Financial Accounting: Tools for Business
Decision-Making
Chapter 4
Accrual Accounting Concepts
Chapter 4 - Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.
Copyright ©2017 John Wiley & Sons Canada, Ltd.
2
Chapter 4 - Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.
Copyright ©2017 John Wiley & Sons Canada, Ltd.
3
Timing Issues
• Users require financial information on a regular basis
• Accounting divides the economic life of a business into
time periods
• Month, quarter (three months), year
o One-year period is known as the fiscal year
o Shorter periods are known as interim periods
• Many transactions affect more than one time period
Copyright ©2017 John Wiley & Sons Canada, Ltd.
4
Accounting Criteria
Statement of Income
"Income Statement"
For the year ending Dec 31, 2020
Revenue
Criteria
1. Sale of product or performance of the service has been substantially completed
(i.e. the customer has possession of the product or has received the service)
2. The dollar amount of the sale is determinable
3. Collection of the cash from the customer is reasonable assured
Expense
Criteria
1. The dollar amount of the expense is determinable
2. The expense can be tied to revenue that has been recognized as revenue
5
Revenue Recognition (1 of 2)
• Revenue: Increase in assets (or settlement of liabilities)
o
Income that results from a company’s ordinary activities
• In general, revenue is recognized
o
o
In a merchandising company when merchandise is sold and
delivered (point of sale)
In a service company when the service is performed
Copyright ©2017 John Wiley & Sons Canada, Ltd.
6
Expense Recognition
• Expenses are recognized when:
o
o
o
Due to ordinary activity, a decrease in future economic benefits
occurs
A decrease in an asset or an increase in a liability
Can be measured reliably
• Tied to changes in assets and liabilities
• Often coincides with revenue recognition
• Recognized, whenever possible, in the period in which
effort is made to generate revenue
o
Sometimes known as matching
Copyright ©2017 John Wiley & Sons Canada, Ltd.
7
Accrual Basis Accounting
• Transactions affecting a company’s financial statements
are recorded in the period the events occur**, rather
than when cash is received or paid
o
o
Revenue is recorded when earned, rather than when cash is
received
Expenses are recorded when goods or services are consumed
or used, rather than when cash is paid
Copyright ©2017 John Wiley & Sons Canada, Ltd.
8
Cash Basis Accounting
• Revenue is recorded only when cash is received
• Expenses are recorded only when cash is paid
• Can lead to misleading information for decisionmaking:
Timing differences between the occurrence of the actual event
and its related cash flows
o Revenue and expenses can be manipulated by timing the
receipt and payment of cash
o
Copyright ©2017 John Wiley & Sons Canada, Ltd.
9
Chapter 4 - Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.
Copyright ©2017 John Wiley & Sons Canada, Ltd.
10
Unadjusted Trial Balance
• Prepared before all adjusting entries have been recorded
and posted
• Shows the balances of all accounts at the end of the
accounting period, before those accounts that have been
adjusted
• Proves total debit balances and total credit balances are
equal before the adjusting entries have been made
• The main source for preparation of financial statements
Copyright ©2017 John Wiley & Sons Canada, Ltd.
11
Adjusting Entries
• Entries made to adjust or update accounts at the end
of the accounting period
• Required because the trial balance may not contain
complete and up-to-date data
o
o
o
Some items are not recorded daily
Some costs are not recorded during the accounting period,
as they expire due to the passage of time
Some items may be unrecorded
Copyright ©2017 John Wiley & Sons Canada, Ltd.
12
Types of Adjusting Entries
Begin underline
Begin underline
Prepayments
• Prepaid expenses
• Unearned revenues
Accruals
• Accrued expenses
• Accrued revenues
end underline
end underline
Copyright ©2017 John Wiley & Sons Canada, Ltd.
13
Prepaid Expenses
• Cash payments of expenses that will benefit more than
one accounting period recorded as assets
o
When expenses are prepaid, an asset (prepaid expenses) is
increased (debited) to show the future service or benefit, and
cash is decreased (credited)
• Expire with the passage of time or through use
o
Not practical to record this expiration on a daily basis, so done
when statements are prepared
• Adjusting entry increases an expense account and
decreases the asset (prepaid) account
Copyright ©2017 John Wiley & Sons Canada, Ltd.
14
Unearned Revenue
• Cash received and recorded as liabilities before revenue
is earned
o
When the cash is received, cash is increased (debited), and a
liability account (unearned revenue) is increased (credited)
• The opposite of prepaid expenses
• Adjusting entry decreases the liability (unearned
revenue) account and increases a revenue account
o
Reflects amount of revenue earned in the period and the
remaining liability at the end of the period
Copyright ©2017 John Wiley & Sons Canada, Ltd.
