Adjusting the Accounts: Accrual Accounting and Financial Reporting Principles

Accrual Basis of Accounting and the Time Period Assumption

• Time Period (Periodicity) Assumption

  • Accountants divide the economic life of a business into artificial time periods for reporting purposes.
  • Accounting time periods are typically a month, a quarter, or a year.
  • Interim Periods: Monthly and quarterly time periods are specifically referred to as interim periods.
  • Fiscal Year: An accounting time period that is exactly one year in length.
  • Calendar Year: An accounting period that runs from January 1 to December 31.
  • Variable Year-End: Some companies use a year-end that varies, resulting in accounting periods of either 52 or 53 weeks.
  • Most large companies are required to prepare both quarterly and annual financial statements.

• Accrual-Basis Accounting

  • Transactions are recorded in the periods in which the specific events occur.
  • Revenue Recognition: Companies recognize revenues when they perform services, rather than necessarily when they receive cash.
  • Expense Recognition: Expenses are recognized when they are incurred, rather than when they are paid.
  • Accrual-basis accounting is the method required by the International Financial Reporting Standards (IFRS).

• Cash-Basis Accounting

  • Revenues are recorded only when cash is received.
  • Expenses are recorded only when cash is paid.
  • Cash-basis accounting is not in accordance with IFRS.

• Revenue Recognition Principle

  • Companies must 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.

• Expense Recognition Principle

  • Also known as the matching principle: efforts (expenses) should be recognized in the period in which the company makes efforts to generate revenue.
  • Examples of efforts include advertising, delivery, and utilities. Expenses follow revenues.

• Five-Step Revenue Recognition Process (Sierra Travels Example)

  • Assume Sierra Travels signs a contract with the Lewis family to provide guide services for a one-week backpacking trip for $€1,500$.
  • The five steps involve identifying the contract, identifying performance obligations, determining the price, allocating the price, and recognizing revenue when obligations are fulfilled.

The Nature and Purpose of Adjusting Entries

• Definition and Necessity

  • Adjusting entries ensure that both the revenue recognition and expense recognition principles are followed.
  • They are required every time a company prepares financial statements.
  • Every adjusting entry includes one income statement account and one statement of financial position account.

• Reasons Adjusting Entries are Required

  • Efficiency: Some events are not recorded daily because it is not efficient (e.g., use of office supplies).
  • Passage of Time: Some costs expire with time (e.g., rent, insurance) rather than through daily transactions.
  • Unrecorded Items: Some items, like a utility bill that hasn't arrived, may be unrecorded at the end of the period.

• Major Categories of Adjusting Entries

  1. Deferrals:
     • Prepaid Expenses: Expenses paid in cash before they are used or consumed.
     • Unearned Revenues: Cash received before services are performed.
  2. Accruals:
     • Accrued Revenues: Revenues for services performed but not yet received in cash or recorded.
     • Accrued Expenses: Expenses incurred but not yet paid in cash or recorded.

• Initial Trial Balance Example: Yazici Advertising A.Ş.

  • