EntriesTypes of Adjusting Entries


Illustration 4-4

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Deferrals are either:

Prepaid expenses

OR

Unearned revenues.

Adjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for DeferralsAdjusting Entries for Deferrals

SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.

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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”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”Adjusting Entries for “Prepaid Expenses”


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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.

Supplies 1,500

Supplies Expense 1,500Oct. 31



Illustration 4-6 (Partial)($2,500 – 1,000 = $1,500)

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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.

Prepaid Insurance 50

Insurance Expense 50Oct. 31




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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.



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Illustration: For Sierra Corporation, assume that depreciation on

the office equipment is $480 a year, or $40 per month.

Accumulated Depreciation-Equipment 40

Depreciation Expense 40Oct. 31




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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

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Receipt of cash that is recorded as a liability because the revenue has not been earned.

Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”Adjusting Entries for “Unearned Revenues”

rent

airline tickets

Cash ReceiptCash Receipt Revenue RecordedRevenue RecordedBEFORE

magazine subscriptions

customer deposits

Unearned revenues often occur in regard to:


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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.



4-24 SO 4 Prepare adjusting entries for deferrals.SO 4 Prepare adjusting entries for deferrals.


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.

Service Revenue 400

Unearned Service Revenue 400Oct. 31


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Made to record:

Revenues earned and

OR

Expenses incurred

in the current accounting period that have not been recognized through daily (routine) entries.

Adjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for AccrualsAdjusting Entries for Accruals

SO 5 Prepare adjusting entries for accruals.SO 5 Prepare adjusting entries for accruals.

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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”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”


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Illustration: In October, Sierra Corporation earned $200 for

guide services that were not billed to clients before October 31.

Service Revenue 200

Accounts Receivable 200Oct. 31


Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”Adjusting Entries for “Accrued Revenues”

Illustration 4-15

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Accrued Expenses

An adjusting entry serves two purposes:

(1) Records the obligations, and

(2) Recognizes the expenses.

Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”Adjusting Entries for “Accrued Expenses”


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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%.

Interest Payable 50

Interest Expense 50Oct. 31


Illustration 4-18

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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 × 3 days).

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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).

Salaries Payable 1,200

Salaries Expense 1,200Oct. 31

Illustration 4-21

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Summary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic RelationshipsSummary of Basic Relationships


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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.

The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

SO 6 Describe the nature and purpose of the adjusted trial balance.SO 6 Describe the nature and purpose of the adjusted trial balance.

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The Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial BalanceThe Adjusted Trial Balance

SO 6SO 6

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Financial statements are prepared directly from the Adjusted Trial Balance.

Financial statements are prepared directly from the Adjusted Trial Balance.

Balance Sheet

Income Statement

Retained Earnings

Statement

Preparing Financial StatementsPreparing Financial StatementsPreparing Financial StatementsPreparing Financial Statements

SO 6 Describe the nature and purpose of the adjusted trial balance.SO 6 Describe the nature and purpose of the adjusted trial balance.

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Illustration 4-27

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Illustration 4-28

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At the end of the accounting period, companies transfer the

temporary account balances to the permanent

stockholders’ equity account—Retained Earnings.

Closing the BooksClosing the BooksClosing the BooksClosing the Books

SO 7 Explain the purpose of closing entries.SO 7 Explain the purpose of closing entries.

Illustration 4-29

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In addition to updating Retained Earnings to its correct

ending balance, closing entries produce a zero balance in

each temporary account.



Illustration 4-30

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There are 4 Closing Entries1. Close all revenue accounts to income

summary.2. Close all expense accounts to income

summary.3. Close income summary to R.E.4. Close dividends to R.E.

That’s all there is to it!


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Illustration 4-31

2012

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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.

Preparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial BalancePreparing a Post-Closing Trial Balance

All temporary accounts will have zero balances.


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Summary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting CycleSummary of the Accounting Cycle

1. Analyze business transactions1. Analyze business transactions

2. Journalize the transactions

2. Journalize the transactions

6. Prepare an adjusted trial balance

6. Prepare an adjusted trial balance

7. Prepare financial statements

7. Prepare financial statements

8. Journalize and post closing entries

8. Journalize and post closing entries

9. Prepare a post-closing trial balance

9. Prepare a post-closing trial balance

4. Prepare a trial balance4. Prepare a trial balance

3. Post to ledger accounts3. Post to ledger accounts

5. Journalize and post adjusting entries:Deferrals/Accruals

5. Journalize and post adjusting entries:Deferrals/Accruals

SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.

Illustration 4-33Required steps in theaccounting cycle

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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:

Quality of EarningsQuality of EarningsQuality of EarningsQuality of Earnings

SO 8 Describe the required steps in the accounting cycle.SO 8 Describe the required steps in the accounting cycle.

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.

accrual accounting concepts

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