Chapter 4 - Financial Accounting: Accrual Accounting Concepts & Adjusting Entries Study Guide
Overview of Accrual vs. Cash-Basis Accounting
Accrual-Basis Accounting:
Transactions that change a company's financial statements are recorded in the accounting periods in which the events occur, even if cash was not received or paid.
Revenue is recognized when the performance obligation is satisfied (service performed or good delivered).
Expenses are recognized when incurred/effort is expended, matching them with related revenues.
Complies with Generally Accepted Accounting Principles (GAAP).
Cash-Basis Accounting:
Revenue is recorded only when cash is received.
Expenses are recorded only when cash is paid.
Does not satisfy GAAP requirements and can produce misleading financial results when timing differences exist between cash flow and business performance.
Comparative Example (2021 vs. 2022 Financial Performance):
Scenario: A business purchased paint, painted a building, and paid employees in 2021. The payment of $80,000 from the customer was received in 2022. Total incurred costs in 2021 were $50,000.
Accrual Basis Outcomes:
2021: Revenue of $80,000 is recognized (performance obligation completed), Expenses equal $50,000. Net Income = $30,000.
2022: Revenue equals $0, Expenses equal $0. Net Income = $0.
Cash Basis Outcomes:
2021: Revenue equals $0, Expenses equal $50,000. Net Loss = $(50,000).
2022: Revenue of $80,000 is recognized (cash collected), Expenses equal $0. Net Income = $80,000.
The Periodicity Assumption
Accounting divides the economic life of a business into artificial time periods.
Common artificial time periods include:
Monthly time periods.
Quarterly time periods (Qtr 1, Qtr 2, Qtr 3, Qtr 4).
Annual time periods (Yearly).
Interim Periods: Accounting time periods that are less than one year (such as monthly or quarterly reports).
Fiscal Year: An accounting period that is exactly one year in length.
Calendar Year: An accounting fiscal year that begins on January 1 and ends on December 31.
The Revenue Recognition Principle
Requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied.
A performance obligation is satisfied when a company performs a service or provides a good to a customer.
Five-Step Revenue Recognition Process:
Step 1: Identify the contract with customers.
Step 2: Identify the separate performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the separate performance obligations.
Step 5: Recognize revenue when each performance obligation is satisfied.
Journal Entry Demonstration for Revenue Recognition (Conrad Window Cleaners):
Scenario: Conrad Window Cleaners performs cleaning services for $100 on June 30, but customers do not pay until July 5.
June 30 Entry (Performance Obligation Satisfied):
Debit: Accounts Receivable $100
Credit: Service Revenue $100
July 5 Entry (Collection of Cash):
Debit: Cash $100
Credit: Accounts Receivable $100
The Expense Recognition Principle
The fundamental guiding rule for expense recognition is: "Let the expenses follow the revenues."
Requires that companies recognize expenses in the period when they make efforts (consume assets or incur liabilities) to generate revenue.
Expense recognition is directly tied to revenue recognition and is frequently referred to as the matching principle.
The critical issue in expense recognition is determining when the expense makes its contribution to revenue, which may not be the same period in which cash is paid.
Examples of efforts expended to generate revenue include advertising expenses, delivery costs, and utility services.
Interrelationships of GAAP Principles in Accounting
The Periodicity Assumption establishes that the economic life of a business can be divided into artificial time periods.
Under these time periods, two primary GAAP rules direct financial measurement:
Revenue Recognition Principle: Recognize revenue in the accounting period in which the performance obligation is satisfied.
Expense Recognition Principle: Recognize expenses in the period that efforts are made to generate those revenues.
Combined, these principles govern Revenue and Expense Recognition in accordance with Generally Accepted Accounting Principles (GAAP).
The Need and Rules for Adjusting Entries
Purpose of Adjusting Entries:
Ensure that the revenue recognition and expense recognition principles are strictly followed.
Necessary because the unadjusted trial balance may not contain up-to-date and complete data.
Reasons Trial Balances May Be Incomplete:
Certain events occur daily, but recording them continuously would be highly inefficient (e.g., use of office supplies, payment of wages).
