FABM 2

ONLINE CLASS

Review of
Accrual Accounting Concepts
Chapter Outline
Learning Objectives
LO 1 Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2 Prepare adjusting entries for deferrals.

2
 Learning Objective 1
Explain the Accrual Basis of
Accounting and the Reasons for
Adjusting Entries

LO 1 3
 Periodicity Assumption
Accountants divide the economic life of a business into
artificial time periods generally a month, quarter, or year.
.....
Jan. Feb. Mar. Apr. Dec.

• Quarterly and annual financial statements HELPFUL HINT

• Prepared by most large companies An accounting time
period
• Reporting periods can be that is one year
• Calendar year from January 1 to long is
called a fiscal year.
December 31
LO 1 4
 Accrual-Basis and Periodicity
What is the periodicity assumption?
a. Companies should recognize revenue in the
accounting period in which services are
performed.
b. Companies should match expenses with revenues.
c. The economic life of a business can be divided into
artificial time periods.
d. The fiscal year should correspond with the
calendar year.

LO 1 5
 Accrual-Basis and Revenue Recognition
Revenue Recognition Principle
Revenue Recognition
Recognize revenue in the Satisfied
accounting period in which the performance
obligation
performance obligation is
satisfied.
Customer Cash
requests received
service
Revenue should be
recognized in the
accounting period in which
the service is performed.

LO 1 6
 Revenue Recognition
A contract is an agreement between two parties that
Step 1: Identify the contract creates enforceable rights or obligations. Sierra has a
with customers. contract with the Lewis family to provide guide
services.

Sierra has only one performance obligation—to

Step 2: Identify the separate
provide guide services. If Sierra also agreed to sell
performance obligations in
the customer camping equipment, a separate
the contract.
performance obligation is recorded for this promise.

The transaction price is the amount of consideration

Step 3: Determine the that a company expects to receive from a customer
transaction price. in exchange for transferring a good or service. The
transaction price for Sierra is $1,500.
Step 4: Allocate the transaction
Sierra has only one performance obligation—to
price to the separate
provide guide services to the Lewis family.
performance obligations.

Sierra recognizes revenue of $1,500 for providing

Step 5: Recognize revenue
guide services to the Lewis family when it satisfies its
when each performance
performance obligation—the completion of the
obligation is satisfied.
guide trip.

LO 1 7
 Accrual-Basis and Expense Recognition
Expense Recognition Principle
Companies recognize expenses in Expense Recognition
Matching
the period in which they make Revenues
efforts (consume assets or incur
liabilities) to generate revenue.
Delivery

“Let the expenses

follow the revenues.” Advertising Utilities

Expenses

LO 1 8
 Revenue and Expense Recognition
Periodicity Assumption GAAP
Relationships
Economic life of business can be
divided into artificial time periods.

Revenue Recognition Expense Recognition

Principle Principle

Recognize revenue in the Recognize expenses with revenues

accounting period in which the in the period when the company
performance obligation is satisfied. makes efforts to generate those
revenues.

Revenue and Expense Recognition

In accordance with generally
accepted accounting principles
(GAAP).
LO 1 9
 Accrual-Basis of Accounting
Which of the following statements about the accrual basis of
accounting is false?
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which services
are performed.
c. This basis is in accordance with generally accepted
accounting principles.
d. Revenue is recorded only when cash is received, and
expense is recorded only when cash is paid.

LO 1 10
 Accrual versus Cash Basis Accounting (1 of 2)
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
• In accordance with generally accepted accounting
principles (GAAP)
LO 1 11
 Accrual- versus Cash Basis Accounting (2 of 2)
Cash-Basis Accounting
• Revenues recognized when cash is received
• Expenses recognized when cash is paid
• Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP)

LO 1 12
 Comparing Accrual- versus Cash Basis
2021 2022

Activity Purchased paint, painted Received payment for work

building, paid employees done in 2021

Revenue $80,000 Revenue $0

Accrual
Expense 50,000 Expense 0
basis
Net income $30,000 Net Income $0

Revenue $0 Revenue $80,000

Cash
Expense 50,000 Expense 0
basis
Net loss $(50,000) Net income $80,000

LO 1 13
 Need for Adjusting Entries
• To 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
• Will include one income staement account and one
balance sheet account

LO 1 14
 The Need for Adjusting Entries
Adjusting entries are made to ensure that
a. expenses are recognized in the period in which
they are incurred.
b. revenues are recorded in the period in which
services are performed.
c. balance sheet and income statement accounts
have correct balances at the end of an
accounting period.
d. All the responses above are correct.

LO 1 15
 Categories of Adjusting Entries
Deferrals Accruals
1. Prepaid Expenses. Expenses 1. Accrued Revenues.
paid in cash before they are Revenues for services
used or consumed. performed but not yet
received in cash or recorded.
2. Unearned Revenues. 2. Accrued Expenses.
Cash received before Expenses incurred but not
services are performed. yet paid in cash or recorded.

