ACCRUAL

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• ACCRUAL
• ACCOUNTING
• CONCEPTS

Accounting, Fifth Edition
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Learning Objectives

• After studying this chapter, you should be able
  to
• Explain the revenue recognition principle and the
  expense recognition principle (MATCHING).
• 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 and prepare closing
  entries.
• Describe the required steps in the accounting
  cycle. (slide 61)
• Self-study

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Revenue Recognition Principle
Companies recognize revenue in the accounting
period in which the performance obligation is
satisfied regardless if cash has been received or
not.
LO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Revenue Recognition Principle
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
LO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Expense Recognition Principle
Illustration 4-1 (Partial)
Let the expenses follow the revenues.
LO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Timing Issues
Illustration 4-1 GAAP relationships in
revenue and expense recognition
Matching
LO 1 Explain the revenue recognition principle
and the expense recognition principle.
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(No Transcript)
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ACCRUAL vs CASH Basis of Accounting

• 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.

• 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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ACCRUAL vs CASH Basis of Accounting
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.
LO 2 Differentiate between the cash basis and
the accrual basis of accounting.
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Timing Issues
Review Question

• Which one of these statements about the accrual
  basis of accounting is false?
• Companies record events that change their
  financial statements in the period in which
  events occur, even if cash was not exchanged.
• Companies recognize revenue in the period in
  which the performance obligation is satisfied.
• This basis is in accord with generally accepted
  accounting principles.
• Companies record revenue only when they receive
  cash, and record expense only when they pay out
  cash.

LO 2 Differentiate between the cash basis and
the accrual basis of accounting.
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The Basics of Adjusting Entries

• 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.

LO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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The Basics of Adjusting Entries
Review Question
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.
LO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Types of Adjusting Entries
Type 1
Type 2
Type 3
Type 4
including depreciation
LO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Trial Balance BEFORE Adjusting Entries
Trial Balance Each account is analyzed to
determine whether it is complete and up-to-date.
Illustration 4-4
LO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Practice Problem for Adjusting Entries 1 2

• Do it! 4-1, p 203
• Set up T accounts for each account listed.
• Indicate if the account is an asset or liability.
• Indicate the and for each T account.
• Place the opening balance (a) into each T account
  as shown in the problem.

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1 - Adjusting Entries for Prepaid Expenses

1. Costs that expire either with the passage of time
   or through use.
2. This adjusting entry results in an increase (a
   debit) to an expense account and a decrease (a
   credit) to an asset account.

LO 4 Prepare adjusting entries for deferrals.
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1 - 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.
Illustration 4-6 (Partial)
LO 4 Prepare adjusting entries for deferrals.
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1 - Adjusting Entries for Prepaid Expenses
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.
Insurance Expense (I/S)
50
Oct. 31
Prepaid Insurance (B/S)
50
Illustration 4-7 (Partial)
LO 4 Prepare adjusting entries for deferrals.
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Practice Problem for Adjusting Entries 1 2

• Do it! 4-1, Items 1 2, p 203
• Set up T accounts for each account listed.
• Indicate if the account is an asset or liability.
• Indicate the and for each T account.
• Place the opening balance (a) into each T account
  as shown in the problem.
• Under the analysis descriptions, determine if the
  number shown is the activity (b) for the period
  or the ending balance (c).
• Create the adjusting journal entry using (b).
• Confirm that one Income Statement and one Balance
  Sheet account are included in the adjusting
  entry.

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1 - 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 assets useful life.
• Depreciation does NOT attempt to report the
  actual change in the value of the asset.

LO 4 Prepare adjusting entries for deferrals.
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1 - Adjusting Entries for Prepaid Expenses
Illustration For Sierra Corporation, assume
that depreciation on the office equipment is 480
a year, or 40 per month.
Depreciation Expense (I/S)
40
Oct. 31
Accumulated Depreciation-Equipment (B/S)
40
Illustration 4-8 (Partial)
LO 4 Prepare adjusting entries for deferrals.
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1 - 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.

