Chapter 3 Study Guide: Accrual Accounting and Adjusting Entries

Accrual versus Cash Basis of Accounting

• Fundamental Account Rules and Normal Balances:

  • DEXA Mnemonic (Debits Increase, Credits Decrease):

    • D: Dividends

    • E: Expenses

    • A: Assets

  • LER Mnemonic (Credits Increase, Debits Decrease):

    • L: Liabilities

    • E: Equity

    • R: Revenue

• Cash-Basis Accounting:

  • Definition: A method of accounting in which revenue is recorded when cash is received, regardless of when it is actually earned. Similarly, an expense is recorded when cash is paid, regardless of when it is actually used or incurred.

  • Timing Mechanism: Does not tie the recognition of revenues and expenses to the underlying business activity, but rather to the actual exchange/flow of cash.

  • Example 1 (Jason Connect Inc.):

    • Scenario: Jason Connect Inc. is an internet service provider. On December 1st, Jason Connect receives $600 from customers for internet services to be provided from December through February (3 months).

    • Cash-Basis Revenue Calculation: For the fiscal year ended December 31st, the full $600$ is recorded as service revenue in December because that is when the cash was received.

    • Monthly breakdown under Cash Basis:

      • December: $600$

      • January: $0$

      • February: $0$

• Accrual-Basis Accounting:

  • Definition: A method of accounting in which revenues are generally recorded when earned (rather than when cash is received) and expenses are matched to the periods in which they help produce revenue (rather than when cash is paid).

  • Revenue Recognition: Revenue is recognized as the company satisfies its performance obligation by transferring control of promised goods or delivering services to a customer.

  • Expense Recognition: Expenses are recognized when they are used or incurred to help generate revenue.

  • Example 2 (Jason Connect Inc.):

    • Scenario: Jason Connect Inc. receives $600$ on December 1st for 3 months of internet services (December, January, February).

    • Monthly allocation: $\frac{600}{3} = 200$ per month.

    • Accrual-Basis Revenue Calculation: For the fiscal year ended December 31st, Jason Connect recognizes $200$ in service revenue for December because only 1 month of service was delivered/earned.

    • Monthly breakdown under Accrual Basis:

      • December: $200$

      • January: $200$

      • February: $200$

    • Unearned Revenue Account: The remaining $400$ received on December 1st is placed into Unearned Revenue (a liability account reflecting the obligation to provide services at a later date).

• Comparative Case Study: Conservation Inc. and the State of Georgia:

  • Background: The state of Georgia hired Conservation Inc., a consulting firm, to explore water resource options for the Atlanta metropolitan area.

  • Timeline of Events:

    • November: Conservation Inc. incurred $60,000$ of expenditures on account (credit) while investigating the water shortage. Conservation delivered its recommendations and billed the state $100,000$ for its work (no cash exchanged).

    • December: Conservation Inc. paid the $60,000$ of expenses in cash.

    • January: Conservation Inc. received the state's check for $100,000$ in cash.

  • Cash Basis Financial Impact:

    • November: Revenue = $0$, Expenses = $0$, Net Income = $0$

    • December: Revenue = $0$, Expenses = $60,000$, Net Income = $-60,000$ (Net Loss)

    • January: Revenue = $100,000$, Expenses = $0$, Net Income = $100,000$

  • Accrual Basis Financial Impact:

    • November: Revenue = $100,000$, Expenses = $60,000$, Net Income = $40,000$

    • December: Revenue = $0$, Expenses = $0$, Net Income = $0$

    • January: Revenue = $0$, Expenses = $0$, Net Income = $0$

  • Conclusion: Accrual basis accurately matches economic reality by recording revenues when the service performance obligation was delivered and matching the corresponding expenses incurred to generate that revenue in November.

Key Elements of Accrual Accounting

• Time-Period Assumption:

  • Allows companies to artificially divide their continuous business operations into distinct time periods (e.g., months, quarters, fiscal years) so they can satisfy internal and external users' demands for financial information.

• Revenue Recognition Principle:

  • Determines when revenue is recorded in journal entries and reported in financial statements.

  • Revenue is recognized in the accounting period in which a company satisfies its performance obligation or promise within a contract.

  • A seller satisfies a performance obligation by transferring control of a promised good or service to a customer.

• Expense Recognition Principle (Matching Principle):

  • Requires that expenses be recorded and reported in the same period as the revenue that they helped to generate.

  • Expenses are recorded when used or consumed rather than when cash is paid.