15
Chapter 4 - Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.
Copyright ©2017 John Wiley & Sons Canada, Ltd.
16
Accruals
• Accruals have not been recognized at all until an
adjustment is made
• Expenses that have been incurred, but not yet paid or
recorded (accrued expenses)
o
Adjusting entry results in an increase to both an expense and
a liability account
• Revenues that have been earned, but not received in
cash (accrued revenues)
o
Adjusting entry results in an increase to both an asset and a
revenue account
Copyright ©2017 John Wiley & Sons Canada, Ltd.
17
Summary of Basic Relationships
Type of
Adjustment
Transaction Journal Entry
during Period
Accounts before Adjustment
Adjusting Entry
Prepayments
Blank
Blank
Blank
Prepaid expenses
Dr. Prepaid Expenses
Cr. Cash (or Accounts Payable)
Expenses understand and net income
overstated; assets and shareholder’s equity
overstated
A = L + SE
O = NE + O
Dr. Expenses
Cr. Prepaid Expenses
Unearned
revenue
Dr. Cash
Cr. Unearned Revenue
Revenues and net income understated;
liabilities overstated and shareholder’s
equity understated
A = L + SE
NE = O + U
Dr. Unearned Revenue
Cr. Revenue
Accruals
Blank
Blank
Blank
Accrued expenses
None
Expenses understated and net income
overstated; liabilities understated and
shareholder’s equity overstated
A = L + SE
NE = U + O
Dr. Expense
Cr. Payable
Accrued revenues
None
Revenue and net income understated; assets
and shareholder’s equity understated
A = L + SE
U = NE + U
Dr. Receivable
Cr. Revenue
Copyright ©2017 John Wiley & Sons Canada, Ltd.
18
Chapter 4 - Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.
Copyright ©2017 John Wiley & Sons Canada, Ltd.
19
Adjusted Trial Balance
• Prepared after all adjusting entries have been recorded
and posted
• Shows the balances of all accounts at the end of the
accounting period, including those accounts that have
been adjusted
• Proves total debit balances and total credit balances are
equal after the adjusting entries have been made
• The main source for preparation of financial statements
Copyright ©2017 John Wiley & Sons Canada, Ltd.
20
Closing Entries
• Revenue, expense, and dividends declared accounts are
components of retained earnings considered to be
temporary accounts.
• Statement of financial position accounts carry forward
into the future
o
Considered to be permanent accounts
• Closing entries
o
o
Temporary account balances are transferred to Retained
Earnings
Produce a zero balance in the temporary accounts to prepare
them for the next period’s activity
Copyright ©2017 John Wiley & Sons Canada, Ltd.
21
Temporary and Permanent Accounts
Temporary Accounts
Normal Balances
Revenues
Credit
Expenses
Debit
Dividends Declared
Debit
Permanent Accounts
Normal Balances
Assets
Debit
Liabilities
Credit
Shareholder’s equity accounts:
Common Shares
Retained Earnings
Credit
Credit
Copyright ©2017 John Wiley & Sons Canada, Ltd.
22
The Closing Process - in this order
1. Close revenue accounts:
Debit each revenue account for its balance and credit
Income Summary the total revenue amount
2. Close expense accounts:
Debit Income Summary for the total expense amount and
credit each expense account for its balance
3. Close Income Summary:
Debit (or credit) Income Summary for the balance in the
account and credit (debit) Retained Earnings
4. Close Dividends Declared account:
Debit Retained Earnings and credit Dividends Declared
account for the balance
Copyright ©2017 John Wiley & Sons Canada, Ltd.
23
The Closing Process Illustrated
Copyright ©2017 John Wiley & Sons Canada, Ltd.
24
Post-Closing Trial Balance
• Lists all permanent accounts and their balances after all
closing entries are journalized and posted
• Proves that total debit balances and total credit balances
are equal after the closing entries have been made
Copyright ©2017 John Wiley & Sons Canada, Ltd.
25
Summary of the Accounting Cycle
Chapter 3
1. Analyze transactions
2. Journalize the transactions
3. Post to the ledger accounts
4. Prepare a trial balance
Chapter 4
5. Journalize and post adjusting entries
6. Prepare an adjusted trial balance
7. Prepare financial statements
8. Journalize and post closing entries
9. Prepare a post-closing trial balance
Copyright ©2017 John Wiley & Sons Canada, Ltd.
26