Certain costs expire with the passage of time rather than through active discrete transactions (e.g., building depreciation, insurance coverage expiration, rent expiration).
Certain items remain unrecorded because explicit documentation, such as utility invoices or service bills, has not yet been received.
Timing & Preparation:
Adjusting entries are required every time a company prepares financial statements.
Every adjusting entry is based on a systematic analysis of each account in the trial balance.
Three Essential Rules for Adjusting Entries:
Adjusting entries never involve the Cash account.
Adjusting entries will either increase revenue or increase an expense.
Adjusting entries always include one income statement account (revenue or expense) and one balance sheet account (asset or liability).
Classifications of Adjusting Entries
Adjusting entries are categorized into Deferrals or Accruals, with each major group containing two specific subcategories:
Deferrals:
Prepaid Expenses (Unrecorded Expenses):
Expenses paid in cash and recorded as assets before they are used or consumed.
Accounts before adjustment: Assets are overstated; Expenses are understated.
Adjusting Entry: Debit Expense account; Credit Asset account (or Contra Asset account).
Unearned Revenues (Unrecorded Revenues):
Cash received and recorded as liabilities before revenue is earned.
Accounts before adjustment: Liabilities are overstated; Revenues are understated.
Adjusting Entry: Debit Liability account; Credit Revenue account.
Accruals:
Accrued Revenues:
Revenues for services performed but not yet received in cash or recorded.
Accounts before adjustment: Assets are understated; Revenues are understated.
Adjusting Entry: Debit Asset account; Credit Revenue account.
Accrued Expenses:
Expenses incurred but not yet paid in cash or recorded.
Accounts before adjustment: Expenses are understated; Liabilities are understated.
Adjusting Entry: Debit Expense account; Credit Liability account.
Detailed Accounting Procedures for Deferrals
Supplies Expense Adjustment:
Example (Sierra Corporation):
Purchased supplies costing $2,500 on October 5 and debited the asset account Supplies.
Trial balance on October 31 shows a balance of $2,500 in Supplies.
An inventory count at the close of business on October 31 reveals $1,000 of supplies remain on hand.
Calculation of used supplies:
October 31 Adjusting Journal Entry:
Debit: Supplies Expense $1,500
Credit: Supplies $1,500
Prepaid Insurance Adjustment:
Example (Sierra Corporation):
Paid $600 on October 4 for a one-year fire insurance policy, with coverage starting October 1. Debited Prepaid Insurance.
Monthly cost calculation:
October 31 Adjusting Journal Entry:
Debit: Insurance Expense $50
Credit: Prepaid Insurance $50
Depreciation Expense Adjustment:
Example (Sierra Corporation):
Annual depreciation on equipment is $480 per year.
Monthly calculation:
Accumulated Depreciation—Equipment is a contra asset account that offsets the main asset account (Equipment) on the Balance Sheet.
October 31 Adjusting Journal Entry:
Debit: Depreciation Expense $40
Credit: Accumulated Depreciation—Equipment $40
Unearned Revenue Adjustment:
Example (Sierra Corporation):
Received $1,200 cash on October 2 from R. Knox for advertising services expected to be completed by December 31, credited to Unearned Service Revenue.
Analysis reveals that $400 of services were performed in October.
October 31 Adjusting Journal Entry:
Debit: Unearned Service Revenue $400
Credit: Service Revenue $400
Detailed Accounting Procedures for Accruals
Accrued Revenue Adjustment:
Example (Sierra Corporation):
Performed services worth $200 in October that were not billed to clients on or before October 31.
October 31 Adjusting Entry:
Debit: Accounts Receivable $200
Credit: Service Revenue $200
November 10 Collection Entry:
Debit: Cash $200
Credit: Accounts Receivable $200
Accrued Interest Adjustment:
Formula for Interest Calculation:
Example (Sierra Corporation):
Signed a three-month note payable in the amount of $5,000 on October 1 at an annual interest rate of 12%.
Interest calculation for one month (October): \text{Interest} = \5,000 \times 12\% \times \frac{1}{12} = \
October 31 Adjusting Entry:
Debit: Interest Expense $50
Credit: Interest Payable $50
Accrued Salaries and Wages Adjustment:
Example (Sierra Corporation):
Paid salaries on October 26; next payment scheduled for November 9.