The Accounting Cycle and Adjusting Entries

• Overview of the 7-Step Accounting Cycle:

  • Step 1: Analyze Transactions

  • Step 2: Journalize Transactions

  • Step 3: Post to the Ledger

  • Step 4: Prepare a Trial Balance

  • Step 5: Adjust the Accounts (Adjusting Journal Entries - AJEs)

  • Step 6: Prepare Financial Statements

  • Step 7: Close the Accounts

• Step 5 Mechanics (Adjusting Journal Entries - AJEs):

  • Definition: Journal entries made at the end of an accounting period (e.g., December 31) to record the completed portion of partially completed transactions.

  • Core Rules for All AJEs:

    1. Every adjusting entry affects at least one Income Statement account (Revenue or Expense) and at least one Balance Sheet account (Asset or Liability).

    2. Cash is NEVER affected by adjusting journal entries. Cash flows trigger transactions either before (deferrals) or after (accruals), but the AJE itself on December 31 never contains the Cash account.

• 3-Step Procedure for Making Adjusting Journal Entries:

  • Step 1: Identify pairs of income statement and balance sheet accounts that require adjustment.

  • Step 2: Calculate the amount of the adjustment based on the amount of revenue earned or expense incurred during the accounting period.

  • Step 3: Record the adjusting journal entry in the general journal.

Four Types of Adjusting Entries

• Classification Matrix:

  • Accruals ("Cash After"): Cash is exchanged after the revenue is earned or expense is incurred.

    • Revenue: Accrued Revenue

    • Expense: Accrued Expense

  • Deferrals ("Cash First"): Cash is exchanged first (upfront), before revenue is earned or expense is incurred.

    • Revenue: Deferred (Unearned) Revenue

    • Expense: Deferred (Prepaid) Expense

Accrued Revenues and Accrued Expenses

• Accrued Revenues ("Cash After"):

  • Definition: Previously unrecorded revenues that have been earned by providing goods or services, but for which no cash has yet been received.          

    

        

  • Adjusting Entry Structure (December 31):

    • Debit: Accounts Receivable (Asset $\\uparrow$)

    • Credit: Revenue (Revenue $\\uparrow$)

  • Subsequent Cash Receipt Entry (When Cash is Collected):

    • Debit: Cash (Asset $\\uparrow$)

    • Credit: Accounts Receivable (Asset $\\downarrow$)

    • (Optional) Credit: Revenue (if additional revenue was earned in the current period)

  • Example 4 (Porter Properties Inc. and Tiger Travel Agency - Rent):

    • Facts: On November 1, Porter Properties Inc. rented office space to Tiger Travel Agency for $5,000$ per month. Occupancy was immediate. Porter requires Tiger Travel to make a payment at the end of every 3 months. No cash was exchanged on November 1.

    • Dec 31 AJE Calculation: 2 months passed (November and December). $2 \\times 5,000 = 10,000$ earned.

    • December 31 Adjusting Journal Entry:

      • Debit: Accounts Receivable $10,000$

      • Credit: Rent Revenue / Service Revenue $10,000$

    • January 31 Cash Receipt Entry: Tiger Travel pays $15,000$ for 3 months (November, December, January).

      • Debit: Cash $15,000$

      • Credit: Service Revenue $5,000$ (for January revenue)

      • Credit: Accounts Receivable $10,000$ (removing the receivable/right to be paid recorded on Dec 31)

• Accrued Expenses ("Cash After"):

  • Definition: Previously unrecorded expenses that have been used or incurred, but not yet paid in cash.          

    

        

  • Adjusting Entry Structure (December 31):

    • Debit: Expense (Expense $\\uparrow$)

    • Credit: Accounts Payable / Wages Payable / Other Payable (Liability $\\uparrow$)

  • Subsequent Cash Payment Entry (When Paid):

    • Debit: Payable (Liability $\\downarrow$)

    • Debit: Expense (Expense $\\uparrow$ for new period labor/costs)

    • Credit: Cash (Asset $\\downarrow$)

  • Example 5 (Porter Properties Inc. - Salaries and Wages):

    • Facts: Porter Properties Inc. pays clerical employees every 2 weeks (10 workdays). Total wages for 10 days is $50,000$ ($5,000$ per day). December 31 falls 4 days into a 10-day pay period. Employees worked all 4 days in December. Pay day is January 6 in Year 2.

    • Dec 31 Adjustment Calculation: Daily rate = $\frac{50,000}{10} = 5,000$ per day. 4 days worked in December = $4 \\times 5,000 = 20,000$ labor used.

