4

Accrual Accounting Concepts

Kimmel ● Weygandt ● Kieso

Accounting, Sixth Edition
4-1
 CHAPTER OUTLINE
LEARNING OBJECTIVES

Explain the accrual basis of accounting and the

1 reasons for adjusting entries.

2 Prepare adjusting entries for deferrals.

3 Prepare adjusting entries for accruals.

4 Prepare an adjusted trial balance and closing entries.

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4-3
 Explain the accrual basis of accounting and
LEARNING
OBJECTIVE 1 the reasons for adjusting entries.

Accountants divide the economic life of a business into

artificial time periods Periodicity/Time Period Assumption.
.....
Jan. Feb. Mar. Apr. Dec.

 Generally a month, a quarter, or a year.

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 ACCRUAL VERSUS CASH BASIS

Accrual-Basis Accounting
► Transactions recorded in the periods in which the
events occur.
 Companies recognize revenues when they
perform services (rather than when they receive
cash).
 Expenses are recognized when incurred (rather
than when paid).

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 ACCRUAL VERSUS CASH BASIS

Cash-Basis Accounting
 Revenues are recorded when cash is received.
 Expenses are recorded when cash is paid.
 Cash-basis accounting is not in accordance
with generally accepted accounting principles
(GAAP). Only micro-businesses might use it
as well as government entities (MoF accrual
accounting project)

4-6 LO 1
 MoF accrual accounting project

 Saudi Arabia’s adoption of the accrual basis accounting program aims to play an effective role
in providing financial data that help measure performance, analyze gaps and seize available
opportunities in light of financial performance.
 The Kingdom’s transition from cash to accrual accounting was not just a technical
requirement. It will help developing effective financial policies.

 In addition, the successful shift will allow the government entities to have an integrated
financial system, based on international accounting standards for public sector called:
 International Public Sector Accounting Standards (IPSAS)

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 ACCRUAL VERSUS CASH BASIS

Illustration: Suppose that Fresh Colors paints a large

building in 2016. In 2016, 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 2017.

2016 2017

ILLUSTRATION 4-2
Accrual-versus cash-basis accounting
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 Recognizing Revenues and Expenses
Illustration 3-1
GAAP relationships in revenue
and expense recognition

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 THE NEED FOR ADJUSTING ENTRIES

Adjusting entries
 Ensure that the revenue recognition and
expense recognition principles are followed.
 Necessary because the trial balance may not
contain up-to-date and complete data.
 Required every time a company prepares
financial statements.

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 Types of Adjusting Entries

Deferrals Accruals

1. Prepaid Expenses + Supplies 1. Accrued Revenues.

+ Depreciation Expenses paid in Revenues for services
cash and recorded as assets before they performed but not yet received
are used or consumed. in cash.
(Expenses paid in advance)
(Owned Revenues, no cash yet)
2. Accrued Expenses.
2. Unearned Revenues.
Expenses incurred but not yet
Cash received before services
paid in cash.
are performed. (Owned Expenses, no cash
(Revenues received in
yet)
advance)
Illustration 3-2
Categories of adjusting entries

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 Adjusting Entries for Deferrals

Made to record expenses or revenues that are

recognized at a date later than the point when cash was
originally exchanged. There are two types:

 Prepaid expenses (including supplies and

depreciation)
OR
 Unearned revenues

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 Prepaid Expenses

Expenses paid in cash before they are used or consumed.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to:

 insurance  rent
 supplies  equipment
 advertising  buildings

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 Prepaid Expenses

Prepaid Expenses
 Costs that expire either with the passage of time or
through use.
 Adjusting entry:
► Increase (debit) to an expense account and
► Decrease (credit) to a prepaid expense account.

