CHAPTER
4
Accrual Accounting
Concepts
Time Period Assumption
• Divides the economic life of a business into
artificial time periods
– Interim period (month, quarter)
– Year (fiscal, calendar)
• WHY?
– To provide immediate feedback on how the
business is doing
Revenue Recognition Principle
• Dictates that revenue be recognized in the
accounting period in which it is earned
• Revenue is considered earned when the
service has been provided or when the goods
are delivered
Matching Principle
• Requires that expenses be recorded in the
same period in which the revenues they
helped produce are recorded
Cash Basis
• Revenue is recorded only when cash is
received
• Expense is recorded only when cash is paid
Accrual Basis Accounting
• Adheres to the time period assumption and
revenue recognition and matching principles
• Revenue is recorded when earned,
rather than when cash is received
• Expense recorded when incurred,
rather than when cash is paid
• Accrual accounting records events when the
economic event occurs
Adjusting Entries
• Adjusting entries are made to adjust or
update accounts at the end of the accounting
period
• Adjusting entries can be categorized as
– Prepayments
– Accruals
Types of Adjusting Entries
– Prepayments
• Prepaid expenses
• Unearned revenues
– Accruals
• Accrued revenues
• Accrued expenses
Prepayments
• Cash has been spent but the item acquired has
not been used or consumed (prepaid expenses)
• Cash has been collected but the revenue has
not been earned (unearned revenues)
Supplies
On January 5 the company paid $2,500 for
advertising supplies.
Cash
Advertising
Supplies
Advertising Supplies
Expense
Jan. 5 2,500 Jan. 5 2,500
GENERAL JOURNAL
Jan. 5
Advertising Supplies
Cash
Purchased advertising supplies
Debit
Credit
2,500
2,500
Supplies
An inventory on January 31 reveals that $1,000 of supplies
remain on hand; therefore, $1,500 of supplies had been used.
($2,500 - $1,000) =$ 1,500
Cash
Advertising
Supplies
Advertising
Supplies Expense
Jan. 5 2,500 Jan. 5 2,500 Jan. 31 1,500 Jan. 31 1,500
Bal. 1,000
GENERAL JOURNAL
Jan. 5
Debit
Credit
Advertising Supplies Expense
1,500
Advertising Supplies
To record advertising supplies consumed
1,500
Prepaid Expenses
On February 4 the company paid $600 for a 1-year insurance
policy; coverage began February 1.
Cash
Feb. 4 600
GENERAL JOURNAL
Feb. 4
Insurance
Expense
Prepaid
Insurance
Feb. 4 600
Debit
Credit
Prepaid Insurance
600
Cash
600
Purchased one-year policy effective February 1
Prepaid Expenses
On February 28, $50 ($600/12 months) of the insurance
had been used or had expired.
Cash
Feb. 4 600
GENERAL JOURNAL
Feb. 28
Insurance
Expense
Prepaid
Insurance
Feb. 4 600 Feb. 28 50
Debit
Feb. 28 50
Credit
Insurance Expense
50
Prepaid Insurance
50
Record insurance expense for the month
Amortization
• How do you apply
the matching
principle to the cost
of a long-lived
asset?
Amortization
• Allocate the cost of an asset to expense over
its useful life
• Amortization is an allocation concept, not a
valuation concept
Note: This is not an attempt to reflect the actual
change in value of an asset.
Amortization Example
• Assume a piece of equipment was purchased
on March 2 for $5,000. Its salvage value is
$200 and its useful life is 10 years
• Straight-line amortization calculation is:
Cost - Salvage value = $5,000 - $200 = $480/yr
Useful Life
10
OR
$40/mo
Amortization Example
Office Equipment
Mar. 2 5,000
Accumulated
Amortization-Office
Equipment
Mar. 31 40
GENERAL JOURNAL
Mar. 31 Amortization Expense
Accumulated Amortization –
Office Equipment
To record monthly amortization
Amortization
Expense
Mar. 31 40
Debit
Credit
40
Accumulated Amortization is a contra asset account – an offset
(deduction) against the asset account.