LO 4 Prepare adjusting entries for deferrals.
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Practice Problem for Adjusting Entries 1 2

• Do it! 4-1, Items 3, p 203
• Set up T accounts for each account listed.
• Indicate if the account is an asset or liability.
• Indicate the and for each T account.
• Place the opening balance (a) into each T account
  as shown in the problem.
• Under the analysis descriptions, determine if the
  number shown is the activity (b) for the period
  or the ending balance (c).
• Create the adjusting journal entry using (b).
• Confirm that one Income Statement and one Balance
  Sheet account are included in the adjusting
  entry.

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1 - Adjusting Entries for Prepaid Expenses
Summary
Illustration 4-10
LO 4 Prepare adjusting entries for deferrals.
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2 - Adjusting Entries for Unearned Revenues

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

1. Adjusting entry to record the revenue that has
   been earned and to show the liability that
   remains.
2. This adjusting entry results in a decrease (a
   debit) to a liability account and an increase (a
   credit) to a revenue account.

LO 4 Prepare adjusting entries for deferrals.
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2 - 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.
Unearned Service Revenue (B/S)
400
Oct. 31
Service Revenue (I/S)
400
Illustration 4-12 (Partial)
LO 4 Prepare adjusting entries for deferrals.
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Practice Problem for Adjusting Entries

• Do it! 4-1, Item 4, p 203
• Set up T accounts for each account listed.
• Indicate if the account is an asset or liability.
• Indicate the and for each T account.
• Place the opening balance (a) into each T account
  as shown in the problem.
• Under the analysis descriptions, determine if the
  number shown is the activity (b) for the period
  or the ending balance (c).
• Create the adjusting journal entry using (b).
• Confirm that one Income Statement and one Balance
  Sheet account are included in the adjusting
  entry.

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2 - Adjusting Entries for Unearned Revenues
LO 4 Prepare adjusting entries for deferrals.
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(No Transcript)
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3 4 - 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. The
  business transaction is MISSING and needs to be
  added.

LO 5 Prepare adjusting entries for accruals.
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3 - Adjusting Entries for Accrued Revenues

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

Adjusting entry results in
LO 5 Prepare adjusting entries for accruals.
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3 - Adjusting Entries for Accrued Revenues
Accrued Revenues This adjusting entry serves two
purposes (1) Shows the receivable that
exists, and (2) Records the revenues for
services performed.
LO 5 Prepare adjusting entries for accruals.
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3 - Adjusting Entries for Accrued Revenues
Illustration In October, Sierra Corporation
performed guide services for 200 that were not
billed to clients before Oct 31.
LO 5 Prepare adjusting entries for accruals.
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3 - Adjusting Entries for Accrued Revenues
ACCOUNTING FOR ACCRUED REVENUES
Illustration 4-16
Reason for Adjustment
Accounts Before Adjustment
Adjusting Entry
Examples
Services performed but not yet received in cash
or recorded
Interest, rent, services performed but not
collected
Assets understated. Revenues understated.
Dr. Assets Cr. Revenues
Illustration 4-16
LO 5 Prepare adjusting entries for accruals.
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4 - Adjusting Entries for Accrued Expenses

• Expenses incurred but not yet paid in cash or
  recorded.

Adjusting entry results in
Accrued expenses often occur in regard to
This adjusting entry serves two purposes (1)
Records the obligations, and (2) Recognizes the
expenses.
LO 5 Prepare adjusting entries for accruals.
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4 - 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
Interest Expense (I/S)
50
Oct. 31
Interest Payable (B/S)
50
Illustration 4-19 (Partial)
LO 5 Prepare adjusting entries for accruals.
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4 - 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
LO 5 Prepare adjusting entries for accruals.
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4 - 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).
Salaries and Wages Expense (I/S)
1,200
Oct. 31
Salaries and Wages Payable (B/S)
1,200
Illustration 4-21
LO 5 Prepare adjusting entries for accruals.
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4 - Adjusting Entries for Accrued Expenses
Illustration 4-22
LO 5 Prepare adjusting entries for accruals.
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Practice Problem for Adjusting Entries 3 4

• Do it! 4-2, p 203
• Create the adjusting journal entry using the
  information provided. Note No T accounts are
  needed for adjusting entries 3 4.
• Confirm that one Income Statement and one Balance
  Sheet account are included in the adjusting entry.