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 Prepaid Expenses_1

Illustration: On October 1, Pioneer

Advertising Inc. paid $600 for a one-year fire
insurance policy. Pioneer 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.
Oct. 1 Prepaid Insurance 600
Cash 600
Oct. 31 Insurance Expense 50
Prepaid Insurance 50
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 Prepaid Expenses_1
Illustration 3-6

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 Prepaid Expenses_2 (Supplies)

Illustration: Pioneer Advertising Inc. Inc.

purchased supplies costing $2,500 on
October 5. Pioneer 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.

Oct. 31 Supplies Expense 1,500

Supplies 1,500

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 Prepaid Expenses_2
Illustration 3-5

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 Prepaid Expenses_3 (Depreciation)

 Buildings, equipment, and motor vehicles (long-lived

assets) are recorded as assets, rather than an
expense, in the year acquired.
 Depreciation is the process of allocating the cost of
an asset to expense (depreciation) over its useful life.
 Depreciation does not attempt to report the actual
change in the value of the asset.

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 Prepaid Expenses_3 (Depreciation)

Illustration: For Pioneer Advertising, assume

that depreciation on the equipment is $480 a
year, or $40 per month.

Oct. 31

Depreciation Expense 40
Accumulated Depreciation 40

Accumulated Depreciation is called

a contra asset account.

Helpful Hint
All contra accounts have increases,
decreases, and normal balances opposite
to the account to which they relate.
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 Prepaid Expenses_3 (Depreciation)
Illustration 3-7

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 Prepaid Expenses_3 (Depreciation)

Statement Presentation
 Accumulated Depreciation- ▼ HELPFUL HINT
Equipment is a contra asset All contra accounts have
increases, decreases,
account. and normal balances
opposite to the account
 Appears just after the account it to which they relate.

offsets (Equipment) on the

balance sheet. ILLUSTRATION 4-9
Balance sheet presentation of
accumulated depreciation

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 Unearned Revenues

Receipt of cash recorded as a liability before services are

performed.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occur in regard to:

 rent  magazine subscriptions
 airline tickets  customer deposits

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 Unearned Revenues
 Adjusting entry is made to record the revenue for
services performed during the period and to show the
liability that remains at the end of the accounting period.
 Results in a decrease to unearned revenues
account (so debited because it is a liability account) and
an increase to revenue account (so credited because it
is a revenue account).

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 Unearned Revenues

Illustration: Pioneer Advertising Inc. received $1,200 on October

2 from R. Knox for advertising services expected to be completed
by December 31. Unearned Service Revenue shows a balance of
$1,200 in the October 31 trial balance. Analysis reveals that the
company performed $400 of services in October.

Oct. 2 Cash 1,200

Unearned Service Revenue 1,200

Oct. 31 Unearned Service Revenue 400

Service Revenue 400

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 Unearned Revenues
Illustration 3-11

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LO 2
 Debit Credit

Assets Liabilities

Equity *
Expenses
Revenues

Prepaid Expenses Unearned Revenues

Supplies
Depreciation Expense Accumulated Depreciation
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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment
$5,000
Unearned Service Revenue
9,200
An analysis of the accounts shows the following.
1. Insurance expires at the rate of $100 per month.
2. Supplies on hand total $800.
3. The equipment depreciates $200 a month.
4. During March, services were performed for $4,000 of the unearned
service revenue reported.
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Prepare the adjusting entries for the month of March.
 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment
$5,000
Unearned Service Revenue
9,200
Prepare the adjusting entries for the month of March.
1. Insurance expires at the rate of $100 per month.
Insurance Expense 100
SOLUTION
Prepaid Insurance 100
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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment
$5,000
Unearned Service Revenue
9,200
Prepare the adjusting entries for the month of March.
2. Supplies on hand total $800.
Supplies Expense 2,000
SOLUTION
Supplies 2,000
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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment
$5,000
Unearned Service Revenue
9,200
Prepare the adjusting entries for the month of March.
3. The equipment depreciates $200 a month.
Depreciation Expense
SOLUTION 200
Accumulated Depreciation 200
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 DO IT! 2 Adjusting Entries for Deferrals