LO 1 16
 Trial Balance
Sierra Corporation
Trial Balance
October 31, 2022
Debit Credit
Cash $15,200
Subsequent
Supplies 2,500
examples are
Prepaid Insurance 600
based on this
Equipment 5,000
trial balance
Notes Payable $ 5,000
from Chapter 3.
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Retained Earnings 0
Dividends 500
Service Revenue 10,000
Salaries and Wages Expense 4,000
Rent Expense 900
$28,700 $28,700

LO 1 17
 DO IT! 1 Timing Concepts
Below is a list of timing concepts (a) Monthly and quarterly time periods.
in the left column, with a
(b) Efforts (expenses) should be matched
description of the concept in the
with results (revenues).
right column. There are more
descriptions provided than (c) Accountants divide the economic life of
concepts. Match the description a business into artificial time periods.
to the concept
(d) Companies record revenues when they
f Accrual-basis accounting.
1. ___ receive cash and record expenses when
they pay out cash.
e Calendar year.
2. ___ (e) An accounting time period that starts
c Periodicity assumption.
3. ___ on January 1 and ends on December 31.

b Expense recognition (f) Companies record transactions in the

4. ___
period in which the events occur.
principle.

LO 1 18
 Learning Objective 2
Prepare Adjusting Entries for Deferrals

LO 2 19
 Adjusting Entries for Deferrals
Deferrals are costs or revenues that are recognized at a date
later than the point when cash was originally exchanged
Types of deferrals:
• Prepaid expenses
• Unearned revenues
Journalize
Trial
Analyze Journalize Post and Post
Balance
AJEs

Adjusted
Financial Closing Post-Closing
Trial
Balance Statements Entries Trial Balance

LO 2 20
 Prepaid Expenses
Payments of expenses that are recorded as an asset to
show the service or benefit the company will receive in
the future.

Cash Payment BEFORE Expense Recorded

Prepayments often occur in regard to

• insurance • rent
• supplies • equipment
• advertising • buildings

LO 2 21
 Prepaid Expenses
• Expire either with the passage of time or through use
• Adjusting entry
▪ Increase (debit) to an expense account and
▪ Decrease (credit) to an asset account

Asset Expense
Unadjusted Credit Debit
Balance Adjusting Adjusting
Entry (-) Entry (+)

LO 2 22
 Supplies
Illustration: Sierra Corporation purchased supplies costing
$2,500 on October 5. Sierra recorded the payment 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
(To record supplies used)

LO 2 23
 Adjustment for Supplies
Basic The expense Supplies Expense is increased $1,500; the asset Supplies is
Analysis decreased $1,500.

Assets = Liabilities + Stockholders’ Equity

Equation
Supplies = Supplies Expense
Analysis
(1) -$1,500 = -$1,500

Debit-Credit Debits increase expenses: debit Supplies Expense $1,500.

Analysis Credits decrease assets: credit Supplies $1,500.

Oct. 31 Supplies Expense 1,500

Journal
Supplies 1,500
Entry
(To record supplies used)

Posting Supplies Supplies Expense

to Oct. 5 2,500 Oct. 31 Adj. 1,500 Oct. 31 Adj. 1,500
Ledger Oct. 31 Bal. 1,000 Oct. 31 Bal. 1,500

LO 2 24
 Insurance
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.

Oct. 31 Insurance Expense 50

Prepaid Insurance 50
(To record expired insurance)

LO 2 25
 Adjustment for Insurance
Assets = Liabilities + Stockholders’ Equity
Equation
Prepaid Insurance = Insurance Expense
Analysis
(1) -$50 = -$50

Basic The expense Insurance Expense is increased $50; the asset Prepaid
Analysis Insurance is decreased $50.

Debit-Credit Debits increase expenses: debit Insurance Expense $50.

Analysis Credits decrease assets: credit Prepaid Insurance $50.

Oct. 31 Insurance Expense 50

Journal
Prepaid Insurance 50
Entry
(To record insurance expired)

Posting Prepaid Insurance Insurance Expense

to Oct. 4 600 Oct. 31 Adj. 50 Oct. 31 Adj. 50
Ledger Oct. 31 Bal. 550 Oct. 31 Bal. 50

LO2 26
 Depreciation
• Buildings, equipment, and motor vehicles (assets that
provide service for many years) are recorded as
assets, rather than an expense, on the date acquired
• Depreciation is the process of allocating the cost of
an asset to expense over its useful life
• Depreciation does not attempt to report the actual
change in the value of the asset
▪ An allocation concept, not a valuation concept

LO 2 27
 Depreciation
Illustration: For Sierra Corporation, assume that depreciation
on the equipment is $480 a year, or $40 per month.

Oct. 31 Depreciation Expense 40

Accumulated Depreciation 40
(To record depreciation)

Accumulated Depreciation is called a contra asset account.

LO 2 28
 Adjustment for Depreciation (1 of 2)
Basic The expense Depreciation Expense is increased $40; the contra asset
Analysis Accumulated Depreciation—Equipment is increased $40.

