CHAPTER 4
Accrual Accounting Concepts
Learning Objectives
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.
10. Describe the purpose and the basic form of a worksheet.
*11. Compare the procedures for revenue recognition under GAAP and IFRS.
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Chapter Outline
Learning Objective 1 - Explain the Revenue Recognition Principle and
the Expense Recognition Principle
 Determining the amount of revenues and expenses to report in a given
accounting period can be difficult.
 Accounting divides the economic life of a business into artificial time periods.
This is the periodicity assumption.
 Many transactions affect more than one of these periods. Determining the
amount of revenues and expenses to report in a given accounting period can be
difficult.
 Proper reporting requires an understanding of the nature of the
company’s business.
 Two principles are used as guidelines:
o Revenue recognition principle
o Expense recognition principle
 The revenue recognition principle requires that revenue be recognized in the
accounting period in which the performance obligation is satisfied. When a company
agrees to perform a service or sell a product to a customer, it has created a
performance obligation.
 A service company recognizes (records) revenue when the services are performed.
TEACHING TIP
Service businesses recognize revenue when the services are performed, although many
customers may have been billed for the services (on account). The cash has not been
received; however, the services have been performed. Therefore, revenue should be
recognized.
Does Delta Airlines record revenue when you buy a plane ticket on May 1 for a flight on June
15? Has the service been provided? The answer to both of these questions is no. Delta
cannot recognize revenue on May 1 because the service has not been provided. The
revenue will be recognized on June 15 when the ticket holder takes the flight.
 The expense recognition principle requires that efforts (expenses) be matched with
accomplishments (revenues).

4-2
The critical issue is determining when the expense makes its contribution to revenue.
Expenses need to be matched with the revenue in the period when the company
makes efforts to generate those revenues.
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TEACHING TIP
Returning to the service business example, suppose employees are paid every two weeks.
When preparing financial statements for May, the accountant realizes that employees were
last paid on Friday, May 22. By May 31, nine days have elapsed and many of the employees
have worked seven or more days. The wages of these employees must be included in
expenses.
The same accountant, however, notices that on May 1 the business renewed its insurance
coverage by paying the $12,000 premium on a one-year insurance policy. Is all of the
$12,000 an expense of May? No. The insurance policy will be in effect for 12 months.
Therefore, $1,000 ($12,000/12 months) should be recognized as expense each month.
Learning Objective 2 - Differentiate Between the Cash Basis and the Accrual
Basis of Accounting
 Accrual-basis accounting means that transactions that change a firm’s
financial statements are recorded in the periods in which the events occur, even
if cash was not exchanged.
 With cash basis accounting, revenue is recognized (recorded) when cash is received.
Expenses are recognized (recorded) only when cash is paid.
 Accrual basis accounting requires accountants to adhere to the revenue recognition
principle and the expense recognition principle.
 Cash basis accounting does not satisfy the requirements of Generally Accepted
Accounting Principles (GAAP), whereas accrual basis accounting does.
 Accrual basis accounting provides an objective measurement of net income.
TEACHING TIP
Return to the illustration of service businesses and the airlines. If the service business used
cash basis accounting, revenue would be recognized only when cash was received. Delta
would recognize revenue on May 1 when the ticket was purchased. All expenses of both a
service business and Delta would be recorded when cash was paid. Point out that with cash
basis accounting, the net income figure is easy to manipulate.
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TEACHING TIP
Explain to students that many businesses use the cash basis of accounting. These
businesses outgrow the method when accounts receivable and accounts payable become
substantial. Also, if the businesses need audited financial statements, they must comply with
GAAP and use the accrual basis. Remind them that companies can use the cash method
and that its use does not mean that income is being manipulated. Without this discussion,
some students may unfairly criticize an employer, relative or friend who is using the cash
basis of accounting.
Learning Objective 3 - Explain why Adjusting Entries are Needed, and Identify the
Major Types of Adjusting Entries
 Adjusting entries are needed to ensure that the revenue recognition and expense
recognition principles are followed.
 The trial balance may not contain up-to-date and complete data for several reasons:
 Some events are not recorded daily because it is not efficient to do so.
 Some costs are not recorded during the accounting period because these costs
expire with the passage of time rather than as a result of recurring daily
transactions.
 Some items may be unrecorded.
 Adjusting entries are required every time a company prepares financial statements.
 Every adjusting entry will include one income statement account and one balance
sheet account.
 Adjusting entries can be classified as either deferrals or accruals. Each of these
classes has two subcategories.
 Deferrals can be prepaid expenses or unearned revenues.
 Accruals are either accrued revenues or accrued expenses.
TEACHING TIP
Explain that cash is not adjusted at the end of the accounting period, thus students should
not use cash in the adjusting process.
4-4
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Learning Objective 4 - Prepare Adjusting Entries for Deferrals
Deferrals fall into two categories—prepaid expenses and unearned revenues.
 Prepaid expenses - expenses paid in cash and recorded as assets until they are used
or consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent
and insurance) or through use (i. e. supplies).
 Unearned revenues – cash received and recorded as liabilities before the services are
performed.