    • December 31 Adjusting Journal Entry:

      • Debit: Wage Expense $20,000$

      • Credit: Wages Payable $20,000$

    • January 6 Year 2 Payment Entry: Pay full $50,000$ payroll (6 days worked in January = $6 \\times 5,000 = 30,000$ wage expense for Year 2).

      • Debit: Wages Payable $20,000$ (clears liability)

      • Debit: Wage Expense $30,000$ (expense for Jan 1–Jan 6)

      • Credit: Cash $50,000$

Deferred Revenues and Deferred Expenses

• Deferred (Unearned) Revenues ("Cash First"):

  • Definition: Transactions for which a company has received cash in advance, but has not yet satisfied its performance obligation (revenue is not yet earned).          

    

        

  • Initial Cash Receipt Entry:

    • Debit: Cash (Asset $\\uparrow$)

    • Credit: Unearned Revenue (Liability $\\uparrow$)

  • Adjusting Entry Structure (December 31):

    • Debit: Unearned Revenue (Liability $\\downarrow$)

    • Credit: Service Revenue (Revenue $\\uparrow$)

  • Example 6 (Alpha Airlines - Ticket Advanced Sales):

    • Facts: Alpha Airlines requires passengers to pay for tickets in advance. On November 1, Alpha received $13,500$ cash from customers for flights to be taken during December.

    • November 1 Initial Entry:

      • Debit: Cash $13,500$

      • Credit: Unearned Revenue $13,500$ (liability reflecting obligation to provide flights later)

    • December 31 AJE Calculation: All flights were completed during December, so the full $13,500$ performance obligation is satisfied.

    • December 31 Adjusting Journal Entry:

      • Debit: Unearned Revenue $13,500$

      • Credit: Service Revenue $13,500$

• Deferred (Prepaid) Expenses ("Cash First"):

  • Definition: Transactions for which a company has paid cash upfront, but has not yet used or consumed the item/service (expense is not yet incurred).          

    

        

  • Common Prepaid Account Names: Prepaid Rent, Prepaid Advertising, Prepaid Insurance, Supplies, Buildings, Equipment.

  • Rule of Thumb for Asset vs. Expense:

    • If an item can be touched/felt (tangible physical asset) or is an unconsumed right, it is recorded initially as an Asset.

    • When the resource is finally "used", "consumed", or "expires", it becomes an Expense.

  • Initial Cash Payment Entry:

    • Debit: Prepaid Asset / Asset (Asset $\\uparrow$)

    • Credit: Cash (Asset $\\downarrow$)

  • Adjusting Entry Structure (December 31):

    • Debit: Expense (Expense $\\uparrow$)

    • Credit: Prepaid Asset / Asset (Asset $\\downarrow$)

  • Example 7 (Porter Properties Inc. - Prepaid Advertising):

    • Facts: Porter Properties Inc. had $4,581$ in Prepaid Advertising at the beginning of November. On November 10, Porter purchased local magazine advertising running during December and January, paying $12,365$ cash. The purchase was debited to Prepaid Advertising. At the end of the year, the balance before adjustments was $16,946$ ($4,581 + 12,365$). Porter determined that $3,263$ of prepaid advertising remained unused and related to future periods.

    • November 10 Initial Entry:

      • Debit: Prepaid Advertising $12,365$

      • Credit: Cash $12,365$

    • Dec 31 Calculation of Used Amount:

      • $\\text{Beginning Balance} + \\text{Additions} - \\text{Amount Used} = \\text{Ending Balance}$

      • $4,581 + 12,365 - X = 3,263$

      • $16,946 - X = 3,263 \\implies X = 13,683$ used/consumed during the period.

    • December 31 Adjusting Journal Entry:

      • Debit: Advertising Expense $13,683$

      • Credit: Prepaid Advertising $13,683$

Depreciation as a Deferred Expense

• Definition and Concepts:

  • Depreciation: The process whereby companies systematically allocate the cost of their tangible (physical) operating long-lived assets over each period in which the assets are used.

  • Required because long-lived physical assets produce revenue over an extended period of time.

  • Exception: Land does NOT depreciate.

  • Supplies Exception: Supplies is the only tangible item you can touch and feel that is directly expensed via supplies expense as consumed, rather than depreciated.

• Contra-Asset Accounts:

  • Definition: Accounts that have a normal balance that is opposite to the balance of their related asset account.

  • For long-lived assets, the contra-asset account is Accumulated Depreciation.

