ACCRUAL ACCOUNTING CONCEPTS

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• ACCRUAL ACCOUNTING CONCEPTS

Financial Accounting, Sixth Edition
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Study 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.

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Accrual Accounting Concepts
Timing Issues
The Basics of Adjusting Entries
The Adjusted Trial Balance and Financial
Statements
Closing the Books
Quality of Earnings

• Types of adjusting entries
• Adjusting entries for deferrals
• Adjusting entries for accruals
• Summary of basic relationships

• Revenue recognition principle
• Expense recognition principle
• Accrual versus cash basis of accounting

• Preparing the adjusted trial balance
• Preparing financial statements

• Preparing closing entries
• Preparing a post-closing trial balance
• Summary of the accounting cycle

• Earnings management
• Sarbanes-Oxley

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Timing Issues
Accountants divide the economic life of a
business into artificial time periods
(Periodicity Assumption).
. . . . .
Jan.
Feb.
Mar.
Apr.
Dec.

• Generally a month, a quarter, or a year.
• Fiscal year vs. calendar year

SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Timing Issues
The Revenue Recognition Principle
Companies recognize revenue in the accounting
period in which it is earned. In a service
enterprise, revenue is considered to be earned at
the time the service is performed.
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Timing Issues
Illustration Assume Conrad Dry Cleaners cleans
clothing on June 30, but customers do not claim
and pay for their clothes until the first week of
July. The journal entries for June and July
would be
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Timing Issues
Illustration 4-1 (Partial)
Let the expenses follow the revenues. This is
commonly referred to as the Matching Principle.
SO 1 Explain the revenue recognition principle
and the expense recognition principle.
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Timing Issues
Accrual versus Cash Basis of Accounting

• Accrual-Basis Accounting
• Transactions recorded in the periods in which the
  events occur.
• Revenues are recognized when earned, even if cash
  was not received.
• Expenses are recognized when incurred, even if
  cash was not paid.

SO 2 Differentiate between the cash basis and
the accrual basis of accounting.
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Timing Issues
Accrual versus Cash Basis of Accounting

• Cash-Basis Accounting
• Revenues are recognized only when cash is
  received.
• Expenses are recognized only when cash is paid.
• Prohibited under generally accepted accounting
  principles (GAAP).

SO 2 Differentiate between the cash basis and
the accrual basis of accounting.
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Timing Issues
Illustration Suppose that Fresh Colors paints a
large building in 2011. In 2011, it incurs and
pays total expenses (salaries and paint costs) of
50,000. It bills the customer 80,000, but does
not receive payment until 2012.
Illustration 4-2 (Partial)
SO 2 Differentiate between the cash basis and
the accrual basis of accounting.
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The Basics of Adjusting Entries

• Adjusting entries are necessary for accounts to
  reflect Economic Reality at the financial
  statement date.
• Adjusting entries make it possible to report
  correct amounts on the balance sheet and on the
  income statement.
• A company must make adjusting entries every time
  it prepares financial statements.
• Includes one income statement account and one
  balance sheet account.

SO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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The Basics of Adjusting Entries

• Revenues - recorded in the period in which they
  are earned.
• Expenses - recognized in the period in which they
  are incurred.
• Adjusting entries - needed to ensure that the
  revenue recognition and expense recognition
  (Matching) principles are followed.

SO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Types of Adjusting Entries
Illustration 4-3 Categories 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
and reported as liabilities before revenue is
earned. Accruals 1. Accrued revenues Revenues
earned but not yet received in cash or
recorded. 2. Accrued expenses Expenses incurred
but not yet paid in cash or recorded.
SO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Types of Adjusting Entries
Trial Balance Each account is analyzed to
determine whether it is complete and up-to-date.
Does it reflect Economic Reality?
Illustration 4-4
SO 3 Explain why adjusting entries are needed,
and identify the major types of adjusting entries
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Adjusting Entries for Deferrals

• Deferrals are either
• Prepaid expenses
• OR
• Unearned revenues.

SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses

• Prepaid Expenses
• 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.

SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses
Illustration Sierra Corporation purchased
supplies costing 2,500 on October 5. Sierra
recorded the purchase by increasing (debiting)
the asset Supplies. This account shows a balance
of 2,500 in the October 31 trial balance. An
inventory count at the close of business on
October 31 reveals that 1,000 of supplies are
still on hand.
Supplies Expense
1,500
Oct. 31
Supplies
1,500
(2,500 1,000 1,500)
Illustration 4-6 (Partial)
SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses
Illustration On October, 4 Sierra Corporation
paid 600 for a one-year fire insurance policy.
Coverage began on October 1. Sierra recorded the
payment by increasing (debiting) Prepaid
Insurance. This account shows a balance of 600
in the October 31 trial balance. Insurance of
50 (600 12) expires each month.
Insurance Expense
50
Oct. 31
Prepaid Insurance
50
Illustration 4-7 (Partial)
SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses

• Depreciation
• Buildings, equipment, and motor vehicles
  (long-lived assets) are recorded as assets,
  rather than an expense, in the year acquired.
• Companies report a portion of the cost of a
  long-lived asset as an expense (depreciation)
  during each period of the assets useful life.
• Depreciation does not attempt to report the
  actual change in the value of the asset.

SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses
Illustration For Sierra Corporation, assume
that depreciation on the office equipment is 480
a year, or 40 per month.
Depreciation Expense
40
Oct. 31
Accumulated Depreciation-Equipment
40
Illustration 4-8 (Partial)
SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Prepaid Expenses

• Statement Presentation
• Accumulated Depreciation-Equipment is a contra
  asset account.
• Appears just after the account it offsets
  (Equipment) on the balance sheet.