An adjusting entry for prepaid expenses will result in an increase (a debit) to an
expense account and a decrease (a credit) to an asset account.

An adjusting entry for unearned revenues will result in a decrease (a debit) to a
liability account and an increase (a credit) to a revenue account.

An adjusting entry for deferrals (prepaid expenses or unearned revenues) will
decrease a balance sheet account and increase an income statement account.
TEACHING TIP
Go through the examples of adjusting entries for the following deferrals including; insurance,
supplies, depreciation, and unearned revenue. Review the concepts of depreciation,
depreciation expense and accumulated depreciation.
TEACHING TIP
Discuss the effects on the income statement and balance sheet if adjustments are not made.
Learning Objective 5 - Prepare Adjusting Entries for Accruals
 Accruals fall into two categories—accrued revenues and accrued expenses.
 Accrued revenues - revenues for services performed but not yet received in cash or
recorded at the statement date.

an adjusting entry for accrued revenues will result in an increase (a debit)
in an asset account and an increase (a credit) to a revenue account.
 Accrued expenses - expenses incurred but not yet paid in cash or recorded at the
statement date.
 an adjusting entry for accrued expenses results in an increase (a debit) to an
expense account and an increase (a credit) to a liability account.
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
an adjusting entry for accruals (accrued revenues or accrued
expenses) increases both a balance sheet and an income statement
account.
TEACHING TIP
Go through the examples of adjusting entries for accrued interest, accrued salaries and
accrued revenues.
TEACHING TIP
Discuss the effects on the income statement and balance sheet if adjustments are not made.
Summary of basic relationships:
Type of Adjustment Accounts Before Adjustment
Prepaid expenses
Assets overstated
Expenses understated
Unearned revenues
Liabilities overstated
Revenues understated
Accrued revenues
Assets understated
Revenues understated
Accrued expenses
Expenses understated
Liabilities understated
Adjusting Entry
Dr. Expenses
Cr. Assets
Dr. Liabilities
Cr. Revenues
Dr. Assets
Cr. Revenues
Dr. Expenses
Cr. Liabilities
Learning Objective 6 - Describe the Nature and Purpose of the Adjusted Trial Balance
 The adjusted trial balance is prepared after all adjusting entries have been journalized
and posted.
 The adjusted trial balance shows the balances of all accounts, including those that have
been adjusted, at the end of the accounting period.
 The purpose of the adjusted trial balance is to prove the equality of the total debit balances
and total credit balances in the ledger after all adjustments.
 Financial statements are prepared from the adjusted trial balance.
TEACHING TIP
Show students an adjusted trial balance and demonstrate how easy it is to prepare financial
statements from the information contained in the trial balance.
4-6
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Learning Objective 7 - Explain the Purpose of Closing Entries
 Closing entries transfer net income (or net loss) and dividends to Retained Earnings.
 This causes the ending balance of Retained Earnings (amount shown on the
Balance Sheet) to agree with the balance shown on the Retained Earnings
Statement.

Close the revenue accounts to the Income Summary account.

Close the expense accounts to the Income Summary account.

Close the Income Summary account to Retained Earnings.

Close Dividends to Retained Earnings.
 Closing entries produce a zero balance in each temporary account (revenues,
expenses, and dividends)
 These accounts are then ready to accumulate data for the next accounting period.

Permanent accounts (assets, liabilities, common stock and retained earnings) are
not closed.
TEACHING TIP
Tell students to look at the date on the income statement in Illustration 4-27. The date is “For
the Month Ending October 31, 2014.” How can one be sure the revenues and expenses
reported on the income statement are just for that period? Closing entries transfer the
temporary account balances to the stockholders’ equity account and reduce the balances in
the temporary accounts to zero. Therefore, at the beginning of the period the temporary
accounts have a balance of zero and the revenues and expenses accumulated are for that
particular period.
 After the closing entries have been journalized and posted, a post-closing trial balance
is prepared.