The ledger of Hammond, Inc. on March 31, 2017, includes these selected
accounts before adjusting entries are prepared.
Debit Credit
Prepaid Insurance $ 3,600
Supplies 2,800
Equipment 25,000
Accumulated Depreciation—Equipment
$5,000
Unearned Service Revenue
9,200
Prepare the adjusting entries for the month of March.
4. During March, services were performed for $4,000 of the unearned
service revenue reported.
Unearned Service Revenue 4,000
SOLUTION
Service Revenue 4,000
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 Adjusting Entries for Accruals

Accruals are made to record:

 Revenues for services performed but not yet recorded at

the statement date (accrued revenues).
(Owned Revenues, no cash received yet)

OR
 Expenses incurred but not yet paid or recorded at the
statement date (accrued expenses).
(Owned Expenses, no cash paid yet)

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 ACCRUED REVENUES

Revenues for services performed but not yet received in

cash or recorded.
Adjusting entry results in:

Revenue Recorded BEFORE Cash Receipt

Accrued revenues often occur in regard to:

 rent
 interest
 services performed

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 ACCRUED REVENUES

Illustration: In October, Pioneer Advertising

Inc. performed services worth $200 that were
not received from clients in October.

Oct. 31
Accounts Receivable 200
Service Revenue 200

On November 10, Pioneer receives cash of $200 for the services

performed.

Nov. 10 Cash 200

Accounts Receivable 200
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 ACCRUED REVENUES
Illustration 3-14

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 ACCRUED EXPENSES

Expenses incurred but not yet paid in cash or

recorded.
Adjusting entry results in:

Expense Recorded BEFORE Cash Payment

Accrued expenses often occur in regard to:

 Interest  utilities
 taxes  salaries

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 ACCRUED EXPENSES

Illustration: Pioneer Advertising Inc. signed a three-month note

payable in the amount of $5,000 on October 1. The note requires
Pioneer to pay interest at an annual rate of 12%. Thus, the
accrued interest expense (interest payable) is: Illustration 3-17

Oct. 31 Interest Expense 50

Interest Payable 50

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 ACCRUED EXPENSES
Illustration 3-18

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 ACCRUED EXPENSES (Accrued Salaries)

Illustration: Sierra Corporation last paid employees' salaries on

October 26 but the accrued salaries at October 31 are $1,200.
Thus, the accrued salaries & wages expense is:

Oct. 31 Salaries and Wages Expense 1,200

Salaries and Wages Payable 1,200
ILLUSTRATION 4-21

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 ACCRUED EXPENSES (Accrued Salaries)
Illustration 3-20

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 Debit Credit

Assets Liabilities

Equity *
Expenses
Revenues

Accrued Revenues Accrued Expenses

(receivable) (payable)

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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. The following information relates to
August.
1. At August 31, the company owed its employees $800 in
salaries that will be paid on September 1.
2. On August 1, the company borrowed $30,000 from a bank on a
15-year mortgage. The annual interest rate is 10%.
3. Revenue for services performed but unrecorded for August
totaled $1,100.
Prepare the adjusting entries needed at August 31, 2017.
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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
1. At August 31, the company owed its employees $800 in
salaries that will be paid on September 1.

SOLUTION

Salaries and Wages Expense 800

Salaries and Wages Payable 800

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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
2. On August 1, the company borrowed $30,000 from a bank
on a 15-year mortgage. The annual interest rate is 10%.

SOLUTION

Interest Expense 250

Interest Payable 250

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 DO IT! 3 Adjusting Entries for Accruals

Micro Computer Services Inc. began operations on August 1, 2017.

At the end of August 2017, management attempted to prepare
monthly financial statements. Prepare the adjusting entries needed
at August 31, 2017.
3. Revenue for services performed but unrecorded for
August totaled $1,100.

