Accrual Accounting Concepts

Cash basis accounting recognizes revenues and expenses only when cash is received or paid.
- Revenues are recorded when cash is received.
- Expenses are recorded when cash is paid.
- Accounting focuses on actual cash flow ("Cash In, Cash Out").

Accrual basis accounting recognizes revenues and expenses when they are earned or incurred, regardless of when cash is received or paid.
- Generally forbidden by GAAP (Generally Accepted Accounting Principles).

Revenue Recognition Principle
- Revenues are recognized in the period they are earned, regardless of cash receipt.
Matching Principle
- Expenses are recorded in the period they help to generate revenues, regardless of when cash is paid.

Scenario: Capital Kitchen Catering (CKC) opened on December 31, 2025, and catered a party that same day for $2,000 on account, with payroll costs of $500 due on January 15, 2026, and cash food expenses of $300 paid on December 31, 2025.
- Cash Basis Income Statement for the year ending 12/31/25:
- Revenues: $0
- Expenses: $(300)
- Net Income (Loss): $(300)
- Accrual Basis Income Statement for the year ending 12/31/25:
- Revenues: $2,000
- Expenses: $(800) (includes $500 payroll costs and $300 food expenses)
- Net Income: $1,200

Definition: Journal entries made at the end of an accounting period to update account balances to align with the revenue recognition and matching principles.

Prepaid assets are paid for in advance but not yet used, becoming expenses over time.
- Example: Insurance policy paid in advance.
- Adjusting Journal Entry on 11/1/25:
- Prepaid Insurance ↑ $600
- Cash ↓ $600
- Insurance Expense Adjustment on 12/31/25:
- Insurance Expense ↑ $200
- Prepaid Insurance ↓ $200
- Consequences of Not Recording Adjusting Entry:
- Understatement of Expenses
- Overstatement of Assets
Other examples of prepaid assets include:
- Prepaid Advertising
- Prepaid Rent
- Supplies

Scenario: Lahey Advertising Company has Supplies of $8,800, Supplies Expense of $0, and $1,100 of supplies on hand on December 31.
- Adjusting Entry:
- Supplies Expense ↑ $7,700
- Supplies ↓ $7,700
- Consequences of Not Recording Adjusting Entry:
- Understatement of Expenses
- Overstatement of Assets

Revenues that are earned but not yet billed or recorded.
- Journal Entry:
- Accounts Receivable ↑ $xxxx
- Service Revenue ↑ $xxxx

Expenses incurred but not yet recorded.
- Journal Entry:
- Expense ↑ $xxxx
- Payable ↑ $xxxx
- Example: Employee salary example with accrual at fiscal year-end.

Interest accrued on notes payable needs to be recorded until paid.
- Interest Expense Calculation Formula:
  $ext{Interest Expense} = ext{Principal} imes ext{Annual Interest Rate} imes rac{ ext{Months Passed}}{12}$
- Example: A $6,000 note at 10% interest due in 5 months accrues interest of:
  $6,000 imes rac{10}{100} imes rac{5}{12} = 250$

Scenario: Unadjusted trial balance includes several items needing adjustments based on predefined data and assumptions.

Required Adjusting Entries:

Supplies Adjusting Entry: Supplies Expense ↑ $700
- Supplies ↓ $700
Unearned Revenue Adjusting Entry: Unearned Revenue ↓ $1,000
- Service Revenue ↑ $1,000
Depreciation Adjusting Entry: Depreciation Expense ↑ $50
- Accumulated Depreciation ↑ $50
Accrued Revenue Adjusting Entry: Accounts Receivable ↑ $900
- Service Revenue ↑ $900
Accrued Interest Adjusting Entry: Interest Expense ↑ $75
- Interest Payable ↑ $75
Accrued Expense (Salary) Adjusting Entry: Salaries Expense ↑ $4,000
- Salaries Payable ↑ $4,000

Closing entries are made at year-end and serve to:
1. Transfer revenues, expenses, and dividends to Retained Earnings.
2. Update the Retained Earnings balance.
3. Reset revenue, expense, and dividend balances to zero for the new year.

Bowry Services Company Adjusted Trial Balance EXAMPLE:
- Record each of the required closing entries for revenues, expenses, and dividends.
- Calculate updated Retained Earnings after journalizing and posting adjustments.