The post-closing trial balance shows the balances of all of the permanent accounts.

The permanent account balances are carried forward to the next accounting period.

All of the temporary accounts have a zero balance.
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4-7
Learning Objective 8 - Describe the Required Steps in the Accounting Cycle
 Analyze business transactions.
 Journalize the transactions.
 Post to ledger accounts.
 Prepare a trial balance.
 Journalize and post adjusting entries—deferrals and accruals.
 Prepare an adjusted trial balance.
 Prepare financial statements:
 Income statement
 Retained earnings statement
 Balance sheet
 Journalize and post closing entries.
 Prepare a post-closing trial balance.
TEACHING TIP
Encourage students not to memorize the steps in the accounting cycle. Rather, they should
think about what must be done in order to “capture” the financial transactions and to make
sure the transactions are ultimately reported in the financial statements.
 Quality of Earnings
 Earnings management is the planned timing of revenues, expenses, gains, and losses
to smooth out bumps in net income.

The quality of earnings is greatly affected when a company manages earnings up or
down to meet some targeted earnings number.
 A company that has a high quality of earnings provides full and transparent
information that will not confuse or mislead users of the financial statements.

A company with questionable quality of earnings may mislead investors and
creditors, who believe they are relying on relevant and reliable information.
 Companies manage earnings in a variety of ways:

4-8
Use of one-time items to prop up earnings numbers (i.e. nonrecurring gains).
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
Inflate revenue numbers in the short-run (to the detriment of the long-run).

Improper adjusting entries
 As the result of investor pressure and the Sarbanes-Oxley Act, many companies are
trying to improve the quality of their financial reporting.
Learning Objective 9 – Understand the Causes of Differences Between Net
Income and Cash Provided by Operating Activities
 Net income is based on accrual basis accounting and is accomplished through the
adjusting entry process.
 Cash provided by operating activities is determined by comparing cash received from
operating activities to cash expenditures from operating activities.

Cash provided by operating activities is essentially net income determined under the
cash-basis of accounting.
TEACHING TIP
Discuss the example provided, paying particular attention to the differences between cashbasis and accrual-basis accounting when recognizing revenues and expenses.
Learning Objective 10 – Describe the Purpose and the Basic Form of a Worksheet

The worksheet is a multiple-column form that may be used in the adjustment process and
in preparing financial statements. Today most accountants use computer spreadsheets.

A worksheet is not a permanent accounting record.
TEACHING TIP
Use the worksheet, Illustration 4A-1, provided in the appendix to discuss its parts and how it
facilitates preparation of the financial statements.
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Learning Objective11- Compare the procedures for revenue recognition under GAAP
and IFRS.

IFRS It is often difficult for companies to determine in what time period they
should report particular revenues and expenses. Both the IASB and FASB
are working on a joint project to develop a common conceptual framework,
as well as a revenue recognition project, that will enable companies to better
use the same principles to record transactions consistently over time.
KEY POINTS
 In this chapter, you learned accrual-basis accounting applied under GAAP. Companies
applying IFRS also use accrual-basis accounting to ensure that they record transactions
that change a company’s financial statements in the period in which events occur.
 Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
 IFRS also divides the economic life of companies into artificial time periods. Under both
GAAP and IFRS, this is referred to as the periodicity assumption.
 IFRS requires that companies present a complete set of financial statements, including
comparative information annually.
 GAAP has more than 100 rules dealing with revenue recognition. Many of these rules
are industry-specific. In contrast, revenue recognition under IFRS is determined
primarily by a single standard. Despite this large disparity in the amount of detailed
guidance devoted to revenue recognition, the general revenue recognition principles
required by GAAP that are used in this textbook are similar to those under IFRS.
 Revenue recognition fraud is a major issue in U.S. financial reporting. The same
situation occurs in other countries, as evidenced by revenue recognition breakdowns at
Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer
Ahold NV.
 A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the
standard is based on the probability that the economic benefits associated with the
transaction will flow to the company selling the goods, providing the service, or
receiving investment income. In addition, the revenues and costs must be capable of
being measured reliably.
 Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows
depreciation based on revaluation of assets, which is not permitted under GAAP.
 The terminology used for revenues and gains, and expenses and losses, differs
somewhat between IFRS and GAAP. For example, income under IFRS is defined as:
Increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity,
other than those relating to contributions from shareholders.