SOLUTION

Accounts Receivable 1,100

Service Revenue 1,100

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 Using T-Account

Debit Credit

Assets Liabilities

Expenses Equity *

Revenues

Accrued Revenues Accrued Expenses

Prepaid Expenses Unearned Revenues
Supplies
Depreciation Expense Accumulated Depreciation
*: Dividends are debit account because they decrease equity
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 Prepare an adjusted trial balance
LEARNING
OBJECTIVE 4 and closing entries.

Analyze
Trial Adjusting
business Journalize Post
Balance Entries
transactions

Journalize
Adjusted Prepare Prepare a
and post
trial financial post-closing
closing
balance statements trial balance
entries

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 PREPARE 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 balance’s 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.

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 ILLUSTRATION 4-26
Adjusted trial balance

4-50 LO 4
 PREPARING FINANCIAL STATEMENTS

Financial
Financialstatements
statementsare
areprepared
prepareddirectly
directlyfrom
from the
the
Adjusted
AdjustedTrial
Trial Balance.
Balance.

Retained
Income Balance
Earnings
Statement Sheet
Statement

4-51 LO 4
 ILLUSTRATION 4-27
Preparation of the income statement and retained
4-52
4-68 earnings statement from the adjusted trial balance
 ILLUSTRATION 4-28
Preparation of the balance sheet
from the adjusted trial balance
4-53 LO 4
 Group activity

Prepare the following statements:

1- Income Statement
2- Retained Earning Statement
4-54 3- Balance Sheet
 Income Statement

4-55
 Retained Earning Statement

4-56
 Balance Sheet
& Equity

4-57
 CLOSING THE BOOKS

At the end of the accounting period, companies transfer the

temporary account balances to the permanent
stockholders’ equity account—Retained Earnings.

ILLUSTRATION 4-29
Temporary versus permanent accounts

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 Preparing Closing Entries

In addition to updating Retained Earnings to its correct

ending balance, closing entries produce a zero balance in
each temporary account.
ILLUSTRATION 4-30
The closing process

4-59 LO 4
4-60 ILLUSTRATION 4-31 LO 4
 Preparing Closing Entries

Illustration 4-32
Posting of closing entries

4-61 LO 4
 Preparing a Post-Closing Trail 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.

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 DO IT! 4b Closing Entries

Hancock Company has the following balances in selected accounts of its

adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close the revenue and expense accounts.
SOLUTION
Service Revenue 98,000
Income Summary 98,000
Income Summary 80,000
Salaries and Wages Expense 51,000
Rent Expense 22,000
Supplies Expense 7,000
4-63 LO 4
 DO IT! 4b Closing Entries

Hancock Company has the following balances in selected accounts of its

adjusted trial balance.
Accounts Payable $27,000 Dividends $15,000
Service Revenue 98,000 Retained Earnings 42,000
Rent Expense 22,000 Accounts Receivable 38,000
Salaries and Wages Expense 51,000 Supplies Expense 7,000
Prepare the entries to close income summary and dividends.
SOLUTION
Income Summary 18,000
Retained Earnings 18,000
Retained Earnings 15,000
Dividends 15,000

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 SUMMARY OF THE ACCOUNTING CYCLE

1.
1. Analyze
Analyze business
business transactions
transactions

9.
9. Prepare
Prepare aa post-closing
post-closing 2.
2. Journalize
Journalize the
the
trial
trial balance
balance transactions
transactions

8.
8. Journalize
Journalize and
and post
post 3.
3. Post
Post to
to ledger
ledger accounts
accounts
closing
closing entries
entries

7.
7. Prepare
Prepare financial
financial 4.
4. Prepare
Prepare aa trial
trial balance
balance
statements
statements

6.
6. Prepare
Prepare an
an adjusted
adjusted trial
trial 5.
5. Journalize
Journalize and
and post
post
balance
balance adjusting
adjusting entries:
entries:
Deferrals/Accruals
Deferrals/Accruals

ILLUSTRATION 4-33
Required steps in the accounting cycle
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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 SUMMARY OF THE ACCOUNTING CYCLE

ILLUSTRATION 4-33
Required steps in the accounting cycle

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 COPYRIGHT

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