ACCT2111 Introductory Financial Accounting
Prof. Rosy Xu
Assistant Professor, CUHK Business School
Lecture 3: Accrual Accounting
Objectives of Lecture 2
I.
Derive the (expanded) accounting equation
II. What is a business transaction?
III. Perform the equation analysis
IV. Perform the debit-credit analysis
V. Explain the process of journalizing and posting
VI. Construct a trial balance
Readings: Pearson Ch.2
Outlook
Objectives of Lecture 3
I.
What is accrual accounting? How does it differ from
cash-basis accounting?
II. Illustrate the deferral adjustments
III. Illustrate the accrual adjustments
IV. Illustrate the depreciation adjustments (a unique
type of deferral)
Readings: Pearson Ch.3
Objective I.
What Is Accrual-Basis Accounting?
How Does It Differ From Cash-Basis
Accounting?
Accrual-Basis Accounting
Measure and report accounting transactions
without the necessity that cash has been received
or paid
• Based on two primary principles:
– Revenue recognition
– Matching principle (expense recognition)
Revenue Recognition Principle
IAS 18 – Revenue
• The entity has transferred to the buyer the significant risks and
rewards of ownership of the goods
• The entity retains neither continuing managerial involvement to
the degree usually associated with ownership nor effective control
over the goods sold
• The amount of revenue can be measured reliably
• It is probable that the economic benefits associated with the
transaction will flow to the entity
• The costs incurred or to be incurred in respect of the transaction
can be measured reliably
Types of Revenue Recognition
Goods
• (Usually) recognized when the products or services have
been delivered to the buyers
Interest Income
• Recognized on a time-proportion basis
Royalty Income
• Recognized on a accruals basis in accordance with the
agreements
Dividend Income
• Recognized when the right to receive payment is
established
Exercise!
How should Doge Coffee recognize its revenue in the
following scenarios?
1. A customer paid for coffee and cakes ($500 in total) to be
delivered two days later
2. A customer paid $500,000 to Doge Coffee for delivering
coffee everyday for her company’s employees over the
next two years
3. A customer purchased a $500 gift card
4. The customer purchased a cup ($100) and the Doge
coffee guarantees a free return within 7 days if the
customer changes his mind
The Matching Concept
Matching expenses with revenues in the same
period when the company makes the efforts to
generate those revenues.
“Let the expenses follow the revenues.”
▼ HELPFUL HINT
An accounting time period
that is one year long is
called a fiscal year.
Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Periodicity Assumption).
.....
Jan.
Feb.
Mar.
Apr.

Generally a month, a quarter, or a year.

Fiscal year vs. calendar year.
Dec.
IAS1 requires an entity to present a complete set of
financial statement at least annually.
Accrual-Basis Accounting Recap
Cash-Basis Accounting
Revenues are recognized only when cash is
received.
Expenses are recognized only when cash is paid.
Accrual- Versus Cash- Basis
Doge Coffee pays total expenses (salaries and expenses of coffee
beans) of $50,000 in 2020. It bills the customer $80,000, but does
not receive payment until 2021.
2020
2021
Why the Fuss?
You don’t really have to…
– For public companies, required by GAAP
But, accrual accounting can better reflect the
underlying economic events – very important for
public firms
Objective II.
Illustrate the Deferral Adjustments
Adjusting Entries
Cash is received at the same time revenue/expense is
recognized (no need for adjustments)
Cash is received before revenue/expense is recognized
(to be adjusted)
Cash is received after revenue/expense is recognized
(to be adjusted)
Adjusting Entries
Ensure that the revenue recognition and the matching
principles are followed
• Are required every time a company prepares financial
statements (are made on the last day of the period)
• No cash involved!!!
• Include one income statement account and one balance
sheet account (“REAL”)
Deferrals vs. Accruals
Deferrals
Deferred expenses (prepaid expenses) OR
Deferred income (unearned revenues)
Adjustment for an item for which the business paid or
received cash in advance
“Money comes FIRST.”