4-10
Income includes both revenues, which arise during the normal course of
operating activities, and gains, which arise from activities outside of the
normal sales of goods and services. The term income is not used this way
under GAAP. Instead, under GAAP income refers to the net difference
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between revenues and expenses. Expenses under IFRS are defined as:
Decreases in economic benefits during the accounting period in the form
of outflows or depletions of assets or incurrences of liabilities that result in
decreases in equity other than those relating to distributions to
shareholders.

Note that under IFRS expenses include both those costs incurred in the
normal course of operations, as well as losses that are not part of normal
operations. This is in contrast to GAAP, which defines each separately.
 The procedures of the closing process are applicable to all companies whether they are
using IFRS or GAAP.
 LOOKING TO THE FUTURE: The IASB and FASB are now involved in a joint project on
revenue recognition. The purpose of this project is to develop comprehensive guidance
on when to recognize revenue. Presently, the Boards are considering an approach that
focuses on changes in assets and liabilities (rather than on earned and realized) as the
basis for revenue recognition. It is hoped that this approach will lead to more consistent
accounting in this area.
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Chapter 4 Review
 What is the revenue recognition principle? What is the expense recognition principle?
 What are the differences in the cash basis and the accrual basis of accounting? Which is
required by GAAP? Why?
 Why are adjusting entries needed? What are the major types of adjusting entries?
 Identify types of prepayments and discuss the adjusting entry for each. What happens if
the adjusting entry is not made?
 Identify types of accruals and discuss the adjusting entry for each. What happens if the
adjusting entry is not made?
 Describe the nature and purpose of the adjusted trial balance.
 Discuss the purpose of closing entries.
 List the required steps in the accounting cycle. Discuss quality of earnings issues.
4-12
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 Discuss the differences between net income and cash provided by operating activities.
How do cash-basis and accrual-basis accounting apply?
 Discuss the use of the worksheet in the preparation of the financial statements.
 Define the difference between the terminology used by GAAP and IFRS for revenues and
gains, and expenses and losses.
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Vocabulary Quiz
Name _______________
Chapter 4
1. Expenses paid in cash and recorded as assets before they are used or
consumed.
2. Entries at the end of an accounting period to transfer the balances of
temporary accounts to a permanent stockholders’ equity account,
Retained Earnings.
3. The process of allocating the cost of an asset to expense over its useful
life.
4. Cash received before a company earns revenues and recorded as a
liability until the services are performed.
5. The principle that dictates that efforts (expenses) be matched with
accomplishments (revenues).
6. Accounting basis in which companies record, in the periods in which the
events occur, transactions that change a company’s financial statements,
rather than in the periods in which the company receives or pays cash.
7. The principle that revenue be recognized in the accounting period in which
the services are performed.
8. Entries made at the end of an accounting period to ensure that the
revenue recognition and expense recognition principles are followed.
9. An account that is offset against an asset account on the balance sheet.
10. Expenses incurred but not yet received in cash or recorded.
4-14
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Solutions to Vocabulary Quiz
Chapter 4
1.
Prepaid expenses
2.
Closing entries
3.
Depreciation
4.
Unearned revenues
5.
Expense recognition principle
6.
Accrual basis accounting
7.
Revenue recognition principle
8.
Adjusting entries
9.
Contra asset account
10.
Accrued expenses
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4-15
Multiple Choice Quiz
Name _______________
Chapter 4
1.
Accountants have developed two principles to use as guidelines in determining the
amount of revenues and expenses to be reported in a given period. These principles
are the:
a.
cash basis accounting principle.
b.
revenue recognition principle.
c.
expense recognition principle.
d.
both cash basis accounting principle and revenue recognition principle are
correct.
2.
Which of the following is NOT true concerning cash basis accounting?
a.
Does not follow GAAP.
b.
Records revenue when cash is received.
c.
Matches expenses with the revenues they help to produce.
d.
Records expenses when cash is paid.
3.
In order for revenues to be recorded in the period in which the services are performed,
and for expenses to be recognized in the period in which they are incurred:
a.
adjusting entries are made.
b.
cash basis accounting is used.
c.
closing entries are made.
d.
none of these answer choices are correct.
4.
Unearned revenues are:
a.
deferrals.
b.
liabilities.
c.
temporary accounts.
d.
both deferrals and liabilities are correct.
5.
All of the following are examples of prepaid expenses except:
a.
prepaid rent.
b.
prepaid insurance.
c.
supplies.
d.
unearned revenues.
6.
Depreciation is:
a.