Assets = Liabilities + Stockholders’ Equity

Equation Accumulated
Analysis Depreciation—Equipment = Depreciation Expense
-$40 = -$40

Debits increase expenses: debit Depreciation Expense $40. Credits

Debit-Credit
increase contra assets: credit Accumulated Depreciation—
Analysis
Equipment $40.

Oct. 31 Depreciation Expense 40

Journal
Entry Accumulated Depreciation—
Equipment 40

LO2 29
 Adjustment for Depreciation (2 of 2)

Oct. 31 Depreciation Expense 40

Journal
Entry Accumulated Depreciation—
Equipment 40

Posting Equipment Depreciation Expense

to Oct. 2 5,000 Oct. 31 Adj. 40
Ledger Oct. 31 Bal. 5,000 Oct. 31 Bal. 40

Accumulated Depreciation—Equipment
Oct. 31 Adj. 40
Oct. 31 Bal. 40

ILLUSTRATION 4.9

LO2 30
 Reporting Depreciation
• Accumulated Depreciation
• A contra asset account with a normal credit balance
• Offsets the related asset account on the balance
sheet
• Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation
Equipment $5,000
Less: Accumulated depreciation—equipment 40
$4,960

LO 2 31
 Prepaid Expenses
Accounting for Prepaid Expenses
Accounts
Reason for Before Adjusting
Examples Adjustment Adjustment Entry
Insurance, Prepaid expenses Assets Dr. Expenses
supplies, originally recorded overstated. Cr. Assets
advertising, rent, in asset accounts Expenses or Contra
depreciation have been used. understated. Assets

LO 2 Copyright ©2019 John Wiley & Son, Inc. 32

 Unearned Revenues
Receipt of cash before the service is performed is
recorded as a liability—unearned revenue.

Cash Receipt BEFORE Revenue Recorded

Unearned revenues often occurs in regard to:

• Rent • Magazine subscriptions
• Airline tickets • Customer deposits

LO 2 33
 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 period
• Results in a decrease (debit) to a liability account and
an increase (credit) to a revenue account
Liability Revenue
Debit Unadjusted Credit
Adjusting Balance Adjusting
Entry (-) Entry (+)

LO 2 34
 Unearned Revenues
Illustration: Sierra Corporation 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. 31 Unearned Service Revenue 400

Service Revenue 400

LO 2 35
 Basic The liability Unearned Service Revenue is decreased $400; the revenue
Analysis Service Revenue is increased $400.

Assets = Liabilities + Stockholders’ Equity

Equation Unearned
Analysis = Service Revenue Service Revenue
= -$400 +$400

Debit-Credit Debits decrease liabilities: debit Unearned Service Revenue $400.

Analysis Credits increase revenues: credit Service Revenue $400.

Journal Oct. 31 Unearned Service Revenue 400

Entry Service Revenue 400

Unearned Service Revenue Service Revenue

Posting Oct. 31 Adj. 400 Oct. 2 1,200 Oct. 3 10,000
to
Ledger 31 Adj. 400
Oct. 31 Bal. 800 Oct. 31 Bal. 10,400

LO 2 36
 Unearned Revenue
Accounting for Unearned Revenues
Accounts
Reason for Before Adjusting
Examples Adjustment Adjustment Entry
Rent, Unearned revenues Liabilities Dr. Liabilities
magazine recorded in liability overstated. Cr. Revenues
subscriptions, accounts are now Revenues
customer recognized as understated.
deposits for revenue for services
future service performed.

LO 2 37
 DO IT! 2: Adjusting Entries Deferrals (1 of 5)
The ledger of Hammond Inc. on March 31, 2022, 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.
Prepare the adjusting entries for the month of March.
LO 2 38
 DO IT! 2: Adjusting Entries Deferrals (2 of 5)
The ledger of Hammond Inc. on March 31, 2022, 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

1. Insurance expires at the rate of $100 per month.

Oct. 31 Insurance Expense 100
Prepaid Insurance 100

LO 2 39
 DO IT! 2: Adjusting Entries Deferrals (3 of 5)
The ledger of Hammond Inc. on March 31, 2022, 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

2. Supplies on hand totaled $800.

Oct. 31 Supplies Expense 2,000

Supplies 2,000

LO 2 40
 DO IT! 2: Adjusting Entries Deferrals (4 of 5)
The ledger of Hammond Inc. on March 31, 2022, 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

3. The equipment depreciates $200 a month.

Oct. 31 Depreciation Expense 200
Accumulated Depreciation-
……..Equipment 200

LO 2 41
 DO IT! 2: Adjusting Entries Deferrals (5 of 5)
The ledger of Hammond Inc. on March 31, 2022, 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
4. During March, services were performed for $4,000 of the
unearned service revenue reported.
Oct. 31 Unearned Service Revenue 4,000
Service Revenue 4,000

LO 2 42
 ***END OF DISCUSSION***

LO 2 43