  • Accumulated Depreciation holds the cumulative reduction in the carrying value of the building/equipment.

• Example 8 (Porter Properties Inc. - Office Building Depreciation):

  • Facts: Porter Properties purchased an office building on January 1 for $450,000$ cash. Depreciation expense on this building is $15,000$ per year.

  • January 1 Purchase Entry:

    • Debit: Building $450,000$

    • Credit: Cash $450,000$

  • December 31 Adjusting Journal Entry:

    • Debit: Depreciation Expense $15,000$

    • Credit: Accumulated Depreciation $15,000$

Preparation of Financial Statements

• Adjusted Trial Balance:

  • Created after posting all adjusting journal entries (AJEs) to the ledger.

  • Reflects updated account balances incorporating all accruals and deferrals.

• Sequence of Financial Statement Preparation:

  1. Income Statement:

     • Prepared first using Revenue and Expense accounts.

     • Calculates Net Income: $\text{Net Income} = \text{Revenues} - \text{Expenses}$

  2. Retained Earnings Statement:

     • Prepared second using Net Income from the Income Statement and Dividends Declared.

     • Formula: $\text{Ending Retained Earnings (12/31)} = \text{Beginning Retained Earnings (1/1)} + \text{Net Income} - \text{Dividends Declared}$

  3. Balance Sheet:

     • Prepared third using Assets, Liabilities, and the newly calculated ending Retained Earnings balance under Stockholders' Equity ($A = L + E$).

Closing the Accounting Cycle

• Permanent vs. Temporary Accounts:

  • Permanent Accounts:

    • Accounts for Asset, Liability, and Stockholders' Equity items.

    • Balances are carried forward from the current accounting period into future accounting periods.

    • Never closed to zero.

  • Temporary Accounts:

    • Accounts for Revenue, Expense, Gain, Loss, and Dividends Declared items.

    • Used to accumulate activities for a single accounting period only.

• Purpose of Closing Entries (Step 7):

  1. Transfer the balances of temporary accounts (revenues, expenses, gains, losses, dividends declared) into Retained Earnings (a permanent stockholders' equity account).

  2. Zero out temporary accounts (reduce balances to $0$ as of January 1) so they are ready to accumulate business activities for the next accounting period.

• 3-Step Procedure for Closing Temporary Accounts:

  • Step 1: Close Revenues (and Gains) to Retained Earnings.

    • Debit: Revenue Accounts (for their full ending balances)

    • Credit: Retained Earnings

  • Step 2: Close Expenses (and Losses) to Retained Earnings.

    • Debit: Retained Earnings (for total sum of expenses)

    • Credit: Expense Accounts (for their individual balances)

  • Step 3: Close Dividends Declared to Retained Earnings.

    • Debit: Retained Earnings

    • Credit: Dividends Declared

• Example 9 (Porter Properties Inc. Year-End Closing):

  • Given Dec 31 General Ledger Balances:

    • Rent Revenue: $2,174,000$

    • Salaries Expense: $1,300,000$

    • Supplies Expense: $150,000$

    • Interest Expense: $15,000$

    • Insurance Expense: $20,000$

    • Retained Earnings (Beginning of year, Jan 1): $1,135,000$

    • Dividends Declared: $5,000$

  • Step 1: Close Revenue to Retained Earnings:

    • Debit: Rent Revenue $2,174,000$

    • Credit: Retained Earnings $2,174,000$

  • Step 2: Close Expenses to Retained Earnings:

    • Total Expenses = $1,300,000 + 150,000 + 15,000 + 20,000 = 1,485,000$

    • Debit: Retained Earnings $1,485,000$

    • Credit: Salaries Expense $1,300,000$

    • Credit: Supplies Expense $150,000$

    • Credit: Interest Expense $15,000$

    • Credit: Insurance Expense $20,000$

  • Step 3: Close Dividends Declared to Retained Earnings:

    • Debit: Retained Earnings $5,000$

    • Credit: Dividends Declared $5,000$

  • Calculation of Financial Summary Results:

    • $\text{Net Income} = \text{Revenues} - \text{Expenses} = 2,174,000 - 1,485,000 = 689,000$

    • $\text{Ending Retained Earnings (12/31)} = 1,135,000 + 689,000 - 5,000 = 1,819,000$

    • All temporary accounts (Rent Revenue, Salaries Expense, Supplies Expense, Interest Expense, Insurance Expense, Dividends Declared) now have a balance of $0$ as of January 1 of the next year.