Chapter 4 Accrual Accounting Concepts

Study Guide

Learning Objectives:
1. Explain the accrual basis of accounting and the 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.

Learning Objective 1: Explain the accrual basis of accounting and the reason for
adjusting entries.

Timing Issues:

The Periodicity Assumption requires accountants to divide the economic life of a

business into artificial time periods.

Companies recognize revenue in the accounting period in which the performance

obligation is satisfied (when service is performed). This is called the Revenue
Recognition Principle.

Expenses are matched with revenues in the period when efforts are expended to
generate revenues. This is called the Expense Recognition Principle.

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.
► Prohibited under generally accepted accounting principles.

Example:
Suppose that Fresh Colors paints a large building in 2024. In 2025, 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 2025.

Prepare income statements using the cash basis:

Income Statement-Cash Basis
2024 2025 Total
Cash Receipts 0 $80,000 $80,000
Cash Payments ($50,000) 0 ($50,000)
Net Income (Loss) ($50,000) $80,000 $30,000

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 Chapter 4 Accrual Accounting Concepts
Study Guide

Prepare income statements using the accrual basis:

Income Statement-Accrual Basis
2024 2025 Total
Revenues $80,000 0 $80,000
Expenses ($50,000) 0 ($50,000)
Net Income (Loss) $30,000 0 $30,000

Adjusting Entries

Adjusting entries make it possible to report correct amounts on the balance sheet
and on the income statement.
A company makes adjusting entries every time it prepares financial statements.
Includes one income statement account and one balance sheet account.
Needed to ensure that the revenue and expenses principles are followed.

Types of Adjusting Entries

Learning Objective 2: Prepare adjusting entries for deferrals.

DEFERRALS
To defer means to postpone or delay. Deferrals are revenues or expenses that
are recognized at a future date (the adjusting entry date) than the point
when was cash originally exchanged.

There are two types of deferrals: Prepaid Expenses and Unearned

Revenue.

1. 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.

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 Chapter 4 Accrual Accounting Concepts
Study Guide

Example (Supplies):
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.

What is the adjusting journal entry?

10/31 Supplies Expense 1,500

Supplies 1,500

Example (Prepaid Insurance):

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.

What is the adjusting journal entry?

10/31 Insurance Expense 50

Prepaid Insurance 50

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 Chapter 4 Accrual Accounting Concepts
Study Guide

Example (Depreciation):
For Sierra Corporation, assume that depreciation on the office equipment is $480 a
year, or $40 per month.

What is the adjusting journal entry?

10/31 Depreciation Expense 40

Accumulated Depreciation (contra asset) 40

Statement Presentation for Depreciation:

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

2. 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.

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Example:
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.

What is the adjusting journal entry?

10/31 Unearned Service Revenue 400

Service Revenue 400

Learning Objective 3: Prepare adjusting entries for accruals.

ACCRUALS

Revenues earned but not yet received in cash or recorded are called Accrued
Revenues.
Expenses incurred but not yet paid in cash or recorded are called Accrued
Expenses.

1. Accrued Revenues
This adjusting entry shows the receivable that exists.
Records the revenue earned.

Example:
In October, Sierra Corporation earned $200 for guide services that were not billed to
clients before October 31. What is the adjusting journal entry?

10/31 Accounts Receivable 200

Service Revenue 200

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2. Accrued Expenses
This adjusting entry records the liability (payable).
Recognizes the expense.
Example (Interest):
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%.

What is the adjusting journal entry?

10/31 Interest Expense 50

Interest Payable 50

Example (Salaries):
Sierra Corporation last paid salaries on October 26; the next payment of salaries will
occur on Nov. 9. The employees receive total salaries of $2,000 for a 5-day work week,
or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days).

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What is the adjusting journal entry?

10/31 Salaries Expense 1,200

Salaries Payable 1,200

Summary of Basic Relationships:

Type of Adjustment Accounts Before Adjustment Adjusting Entry

Prepaid Expenses Assets overstated Dr. Expense
Expenses understated Cr. Asset

Unearned Revenues Liabilities overstated Dr. Liability

Revenue understated Cr. Revenue

Accrued Revenue Assets understated Dr. Asset (Receivable)

Revenue understated Cr. Revenue

Accrues Expense Expenses understated Dr. Expense

Liabilities understated Cr. Liability (Payable)

Learning Objective 4: Prepare an adjusted trial balance and closing entries.

The Adjusted Trial Balance

This trial balance is prepared from the ledger accounts after all adjusting entries
are journalized and posted.

The purpose of the adjusted trial balance is to prove the equality of debits
balances and credits balances in the ledger.

The adjusted trial balance is the primary basis for the preparation of the financial
statements.

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Example of an Adjusted Trial Balance

Which financial statements are prepared directly from the Adjusted Trial Balance?

1. Income Statement

2. Retained Earnings Statement

3. Balance Sheet

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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 account—Retained Earnings.

 In addition to updating Retained Earnings to its correct ending balance, closing

entries produce a _______ balance in each ________________ account.

Date Closing Entries for Sierra Corp Debit Credit

1) Year End Service Revenue 10,600
Income Summary 10,600
(to close revenue accounts)
2) Income Summary 7,740
Salary Expense 5,200
Advertising Supplies Expense 1,500
Rent Expense 900
Insurance Expense 50
Interest Expense 50
Depreciation Expense 40
(to close expense accounts)
3) Income Summary 2,860
Retained Earnings 2,860
(to close net income to retained earnings)
4) Retained Earnings 500
Dividends 500
(to close dividends to retained earnings)

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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 have a zero balance.

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Summary of the Accounting Cycle:

1. Analyze business transactions

2. Journalize the transcations
3. Post to ledger accounts
4. Prepare a trial balance
5. Journalize and post adjusting entries: Deferrals/Accruals
6. Prepare an adjusted trial balance
7. Prepare financial statements
8. Journalize and post closing entries
9. Prepare a post-clsoing trial balance

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