Illustration 4-9
SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Unearned Revenues

• Receipt of cash that is recorded as a liability
  because the revenue has not been earned.

Cash Receipt
Revenue Recorded
BEFORE
Unearned revenues often occur in regard to

• magazine subscriptions
• customer deposits

• rent
• airline tickets

SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Unearned Revenues

• Unearned Revenues
• Adjusting entry to record the revenue that has
  been earned 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.

SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Unearned Revenues
Illustration Sierra Corporation received 1,200
on October 2 from R. Knox for guide services for
multi-day trips expected to be completed by
December 31. Unearned Service Revenue shows a
balance of 1,200 in the October 31 trial
balance. From an evaluation of the service
Sierra performed for Knox during October, the
company determines that it has earned 400 in
October.
Unearned Service Revenue
400
Oct. 31
Service Revenue
400
Illustration 4-12 (Partial)
SO 4 Prepare adjusting entries for deferrals.
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Adjusting Entries for Accruals

• Made to record
• Revenues earned and
• OR
• Expenses incurred
• in the current accounting period that have not
  been recognized through daily (routine) entries.

SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Revenues
Accrued Revenues An adjusting entry serves two
purposes (1) Shows the receivable that
exists, and (2) Records the revenues earned.
SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Revenues
Illustration In October, Sierra Corporation
earned 200 for guide services that were not
billed to clients before October 31.
Accounts Receivable
200
Oct. 31
Service Revenue
200
Illustration 4-15
SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Expenses
Accrued Expenses An adjusting entry serves two
purposes (1) Records the obligations,
and (2) Recognizes the expenses.
SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Expenses
Illustration Sierra Corporation signed a
three-month note payable in the amount of 5,000
on October 1. The note requires Sierra to pay
interest at an annual rate of 12.
Illustration 4-18
Interest Expense
50
Oct. 31
Interest Payable
50
Illustration 4-19 (Partial)
SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Expenses
Illustration Sierra Corporation last paid
salaries on October 26 the next payment of
salaries will not occur until November 9. The
employees receive total salaries of 2,000 for a
five-day work week, or 400 per day. Thus,
accrued salaries at October 31 are 1,200 (400
3 days).
Illustration 4-20
SO 5 Prepare adjusting entries for accruals.
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Adjusting Entries for Accrued Expenses
Illustration Sierra Corporation last paid
salaries on October 26 the next payment of
salaries will not occur until November 9. The
employees receive total salaries of 2,000 for a
five-day work week, or 400 per day. Thus,
accrued salaries at October 31 are 1,200 (400 x
3 days).
Salaries Expense
1,200
Oct. 31
Salaries Payable
1,200
Illustration 4-21
SO 5 Prepare adjusting entries for accruals.
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Summary of Basic Relationships
SO 5 Prepare adjusting entries for accruals.
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The Adjusted Trial Balance
After all adjusting entries are journalized and
posted the company prepares another trial balance
from the ledger accounts (Adjusted Trial
Balance). The adjusted trial balances purpose is
to prove the equality of debit balances and
credit balances in the ledger. The adjusted
trial balance is the primary basis for the
preparation of the financial statements.
SO 6 Describe the nature and purpose of the
adjusted trial balance.
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The Adjusted Trial Balance
SO 6
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Preparing Financial Statements
Financial statements are prepared directly from
the Adjusted Trial Balance.
Balance Sheet
Income Statement
Retained Earnings Statement
SO 6 Describe the nature and purpose of the
adjusted trial balance.
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Preparing Financial Statements
Illustration 4-27
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Preparing Financial Statements
Illustration 4-28
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Closing the Books
At the end of the accounting period, companies
transfer the temporary account balances to the
permanent stockholders equity accountRetained
Earnings.
Illustration 4-29
SO 7 Explain the purpose of closing entries.
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Closing the Books
In addition to updating Retained Earnings to its
correct ending balance, closing entries produce a
zero balance in each temporary account.
Illustration 4-30
SO 7 Explain the purpose of closing entries.
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Closing the Books

• There are 4 Closing Entries
• Close all revenue accounts to income summary.
• Close all expense accounts to income summary.
• Close income summary to R.E.
• Close dividends to R.E.
• Thats all there is to it!

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Closing the Books
2012
Illustration 4-31
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Preparing a Post-Closing Trial Balance
The purpose of the post-closing trial balance is
to prove the equality of the permanent account
balances that the company carries forward into
the next accounting period.
All temporary accounts will have zero balances.
SO 7 Explain the purpose of closing entries.
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Summary of the Accounting Cycle
Illustration 4-33 Required steps in
the accounting cycle
1. Analyze business transactions
2. Journalize the transactions
9. Prepare a post-closing trial balance
8. Journalize and post closing entries
3. Post to ledger accounts
7. Prepare financial statements
4. Prepare a trial balance
6. Prepare an adjusted trial balance

• Journalize and post adjusting entries
• Deferrals/Accruals

SO 8 Describe the required steps in the
accounting cycle.
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Quality of Earnings
Quality of Earnings company provides full and
transparent information. Earnings Management -
the planned timing of revenues, expenses, gains,
and losses to smooth out bumps in net income.
Companies may manage earnings by

• one-time items to prop up earnings numbers.
• inflate revenue numbers in the short-run.
• improper adjusting entries.

As a result of the Sarbanes-Oxley Act, many
companies are trying to improve the quality of
their financial reporting.
SO 8 Describe the required steps in the
accounting cycle.