the wearing away of an asset.
b.
the process of an asset becoming obsolete.
c.
a valuation process.
d.
The process of allocating the cost of an asset to expense over its useful life.
4-16
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7.
Accumulated depreciation is a:
a.
contra asset account.
b.
contra revenue account.
c.
unearned revenue account.
d.
expense account.
8.
Which of the following companies would probably not have unearned revenue:
a.
Delta Airlines.
b.
Hurst Publishing Company.
c.
Poppa John’s Pizza.
d.
All State Insurance Company.
9.
Adjusting entries for accruals:
a.
are required in order to record revenues for services performed and expenses
incurred in the current accounting period that have not been recognized through
daily entries and thus are not yet reflected in the accounts.
b.
will increase both a balance sheet and an income statement account.
c.
are not required under GAAP.
d.
both are required in order to record revenues for services performed and
expenses incurred in the current accounting period that have not been
recognized through daily entries and thus are not yet reflected in the accounts
and will increase both a balance sheet and an income statement account are
correct.
10.
An assumption that the economic life of a business can be divided into artificial time
periods is the:
a.
cash basis assumption.
b.
accrual assumption.
c.
calendar year assumption.
d.
periodicity assumption.
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4-17
Solutions to Multiple Choice Quiz
Chapter 4
1.
d
2.
c
3.
a
4.
d
5.
d
6.
d
7.
a
8.
c
9.
d
10.
d
4-18
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Exercise 1 - World Wide Web Research, Accrual Accounting, and Financial
Statement Analysis Activity
Chapter 4
Refer to the financial statements in the Annual Report of Target Corporation to answer the
following questions. If researching the Web, go to http://www.target.com, click on Investor
relations, and then Annual Reports. Go to the most recent Annual Report.
1.
What is the date of the financial statements?
2.
What is the exact title of Target’s income statement?
3.
Which of the accounts found on the income statement and balance sheet (Statement of
Financial Position) have, most likely, been adjusted?
4.
Which of the accounts found on the income statement and balance sheet have been
created as a result of adjusting entries?
5.
What is the name of the accounting firm that conducted the external audit of Target?
6.
What is meant by ‘consolidated’ in the titles of the financial statements?
Solutions: Information available on website
Note: The website is constantly being updated. Please check to see that the
information requested in this exercise is available.
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4-19
Exercise 2 - Accrual Accounting Activity
Chapter 4
Your roommate, an accounting major, is working part time at Modern Dry Cleaners. She just
came home from work and is complaining because the owner wants her to prepare year-end
adjusting entries. “Roomie” contends that because the business is relatively small and
because they will not make “too significant” an impact on the financial condition of the
business, adjusting entries should not be prepared.
Use the space provided to try to convince your roommate that adjusting entries should be
made.
Solution:
Unless adjusting entries are made, financial statements will not be correct. Failure to
record adjusting entries violates the revenue recognition principle and the expense
recognition principle. In addition, accrual basis accounting is not being followed if
adjusting entries are not made.
Failure to record adjusting entries will, more than likely, cause revenues, expenses,
assets, liabilities, and owners’ equity accounts to be over- or under-stated.
4-20
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Exercise 3 - Accrual Accounting and Creative Activity
Chapter 4
Return to the financial statements prepared for the new business in Campus Town USA in
earlier chapters in answering the following questions:
1.
Determine which accounts should be adjusted and make the necessary adjustments.
2.
What would have been the consequences had you not made these entries? Be specific.
3.
Make the required closing entries.
4.
What would have been the consequences had you not made the closing entries?
(This activity is intended for group assignment)
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4-21
Exercise 4 - World Wide Web Research, Accrual Accounting, and Financial
Statements Activity
Chapter 4
Obtain an annual report for Tootsie Roll. If you are researching the Web go to
http://www.tootsie.com/. Using information found in the financial statements of the Annual
Report, make the following closing entries:
1.
Make journal entries to close the revenue and expense accounts.
2.
Make a journal entry to close the income summary account.
3.
Make a journal entry to close the dividend account.
4.
What is the date of the closing entries?
Solutions: Information available on website
Note: The website is constantly being updated. Please check to see that the
information requested in this exercise is available.
4-22
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Exercise 5 - Accrual Accounting and Creative Activity
Chapter 4
Refer to the income statement prepared for Joe’s Tees in the exercises for Chapter 2. Does
the income statement prepared in Chapter 2 violate rules of accrual accounting? (Pay
