4-1 accrual accounting concepts accounting, fifth edition 4

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ACCRUAL ACCOUNTINGCONCEPTS

Accounting, Fifth Edition

4

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After studying this chapter, you should be able to:

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.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

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Preview of Chapter 4

AccountingFifth Edition

Kimmel Weygandt Kieso

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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).

LO 1 Explain the revenue recognition principle LO 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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What is the periodicity assumption?What is the periodicity assumption?

a.a. Companies should recognize 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.

Review QuestionReview Question



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The Revenue Recognition Principle

Companies recognize

revenue in the accounting

period in which the

performance obligation is

satisfied.


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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.”


Illustration 4-1 (Partial)

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Illustration 4-1 GAAPrelationships in revenueand expense recognition

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Accrual-Basis Accounting

► Transactions recorded in the periods in which the

events occur.

► Revenues are recognized when services performed,

even if cash was not received.

► Expenses are recognized when incurred, even if cash

was not paid.


Accrual versus Cash Basis of Accounting

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

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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).

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Illustration: Suppose that Fresh Colors paints a large building in 2013. In 2013, 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 2014.



2013 2014

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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 the performance obligation is satisfied.

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.




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Adjusting entries

ensure that the revenue recognition and expense

recognition principles are followed.

are required every time a company prepares financial

statements.

includes one income statement account and one

balance sheet account.

never include cash.

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

LO 3 LO 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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Adjusting entries are made to ensure that:

a. expenses are recognized in the period in which they are incurred.

b. revenues are recognized in the period in which the performance obligation is satisfied.

c. balance sheet and income statement accounts have correct balances at the end of an accounting period.

d. All of the above.


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 before service are performed.

Accruals:

1. Accrued revenues: Revenues for services performed 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.

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

LO 4 Prepare adjusting entries for deferrals.LO 4 Prepare adjusting entries for deferrals.

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Payment of cash, that is recorded as an asset because service or benefit will be received in the future.

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

insurance

supplies

advertising

Cash PaymentCash Payment Expense RecordedExpense RecordedBEFORE

rent

equipment

buildings

Prepayments often occur in regard to:


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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.



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Adjusting entries for prepaid expenses

Increases (debits) an expense account and

Decreases (credits) an asset account.


Illustration 4-5

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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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SummaryIllustration 4-10

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Receipt of cash recorded as a liability before services are performed.

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.



4-32 LO 4 Prepare adjusting entries for deferrals.LO 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.


Illustration 4-11



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




Illustration 4-13Summary

Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed

ACCOUNTING FOR UNEARNED REVENUES

ExamplesReason for Adjustment

Accounts BeforeAdjustment

AdjustingEntry

Rent, magazine subscriptions, customer deposits for future service

Liabilities overstated.Revenues understated.

Dr. Liabilities Cr. Revenues

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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 entries.

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

LO 5 Prepare adjusting entries for accruals.LO 5 Prepare adjusting entries for accruals.

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Revenues for services performed but not yet received in cash or recorded.

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

rent

interest

services performed

BEFORE

Accrued revenues often occur in regard to:

Cash ReceiptCash ReceiptRevenue RecordedRevenue Recorded

Adjusting entry results in:


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Accrued Revenues

An adjusting entry serves two purposes:

(1) Shows the receivable that exists, and

(2) Records the revenues for services performed.



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Adjusting entries for accrued revenues

Increases (debits) an asset account and

Increases (credits) a revenue account.



Illustration 4-14

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Illustration: In October, Sierra Corporation performed guide

services for $200 that were not billed to clients before October

31.

Service Revenue 200

Accounts Receivable 200Oct. 31



Illustration 4-15

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Illustration 4-16



Illustration 4-16Summary

Services performed but not yet received in cash or recorded

ACCOUNTING FOR ACCRUED REVENUES

ExamplesReason for Adjustment

Accounts BeforeAdjustment

AdjustingEntry

Interest, rent, services performed but not collected

Assets understated.Revenues understated.

Dr. Assets Cr. Revenues

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Expenses incurred but not yet paid in cash or recorded.

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

BEFORE

Accrued expenses often occur in regard to:

Cash PaymentCash PaymentExpense RecordedExpense Recorded

taxes

salaries

Adjusting entry results in:


rent

interest

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Accrued Expenses

An adjusting entry serves two purposes:

(1) Records the obligations, and

(2) Recognizes the expenses.



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Adjusting entries for accrued expenses

Increases (debits) an expense account and

Increases (credits) a liability account.



Illustration 4-17

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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 and Wages Payable 1,200

Salaries and Wages Expense 1,200Oct. 31

Illustration 4-21

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SummaryIllustration 4-22

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


Illustration 4-23Summary of adjusting entries

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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

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

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LO 6LO 6

Illustration 4-26Adjusted trial balance

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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.




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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


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Illustration 4-27

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Illustration 4-28

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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

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.


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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

LO 7 Explain the purpose of closing entries.LO 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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Illustration 4-31

2014

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Illustration 4-32Posting of closing entries

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


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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

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

Illustration 4-33Required steps in theaccounting cycle

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Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.

Keep an Eye on CashKeep an Eye on CashKeep an Eye on CashKeep an Eye on Cash

LO 9 LO 9 Understand the causes of differences between Understand the causes of differences between net net income and cash provided by operating income and cash provided by operating activities.activities.

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

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The difference for Sierra is $2,840 ($5,700 - $2,860). The following summary shows the causes of this difference.

Keep an Eye on CashKeep an Eye on CashKeep an Eye on CashKeep an Eye on Cash

LO 9 LO 9

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Trial BalanceTrial Balance –

Each account is

analyzed to

determine whether

it is complete and

up-to-date.