40
Balance Sheet Presentation
Office equipment
Less: Accumulated amortization
Net book value
Net book value
$5,000
40
4,960
Unearned Revenues
Received on August 2 $1,200 for advertising services
expected to be completed by December 31.
Cash
Aug. 2 1,200
Service
Revenue
Aug. 2 1,200
GENERAL JOURNAL
Aug. 2
Unearned Service
Revenue
Debit
Credit
Cash
1,200
Unearned Service Revenue
1,200
Collected money for work to be performed by
December 31
Unearned Revenues
During August, $400 of the revenue was earned.
Cash
Aug. 2 1,200
Unearned Service
Revenue
Service
Revenue
Aug. 31 400 Aug. 2 1,200
Aug. 31 400
Bal. 800
GENERAL JOURNAL
Aug. 31
Unearned Service Revenue
Service Revenue
To record revenue earned
Debit
Credit
400
400
Accruals
• Revenue has been earned, but not
collected (accrued revenues)
• Expenses were incurred, but not yet paid
(accrued expenses)
Note: Entry has not yet been recorded!
Accrued Revenues
• Revenues earned but not yet received in
cash or recorded at the end of period
Accrued Revenues
Earned $200 for advertising services to clients in
October, but they were not billed until after October 31.
Accounts
Receivable
Oct. 31 200
GENERAL JOURNAL
Oct . 31
Accounts Receivable
Service Revenue
Service
Revenue
Oct. 31 200
Debit
Credit
200
200
Accrued Expenses
• Expenses incurred but not yet paid or
recorded at the end of period
Accrued Interest Expense
Interest expense is the cost a company
incurs to use money. Information needed to
calculate interest expense:
• Face value of note
• Interest rate (always expressed in annual rate)
• The length of time note is outstanding
Accrued Interest Expense
Formula for Calculating Interest
Face Value
of Note
$ 5,000 X
Annual
Interest
Rate
12%
Time
in Terms of
One Year
X
1/2
Interest
=
$50
Accrued Interest Expense
Interest Expense
Oct. 31 50
GENERAL JOURNAL
Interest Payable
Oct. 31 200
Debit
Credit
Oct. 31 Interest Expense
50
Interest Payable
Accrue interest expense for the month
50
Accrued Salaries Expense
• Assume that the employees receive total
salaries of $2,000 for a five-day (Monday to
Friday) work week, or $400 a day.
• Salaries were last paid on October 26 and the
next payment of salaries will be November 9.
As shown on the calendar on the following
slide there are three unpaid work days remain
as of October 31.
Accrued Salaries Expense
(Salaries paid after the service has been performed)
Accrued Salaries Expense
Salaries Expense
Oct. 31 1,200
GENERAL JOURNAL
Salaries Payable
Oct. 31 1,200
Debit
Credit
Oct. 31 Salaries Expense
1,200
Salaries Payable
Accrue salary expense for the month
1,200
Adjusted Trial Balance
• Adjusted trial balance proves the equity of
total debit balances and total credit balances
after the adjusting entries have been made
• Financial statements can be easily prepared
from the adjusted trial balance
Closing the Books
• Closing entries
– Transfer the temporary account balances to
update the retained earnings account
– Reduce the balances in the temporary
accounts to zero to prepare for the next
period’s postings
Illustration 4-17
Temporary
Permanent
All revenue accounts
All asset accounts
All expense accounts
All liability accounts
Dividends account
Shareholders’ equity
accounts
Individual Revenues
Individual Expenses
2
Income Summary
3
Retained Earnings
4
Dividends
1
Retained Earnings
is a permanent
account; the others
shown here
are temporary
Required Steps in the Accounting Cycle
•
Analyse business transactions
•
Journalize the transactions
•
Post to general ledger accounts
•
Prepare a trial balance
•
Journalize and post adjusting entries
(prepayments and accruals)
Required Steps in the Accounting Cycle
•
Prepare an adjusted trial balance
•
Prepare financial statements
•
Journalize and post closing entries
•
Prepare a post-closing trial balance