Deferred Expenses: Example (a)
On October 4, Doge Coffee paid $2,400 for a oneyear fire insurance policy. Coverage began on
October 1. Doge Coffee recorded the payment by
increasing the account Prepaid Insurance.
Insurance of $200 ($2,400 ÷ 12) expires each month.
Deferred Expenses: Example (b)
Doge Coffee purchased supplies of coffee beans costing
$8,500 on October 5. Dodge Coffee recorded the purchase by
increasing the account Supplies. This account shows a balance
of $8,500 in the October 31 trial balance.
An inventory count at the close of business on October 31
reveals that $6,000 of supplies are still on hand.
• What if another $3,000 of coffee beans were purchased
during Oct? How much expenses should you adjust?
Deferred Expenses Recap
ACCOUNTING FOR DEFERRED EXPENSES
Examples
Insurance,
supplies,
advertising
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Prepaid
expenses in
asset accounts
have been used
(expenses
incurred)
Assets overstated.
Dr. Expenses
Cr. Assets
Expenses
understated.
Deferred Income: Example (c)
Tesla Inc is interested in working with Doge Coffee for
multiple events over the next three months. On
October 2, Doge Coffee received a $1,200 cash
advance from Tesla Inc. Doge Coffee recorded the
payment by increasing Unearned Revenue.
Deferred Income Recap
ACCOUNTING FOR DEFERRED INCOME
Examples
Subscriptions
(think about
Netflix), customer
deposits for
future service.
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Unearned
Revenues
recorded in
liability accounts
are now
recognized as
revenue for
services
performed.
Liabilities
overstated.
Dr. Liabilities
Cr. Revenues
Revenues
understated.
Objective III.
Illustrate the Accrual Adjustments
Accruals
Accrued expenses (accrued liabilities) OR Accrued
revenues (accounts receivables)
•
Accrued Expense: an expense that has been
incurred but not yet paid (a liability)
•
Accrued Revenue: a revenue that has been earned
but not yet collected (an asset)
“Money comes LATER.”
Accrued Expenses: Example (d)
Doge Coffee signed a three-month note payable in
the amount of $1,000,000 on October 1. The note
requires Doge Coffee to pay interests at an annual
rate of 6%.
Accrued Expenses: Example (e)
Doge Coffee last paid salaries on October 26; the next payment
of salaries will not occur until November 9. The employees
receive total salaries of $5,000 for two work weeks, or $500 per
day.
Accrued salaries at October 31 are $1,500 ($500 × 3 days).
Accrued Expenses Recap
Accrued Revenues: Example (f)
In October, Doge Coffee provided coffee to the Rosy’s
friends that were not billed to them before October 31
($1,000).
Accrued Revenues Recap
ACCOUNTING FOR ACCRUED REVENUES
Examples
Investment
interest, services
performed but not
collected.
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Services
performed or sales
made but not yet
received in cash or
recorded.
Assets understated.
Dr. Assets
Cr. Revenues
Revenues
understated.
Objective IV.
Illustrate the Depreciation
Adjustments
Depreciation
The process of allocating the cost of long-term
asset (aka non-current assets) to expense over its
expected useful life.
•
•
Depreciation Expense: the periodic expense
Accumulated Depreciation: total amount of
depreciation expensed over the life of the asset.
•
•
Contra asset account – reduces asset
Normal balance: credit balance
We will discuss more in Chapter 7…
Depreciation
Statement Presentation
•
Accumulated DepreciationEquipment is a contra asset
account.
•
Appears just after the account it
offsets (Equipment) on the balance
sheet.
▼ HELPFUL HINT
All contra accounts have
increases, decreases,
and normal balances
opposite to the account
to which they relate.
Book value
Depreciation: Example
On October 2, Doge Coffee purchased coffee
machines by paying $5,000 cash to Nespresso.
Assume that depreciation on the equipment is $480 a
year, or $40 per month.
Summary of Adjusting Entries
After Today’s Class…
Work out the adjusted journal, ledger, and trial balance
by yourself.
Review Ch.3 of Pearson textbook.
Work on Assignment#3 (Due: Oct 6, 11am)
Read Ch.4 of Pearson textbook