Chapter 3

ACCRUAL ACCOUNTING CONCEPTS

LO 1: Explain the accrual basis of accounting and the reasons for adjusting
entries.
• Periodicity Assumption: Accounting divides the economic life of a business into artificial time
periods (ex: month, quarter, or year)
o Fiscal Year: an accounting time period that is one year long.
• Revenue Recognition Principle: requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied (when the money is EARNED, not collected.)

Ex: John mowed Danny’s lawn for $40 on May 15. Danny didn’t have the money to pay John until May
26. What are the journal entries for George on May 15 and May 26?

• Expense Recognition (Matching) Principle: requires that companies match expenses with revenues
in the period when the company makes efforts to generate those revenues. (when the expense has
been INCURRED, not paid.)
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ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-Basis Accounting

• Transactions recorded in the periods in which the events occur.

• Revenues are recognized when services performed, even if cash was not received.
• Expenses are recognized when incurred, even if cash was not paid.

Cash-Basis Accounting

• Revenues are recognized only when cash is received.

• Expenses are recognized only when cash is paid.
• Not in accordance with generally accepted accounting principles (GAAP).

Ex: Suppose that P Company paints a large office building in 20 YR 1. In 20 YR 1, it incurs and pays total
expenses (salaries and paint costs) of $30,000. It bills the customer $50,000, but does not receive
payment until 20 YR 2.
Accrual Basis Cash Basis
Revenue $ 50,000 Revenue $ -
20 YR 1 Expenses $ 30,000 20 YR 1 Expenses $ 30,000
Net Income $ 20,000 Net Income $ (30,000)

20 YR 2 Revenue $ - 20 YR 2 Revenue $ 50,000

Expenses $ - Expenses $ -
Net Income $ - ADJUSTING Net Income $ 50,000 ENTRIES
• Ensure that the revenue recognition and expense recognition principles are followed.
• Required every time a company prepares financial statements.
• Includes one income statement account and one balance sheet account.

Types of Adjusting Entries

Deferrals:

1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned revenues: Cash received before service are performed.

Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

*ADJUSTING ENTRIES NEVER INVOLVE CASH

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LO 2: Prepare adjusting entries for deferrals.

DEFERRALS
1. PREPAID EXPENSES: Cash payment BEFORE expense is recorded.
• Costs that expire either with the passage of time or through use.
• Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit)
to an asset account.

Examples of Prepaid Expenses (Assets): Supplies, Prepaid insurance, Prepaid Advertising, Prepaid Rent,
Equipment, and Buildings.
*Adjusted because they have been USED or CONSUMED in the business operations.

Ex (Prepaid Insurance): Jones Co. pays $5,000 for Insurance for 24 months on January 1. What is the
journal entry on January 1 and the adjusting entry at the END of the year when 12 months of the
insurance is USED UP?

INSURANCE EXPENSE
Dec. 31 $2,500

Balance $2,500

PREPAID INSURANCE
Jan. 1 $5,000 Dec. 31 $2,500

Balance $2,500

($5,000/24 months) * 12 months

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Depreciation: the process of allocating the cost of an asset to expense (depreciation) over its useful life.

• Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an
expense, in the year acquired.
• Depreciation does not attempt to report the actual change in the value of an asset.

• “Using Up” of these long-lived fixed assets is debited to depreciation expense and the account that is
credited is the accumulated depreciation account which is a contra-asset
(Normal Balance is a CREDIT….opposite of an asset.)

• For journal entry think of the term DEAD to help you remember.

Ex: Bob’s office equipment depreciated by $300 during the year. The journal entry to record
depreciation on December 31 is

• The difference between the original cost of the office equipment and the balance in the
accumulated depreciation—office equipment account is called the BOOK VALUE OF THE ASSET
(or net book value).

• It is computed as follows:

Book Value of Asset = Cost of the Asset – Accumulated Depreciation of Asset

Ex: Cost of Equipment= $50,000 (on balance sheet)

Accumulated Depreciation-Equipment= $40,000
Book Value = $50,000 - $40,000
Book Value= $10,000

SUMMARY
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2. UNEARNED REVENUES: Cash receipt BEFORE revenue is recorded.