Employees earn total salaries of $2,000 for a five-day work week (Monday–Friday).
Daily salary rate calculation: \text{Daily Rate} = \frac{\2,000}{5\,\text{days}} = \
Adjustment period covers 3 unpaid work days in October (October 29, 30, 31):
- **October 31 Adjusting Entry**:
- Debit: Salaries & Wage Expense $1,200
- Credit: Salaries & Wage Payable $1,200
Comprehensive Practice Problems for Adjusting Entries
Practice Problem 1: Hammond Company (Hammond, Inc.) Deferrals
Unadjusted Ledger Balances on March 31:
Prepaid Insurance: $3,600 (Debit)
Supplies: $2,800 (Debit)
Equipment: $25,000 (Debit)
Accumulated Depreciation—Equipment: $5,000 (Credit)
Unearned Service Revenue: $9,200 (Credit)
Transaction 1: Insurance expires at the rate of $100 per month.
Entry: Debit Insurance Expense $100 / Credit Prepaid Insurance $100
Transaction 2: Supplies on hand total $800.
Calculation: $2,800 - $800 = $2,000 used.
Entry: Debit Supplies Expense $2,000 / Credit Supplies $2,000
Transaction 3: During March, services were performed for $4,000 of the unearned service revenue reported.
Entry: Debit Unearned Service Revenue $4,000 / Credit Service Revenue $4,000
Practice Problem 2: Micro Computer Services Accruals
Operations began August 1, 2022. Preparing monthly financial statements for August 31, 2022:
Item 1: Company owed employees $800 in salaries and wages to be paid September 1.
Entry: Debit Salaries and Wages Expense $800 / Credit Salaries and Wages Payable $800
Item 2: Borrowed $30,000 on August 1 on a 15-year mortgage at an annual interest rate of 10%.
Calculation: \text{Monthly Interest} = \30,000 \times 10\% \times \frac{1}{12} = \
Entry: Debit Interest Expense $250 / Credit Interest Payable $250
Item 3: Service revenue performed but unrecorded for August totaled $1,100.
Entry: Debit Accounts Receivable $1,100 / Credit Service Revenue $1,100
The Adjusted Trial Balance and Financial Statements
Skolnick Co. Comprehensive Case (Quarter Ended June 30, 2022):
Adjusted Trial Balance Data:
Debits:
Cash: $6,700
Accounts Receivable: $600
Prepaid Rent: $900
Supplies: $1,000
Equipment: $15,000
Dividends: $600
Rent Expense: $1,500
Salaries & Wage Expense: $9,400
Depreciation Expense: $850
Supplies Expense: $200
Utilities Expense: $510
Interest Expense: $50
Total Debits: $37,310
Credits:
Accumulated Depreciation: $850
Notes Payable: $5,000
Accounts Payable: $1,510
Salaries and Wages Payable: $400
Interest Payable: $50
Unearned Rent Revenue: $500
Common Stock: $14,000
Retained Earnings: $0
Service Revenue: $14,200
Rent Revenue: $800
Total Credits: $37,310
Statement Calculations:
a. Net Income Computation:
Revenues: Service Revenue ($14,200) + Rent Revenue ($800) = $15,000
Expenses: Salaries & Wage Expense ($9,400) + Rent Expense ($1,500) + Depreciation Expense ($850) + Utilities Expense ($510) + Supplies Expense ($200) + Interest Expense ($50) = $12,510
Net Income calculation:
b. Asset and Liability Balance Determinations:
Total Assets: Cash ($6,700) + Accounts Receivable ($600) + Prepaid Rent ($900) + Supplies ($1,000) + Equipment ($15,000) - Accumulated Depreciation ($850) = $23,350
Total Liabilities: Notes Payable ($5,000) + Accounts Payable ($1,510) + Salaries and Wages Payable ($400) + Interest Payable ($50) + Unearned Rent Revenue ($500) = $7,460
c. Retained Earnings Balance at June 30, 2022:
Retained Earnings, April 1: $0
Add Net Income: $2,490
Less Dividends: $600
Retained Earnings, June 30: $1,890
d. Accounting Equation Breakdown: (Where Stockholders' Equity equals Common Stock of $14,000 + Retained Earnings of $1,890 = $15,890).
