ACCT 1235 – Introduction to Financial

Accounting I & II

Chapter 4

Accrual Accounting Concepts

Copyright ©2020 John Wiley & Sons, Inc.

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 and financial
statements.
LO 5: Prepare closing entries and a post-closing trial
balance.
Accrual Accounting
• Users require financial information on a regular basis
• Accounting divides the economic life of a business
into time periods
• Year, quarter (three months), month
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
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 Revenue is recorded when earned, rather than when
cash is received
o Expenses are recorded when goods or services are
consumed or used, rather than when cash is paid
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 decision-
making:
o 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
Revenue Recognition (1 of 2)
• Revenue: Increase in assets (or settlement of liabilities)
o Results from a company’s ordinary activities
• In general, revenue is recognized
o In a merchandising company when merchandise is sold and
delivered (point of sale)
o In a service company when the service is performed
• Under ASPE, revenue can be recognized when:
o Performance of an obligation is substantially complete
o Revenue can be reliably measured
o Collection is reasonably certain
Revenue Recognition (2 of 2)
• Under I F R S, revenues are recognized when a company
satisfies a performance obligation
• Five-step process to measure and report revenue:
1. Identify the contract with the client or customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance
obligations in the contract
5. Recognize revenue when (or as) the company satisfies the
performance obligation
Expense Recognition
• Expenses are recognized (recorded) when a decrease in
economic resources occurs:
o Assets are consumed (they decrease) or liabilities are
incurred (they increase)
o Due to company’s ordinary revenue-generating activities
• 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
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 Some items are not recorded daily
o Some costs are not recorded during the accounting
period, as they expire due to the passage of time
o Some items may be unrecorded because their amounts
are not known
Types of Adjusting Entries
• Prepayments
o Prepaid expenses
o Deferred revenues
• Accruals
o Accrued expenses
o Accrued revenues
Prepaid Expenses
• Cash payments of expenses that will benefit more than one
accounting period are 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 periodically, usually when statements are prepared
• Adjusting entry increases (credits) an expense account and
decreases (debits) the asset (prepaid) account
Deferred Revenues
• Cash received before revenue is earned
• Recorded as a liability to recognize the performance
obligation
o When the cash is received, cash is increased (debited), and a
liability account (deferred revenue) is increased (credited)
• The opposite of prepaid expenses
• Adjusting entry decreases the liability (deferred revenue)
account and increases a revenue account
o Reflects amount of revenue earned in the period
o Remaining balance is the liability at the end of the period
Accruals
• Accruals have not been recognized at all until an
adjustment is made
• Accrued expenses
o Expenses that have been incurred but not yet paid or
recorded
o Adjusting entry results in an increase to both an expense and
a liability account
• Accrued revenues
o Revenues that have been earned but not yet received in cash
o Adjusting entry results in an increase to both an asset and a
revenue account
Summary of Basic Relationships
Type of Adjustment Transaction Journal Entry during Period Accounts before Adjustment Adjusting Entry
Prepayments
Prepaid expenses Dr. Prepaid Expenses Expenses understated and net income Dr. Expenses
Cr. Cash (or Accounts Payable) overstated; assets and shareholder’s equity Cr. Prepaid Expenses
overstated
A = L + SE
O = NE + O
Deferred revenues Dr. Cash Revenues and net income understated; Dr. Deferred Revenue
Cr. Deferred Revenue liabilities overstated and shareholder’s Cr. Revenue
equity understated
A = L + SE
NE = O + U
Accruals
Accrued expenses None Expenses understated and net income Dr. Expense
overstated; liabilities understated and Cr. Payable
shareholder’s equity overstated
A = L + SE
NE = U + O
Accrued revenues None Revenue and net income understated; Dr. Receivable
assets and shareholder’s equity understated Cr. Revenue
A = L + SE
U = NE + U
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
Financial Statements
• Prepared in the following order:
1. Statement of income is prepared first using revenue and
expense accounts
2. Statement of changes in equity is prepared next, using equity
accounts and net income (loss) from the statement of income
3. Statement of financial position is prepared third, using asset,
liability and equity accounts
Closing Entries
• Revenue, expense, and dividends declared accounts are
components of retained earnings
o Considered to be temporary accounts.
• Statement of financial position accounts carry forward into the
future
o Considered to be permanent accounts
• Closing entries
o Temporary account balances are transferred to Retained Earnings
o Produce a zero balance in the temporary accounts to prepare them
for the next period’s activity
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 Credit
Retained Earnings Credit
The Closing Process
1. Close revenue accounts:
Debit each revenue account for its balance and credit Income Summary for
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
The Closing Process Illustrated
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
Review of the Accounting Cycle
1. Analyze transactions
2. Journalize the transactions
3. Post to the ledger accounts
4. Prepare a trial balance
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
IFRS and ASPE Review
Comparing IFRS and ASPE Review
Key Standard International Financial Reporting Accounting Standards for
Differences Standards (IFRS) Private Enterprises (ASPE)
Revenue recognition The following five-step process is used to Revenue is recognized when:
measure and reporting: 1. Performance is
1. Identify the contract with the client or substantially complete,
customer. 2. Revenue amount is able
2. Identify the performance obligations in to be reliably measured,
the contract. and
3. Determine the transaction price. 3. Collection is reasonably
4. Allocate the transaction price to the certain.
performance obligations in the contract.
5. Recognize revenue when (or as) the
company satisfies the performance
obligation.