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Summary of Basic Relationships
Illustration 4-23 Summary of adjusting entries
LO 5 Prepare adjusting entries for accruals.
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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.
LO 6 Describe the nature and purpose of the
adjusted trial balance.
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The Trial Balance AFTER Adjusting Entries
Illustration 4-26 Adjusted trial balance
LO 6
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The Adjusted Trial Balance
Review Question

• Which of the following statements is incorrect
  concerning the adjusted trial balance?
• 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.
• The adjusted trial balance provides the primary
  basis for the preparation of financial
  statements.
• The adjusted trial balance lists the account
  balances segregated by assets and liabilities.
• The adjusted trial balance is prepared after the
  adjusting entries have been journalized and
  posted.

LO 6 Describe the nature and purpose of the
adjusted trial balance.
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Preparing Financial Statements
Financial statements are prepared directly from
the Adjusted Trial Balance.
Balance Sheet
Income Statement
Retained Earnings Statement
LO 6 Describe the nature and purpose of the
adjusted trial balance.
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Preparing Financial Statements
Illustration 4-27
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Preparing Financial Statements
Illustration 4-28
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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.
LO 6 Describe the nature and purpose of the
adjusted trial balance.
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Closing the Books
Personal example If someone asked you how much
you had in your bank account on Dec 31st, would
you answer be any different if that same person
asked you on January 1st?
At the end of the accounting period, companies
transfer the temporary account balances to the
permanent stockholders equity accountRetained
Earnings.
Illustration 4-29
Personal example If someone asked you how much
you had in your bank account on Dec 31st would
your answer be any different if you were asked
again on January 1st?
Personal example If someone asked you how much
you made in 2014, what would your response be?
What if they asked you how much you made in 2015,
what would your answer be?
LO 7 Explain the purpose of closing entries.
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Closing Steps

1. Close the Revenue accounts into the Income
   Summary.
2. Close the Expense accounts in the Income Summary.
3. Close the Income Summary accounts to the Capital
   Account as either a net income or net loss.
4. Close the Dividends account into the Capital
   account.

R E I D
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Closing Steps
Salaries Expenses
Consulting Revenues
25,000
18,100
Examine the accounts presented.
Retained Earnings
Income Summary
7,000
3-51
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Recording Closing Entries
Closing Steps - R
Salaries Expenses
Consulting Revenues
25,000
18,100
Income Summary
Close revenues with a debit to the revenue
account and a credit to Income Summary.
3-52
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Closing Steps - E
Salaries Expenses
Consulting Revenues
25,000
25,000
18,100
Close expense accounts with a credit to expenses
and a debit to Income Summary.
Income Summary
25,000
3-53
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Recording Closing Entries
Closing Steps - I
Salaries Expenses
Consulting Revenues
25,000
25,000
18,100
18,100
Income Summary
Determine the balance in the Income Summary
account.
18,100
25,000
3-54
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Closing Steps - I
Salaries Expenses
Close the Income Summary to Retained Earnings.
18,100
18,100
Retained Earnings
Income Summary
18,100
25,000
7,000
6,900
3-55
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Recording Closing Entries
Closing Steps - D

• The dividends account is closed to Retained
  Earnings.

Determine the ending balance in Retained Earnings.
3-56
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Closing Steps - D

• The dividends account is closed to Retained
  Earnings.

Determine the ending balance in Retained Earnings.
3-57
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Closing the Books
2014
Illustration 4-31
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Closing Entries Practice Problem

• E4-18, p. 209
• Set up T accounts for each account listed.
• Indicate if the account is an asset or liability.
• Indicate the and for each T account.
• Place the opening balance into each T account.
• Close the accounts in order (REID) by forcing the
  T account to equal ZERO.
• Create journal entries based on step 5 above.

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Preparing a Post-Closing Trial Balance

• Trial Balance prepared after the closing entries
  have been posted.
• The purpose is to insure that all nominal or
  temporary (REID) accounts have been closed.
• The only accounts on this trial balance should be
  assets, liabilities, and equity accounts.

LO 7 Explain the purpose of closing entries.
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Summary of the Accounting Cycle
Illustration 4-33 Required steps in
the accounting cycle
1. Analyze business transactions
2. Journalize the transactions
9. Prepare a post-closing trial balance
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

• Journalize and post adjusting entries
• Deferrals/Accruals

LO 8 Describe the required steps in the
accounting cycle.