The Closing Process and Journal Entries
Temporary vs. Permanent Accounts:
Temporary Accounts (Closed at the end of every accounting period):
All Revenue Accounts
All Expense Accounts
Dividends
Permanent Accounts (Not closed; balances carry over to future periods):
All Asset Accounts
All Liability Accounts
Stockholders' Equity Accounts
Closing Entries Flow:
Close Revenue Accounts to Income Summary.
Close Expense Accounts to Income Summary.
Close Income Summary to Retained Earnings.
Close Dividends directly to Retained Earnings.
Sierra Corporation Closing Entries (October 31, 2022):
Data Summary: Service Revenue $10,600; Expenses ($5,200 Salaries + $1,500 Supplies + $900 Rent + $50 Insurance + $50 Interest + $40 Depreciation = $7,740); Net Income $2,860; Dividends $500.
Entry 1 (Close Revenues):
Debit: Service Revenue $10,600
Credit: Income Summary $10,600
Entry 2 (Close Expenses):
Debit: Income Summary $7,740
Credit: Salaries and Wages Expense $5,200
Credit: Supplies Expense $1,500
Credit: Rent Expense $900
Credit: Insurance Expense $50
Credit: Interest Expense $50
Credit: Depreciation Expense $40
Entry 3 (Close Net Income to Retained Earnings):
Debit: Income Summary $2,860
Credit: Retained Earnings $2,860
Entry 4 (Close Dividends to Retained Earnings):
Debit: Retained Earnings $500
Credit: Dividends $500
December 31 Closing Entries Practice Problem:
Ledger balances provided: 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 Wage Expense $51,000; Supplies Expense $7,000.
Journal Entries:
Close Revenue: Debit Service Revenue $98,000 / Credit Income Summary $98,000
Close Expenses: Debit Income Summary $80,000 / Credit Salaries and Wage Expense $51,000, Credit Rent Expense $22,000, Credit Supplies Expense $7,000
Close Net Income: Debit Income Summary $18,000 / Credit Retained Earnings $18,000
Close Dividends: Debit Retained Earnings $15,000 / Credit Dividends $15,000
Knowledge Checks and Practical Applications
Revenue Recognition Scenarios & Timing:
CBS sells advance payment advertising services on May 1 for services to be provided during June: Recognized in the End of June adjusting entry.
PetTown sells specialty cat food on June 29, delivered on July 3: Recognized When delivered on July 3.
Ace Airlines receives payment on May 1 for a flight scheduled for July 16: Recognized On the flight date, July 16.
Dell receives an order for a computer on March 1, delivered on March 18: Recognized On the delivery date, March 18.
Microsoft sells a 1-year subscription to Excel starting June 1 with payment received June 1: Recognized At the end of each month beginning with June 30.
Expense Recognition True/False Evaluation:
Statement: "The expense recognition principle requires that companies recognize expenses in the period in which they pay for the expenses." -> False (recognized in the period efforts are expended to generate revenue).
Statement: "The critical issue in expense recognition is determining when the expense makes its contribution to revenue." -> True.
Statement: "In recognizing expenses, a simple rule is followed, 'Let the revenue follow the expenses'." -> False (the rule is "Let the expenses follow the revenues").
Need for Adjusting Entries True/False Evaluation:
Statement: "Adjusting entries are required every time a company prepares financial statements." -> True.
Statement: "Every adjusting entry will include either income statement accounts or balance sheet accounts." -> False (every adjusting entry must include both one income statement account and one balance sheet account).
Statement: "Adjusting entries ensure that the revenue recognition and expense recognition principles are followed." -> True.
Categorization of Adjusting Entry Types:
Interest of $200 has been incurred and unpaid on a note payable: Accrued expense.
Rent collected in advance totaling $1,100 has not been earned: Unearned revenue.
Supplies of $400 are on hand when Supplies account shows a $1,600 balance: Prepaid expense.
Services performed but unbilled total $700: Accrued revenue.