• Adjusting entry is made to record the revenue for services performed during the period and to show
the liability that remains.
• Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a
revenue account.

Examples of Unearned Revenue (Liability): Unearned Rent, Unearned Ticket Revenue, Unearned
Subscription Revenue, Unearned Service Revenue, and Customer Deposits.
*Adjusted because originally when cash is received services weren’t provided so a liability was recorded.
By the end of the accounting period some services were provided to the customer.

Ex: Tom receives $50 from his neighbor Dave before mowing the lawn on August 25 because Dave is
going on vacation. Tom mows Dave’s lawn on September 5. Prepare the journal entries for Tom for both
days.
Service Revenue
Sept. 5 $50

Balance $50

Unearned Service Revenue

Sept. 5 $50 Aug. 25 $50

Balance $0

SUMMARY
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LO 3: Prepare adjusting entries for accruals.

ACCRUALS
3. ACCRUED REVENUES: Revenue recorded BEFORE cash receipt.
• An adjusting entry serves 2 purposes:
1. Shows the receivable that exists.
2. Records the revenues for services performed.

Examples of Accrued Revenue: Rent Revenue, Interest Revenue, and Service Revenue.
*Adjusted because services have been provided to the customer, but have not been billed or recorded.
Interest has been earned, but has not been received or recorded.

Ex: George shoveled Kim’s driveway for $30 on December 20. Kim didn’t have the money to pay George
until December 28. What are the journal entries for George on December 20 and December 28?

SUMMARY
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4. ACCRUED EXPENSES: Expenses recorded BEFORE cash payment.

• An adjusting entry serves 2 purposes:
1. Records the obligations (payable).
2. Recognizes the expenses.

Examples of Accrued Expenses: Interest, Taxes, Utilities, and Salaries.

*Adjusted because expenses were incurred but have not been paid or recorded.

Ex (Salaries and Wages): Employees of Lincoln Co. are paid $5,000 every 2 weeks. If December 31 occurs
at the end of the 1st week of the pay period what journal entry is made? When the payment for the 2
week pay period actually happens January 7 what is the journal entry?

($5,000/ 2 weeks)

Salaries and Wages Expense- Current Year Salaries and Wages Payable- Current Year
Dec. 31 $2,500 Dec. 31 $2,500

Balance $2,500 Balance $2,500

Labor occurred in the current year

(last week of December)
Labor occurred next year
(first week of January)

Salaries and Wages Expense- Next Year Salaries and Wages Payable- Current Year
Jan. 7 $2,500 Jan. 7 $2,500 Dec. 31 $2,500
Balance $2,500
*Expenses are closed out at YEAR END Balance $0
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Ex (Interest): M Corporation signed a three-month note payable in the amount of $8,000 on

November 1. The note requires M Corporation to pay interest at an annual rate of 10%. What is the
adjusting entry to record the accrual of interest in November?

Face Value of Note × Annual Interest Rate × Time in Terms of One Year = Interest
$8,000 x 10% x (1/12) = 66.67 ≈ $67

SUMMARY

LO 4: Prepare an Adjusted Trial Balance

• Adjusted Trial Balance: Prepared after

all adjusting entries are journalized
and posted to the ledger accounts.
o Purpose is to prove the
EQUALITY of debit
balances and credit
balances in the ledger.
o The primary basis for the
preparation of the financial
statements.

• Order the financial statements are

prepared from the adjusted trial
balance.
1. Income Statement
2. Owner’s Equity Statement
3. Balance Sheet
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Companies can prepare financial statements directly from the adjusted trial balance.
Illustrations below present the interrelationships of data in the adjusted trial balance
and the financial statements.

1. Preparation of the Income Statement and Owner’s Equity statement from the
adjusted trial balance
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2. Preparation of the Balance Sheet from the adjusted trial balance