Illustration 4-4

Adjusting Entries in an Automated World— Using a Worksheet

Appendix 4AAppendix 4AAppendix 4AAppendix 4A

LO 10 LO 10

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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 Dividends 500 Service Revenue 10,000

Salaries & Wages Exp. 4,000 Rent Expense 900

Totals 28,700 28,700

Balance SheetAdjusted Income

Trial Balance Adjustments Trial Balance Statement

LO 10 Describe the purpose and the basic form of a worksheet.LO 10 Describe the purpose and the basic form of a worksheet.

1. Prepare a Trial Balance on the Worksheet Illustration 4A-1

Steps in Preparing a Worksheet Steps in Preparing a Worksheet Steps in Preparing a Worksheet Steps in Preparing a Worksheet

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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 Dividends 500 Service Revenue 10,000

Salaries & Wages Exp. 4,000 Rent Expense 900

Totals 28,700 28,700



1. Prepare a Trial Balance on the Worksheet

Trial balance amounts come directly from ledger accounts.

Include all accounts with balances.

Illustration 4A-1


LO 10 Describe the purpose and the basic form of a worksheet.LO 10 Describe the purpose and the basic form of a worksheet.

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Illustration 4-24General journal showing adjusting entries

Adjusting Journal Entries

Using a WorksheetUsing a WorksheetUsing a WorksheetUsing a Worksheet

2012

LO 10 LO 10

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Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.Cash 15,200 Supplies 2,500 1,500 Prepaid Insurance 600 50 Equipment 5,000 Notes Payable 5,000 Accounts Payable 2,500 Unearned Service Revenue 1,200 400 Common Stock 10,000 Dividends 500 Service Revenue 10,000 400

200 Salaries & Wages Exp. 4,000 1,200 Rent Expense 900

Totals 28,700 28,700

Supplies Expense 1,500 Insurance Expense 50 Accumulated Depreciation 40 Depreciation Expense 40 Accounts Receivable 200 Interest Expense 50 Interest Payable 50 Salaries and Wages Payable 1,200

Totals 3,440 3,440



2. Enter the Adjustments in the Adjustments Columns

(a)(b)

(a)

(g)

(c)

(d)

(d)

(e)

(b)

(e)(f)

(f)(g)

(c)

Enter adjustment amounts, total adjustments columns,and check for equality.

Add additional accounts as needed.

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.


LO 10 Describe the purpose and the LO 10 Describe the purpose and the basic form of a worksheet.basic form of a worksheet.

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Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.Cash 15,200 15,200 Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 5,000 Notes Payable 5,000 5,000 Accounts Payable 2,500 2,500 Unearned Service Revenue 1,200 400 800 Common Stock 10,000 10,000 Dividends 500 500 Service Revenue 10,000 400 10,600

200 Salaries & Wages Exp. 4,000 1,200 5,200 Rent Expense 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500 Insurance Expense 50 50 Accumulated Depreciation 40 40 Depreciation Expense 40 40 Accounts Receivable 200 200 Interest Expense 50 50 Interest Payable 50 50 Salaries and Wages Payable 1,200 1,200

Totals 3,440 3,440 30,190 30,190



3. Complete the Adjusted Trial Balance Columns

(a)(b)

(a)

(g)

(c)

(d)

(d)

(e)

(b)

(e)(f)

(f)(g)

(c)

Total the adjusted trial balance columns and check for equality.


LO 10 Describe the purpose and the LO 10 Describe the purpose and the basic form of a worksheet.basic form of a worksheet.

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Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.Cash 15,200 15,200 Supplies 2,500 1,500 1,000 Prepaid Insurance 600 50 550 Equipment 5,000 5,000 Notes Payable 5,000 5,000 Accounts Payable 2,500 2,500 Unearned Service Revenue 1,200 400 800 Common Stock 10,000 10,000 Dividends 500 500 Service Revenue 10,000 400 10,600 10,600

200 Salaries & Wages Exp. 4,000 1,200 5,200 5,200 Rent Expense 900 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500 1,500 Insurance Expense 50 50 50 Accumulated Depreciation 40 40 Depreciation Expense 40 40 40 Accounts Receivable 200 200 Interest Expense 50 50 50 Interest Payable 50 50 Salaries and Wages Payable 1,200 1,200

Totals 3,440 3,440 30,190 30,190 7,740 10,600



LO 10LO 10

4. Extend Amounts to Financial Statement Columns

(a)(b)

(a)

(g)

(c)

(d)

(d)

(e)

(b)

(e)(f)

(f)(g)

(c)

Extend all revenue and expense account balances to the income statement columns.


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Account Titles Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Cash 15,200 15,200 15,200 Supplies 2,500 1,500 1,000 1,000 Prepaid Insurance 600 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 1,200 400 800 800 Common Stock 10,000 10,000 10,000 Dividends 500 500 500 Service Revenue 10,000 400 10,600 10,600

200 Salaries & Wages Exp. 4,000 1,200 5,200 5,200 Rent Expense 900 900 900

Totals 28,700 28,700

Supplies Expense 1,500 1,500 1,500 Insurance Expense 50 50 50 Accumulated Depreciation 40 40 40 Depreciation Expense 40 40 40 Accounts Receivable 200 200 200 Interest Expense 50 50 50 Interest Payable 50 50 50 Salaries and Wages Payable 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 10,600 10,600 22,450 22,450

Balance Sheet Adjusted Income


(a)(b)

(a)

(g)

(c)

(d)

(d)

(e)

(b)

(e)(f)

(f)(g)

(c)

Compute Net Income or Net Loss.

5. Total Columns, Compute Net Income (Loss)


LO 10LO 10

4-74 LO 11LO 11

4-75 LO 11LO 11

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