particular attention to the requirements of the expense recognition principle.)
1.
Amend the income statement so that it better conforms to the practice of accrual
accounting.
2.
Explain why the statements that you just prepared are superior to those you prepared in
Chapter 2.
Solutions
1.
2.
Revenues
Less Expenses:
Cost of shirts
Depreciation expense – cart
License
Net income
$8,000
$4,480
500
125
5,105
$2,895
This income statement is superior to the one prepared in Chapter 2
because it applies both the revenue recognition principle and the expense
recognition principle. By depreciating the cart, a portion of the cart’s
original cost is allocated to each accounting period that the cart is used to
produce revenues (expense recognition principle). Such expense
recognition provides a better indication of the company’s profitability each
period.
Copyright © 2013 John Wiley & Sons, Inc.
Kimmel, Financial Accounting, 7/e, Instructor’s Manual
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Exercise 6 - World Wide Web Research, Accrual Accounting
Chapter 4
Obtain an annual report for Tootsie Roll from your school library or on the World Wide Web. If
you are researching the Web go to http://www.tootsie.com/. Does Tootsie Roll use cash or
accrual accounting? Provide evidence to support your answer.
Solutions: Information available on website
Note: The website is constantly being updated. Please check to see that the
information requested in this exercise is available.
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Copyright © 2013 John Wiley & Sons, Inc.
Kimmel, Financial Accounting, 7/e, Instructor’s Manual
(For Instructor Use Only)
Exercise 7 - Accrual Accounting and Ethics Activity
Chapter 4
You have just graduated from the local University and landed what you had thought was a
great job as an accountant for Crazy House Interiors, an upscale design studio. Your
apartment is wonderful and you have made a lot of new friends. However, you boss has just
asked you to “do him a favor.” Crazy House is planning to ask one of the local banks for a
loan. However, there is some concern because this year’s revenues are considerably lower
than the revenues of the previous year.
One of the more talented designers has just landed a contract for a large, profitable project.
Half of the fee for the project is to be collected when the contract is signed at the end of this
week, with the remainder of the money due when the project is completed. Work will begin on
the project when the contract is signed.
Your boss has asked you to record the initial payment of $125,000 as revenue at the time the
money is received. Not wanting to disappoint the boss, you originally agreed to record the
transaction as he requested. However, you are having second thoughts about recording the
transaction and your ethical responsibilities.
What should you do? Why?
Solution:
Refuse to record the $125,000 advance as revenue until the services have been
performed. The $125,000 should be recorded as unearned revenue, a liability account,
until the job (or a portion of the job) is completed. In Chapter 1 of this text, you learned
that generally accepted accounting principles (GAAP) require accounting information to
be reliable. In order to be reliable accounting information must be verifiable and make a
faithful representation. Information is verifiable only if it is free of error. Faithful
representation means that the information is factual. If the $125,000 advance is reported
as revenue before the job is started the accounting information is neither “free of error”
nor “factual.” What makes this situation worse is the fact that individuals external to the
business are depending on this information in a decision making scenario. The decision
Copyright © 2013 John Wiley & Sons, Inc.
Kimmel, Financial Accounting, 7/e, Instructor’s Manual
(For Instructor Use Only)
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the bankers make will affect the bank, the banks’ stockholders, and the banks’
employees.
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Copyright © 2013 John Wiley & Sons, Inc.
Kimmel, Financial Accounting, 7/e, Instructor’s Manual
(For Instructor Use Only)
Exercise 8 - Accounting Insights Activity
Chapter 4
1.
Name at least three industries in which businesses would have unearned revenue?
2.
What is the source of these unearned revenues? Be specific in the examples you cite.
3.
When is the revenue recognized and what journal entry would be made at the time of
recognition?
Solutions:
1.
Airlines, magazine publishers, and insurance companies.
2.
Cash received for airline tickets purchased on June 1 for trips to be taken July 4
with a return on July 8, would be classified as unearned revenue.
Cash received on April 1 for 12-month subscriptions to a magazine would be
classified as unearned revenue.
Insurance companies have unearned revenue when they receive insurance
premiums covering policies of 3 month, 6 month, or 12 month periods.
3.
When the services have been performed (i.e. when the airline trip is taken, when
the magazine is mailed, or when a portion of the time covered by the insurance
policy passes), the revenue can be recognized. The journal entry to recognize
revenue would be to decrease unearned revenue (debit unearned revenue) and
increase revenue (credit revenue).
Copyright © 2013 John Wiley & Sons, Inc.
Kimmel, Financial Accounting, 7/e, Instructor’s Manual
(For Instructor Use Only)
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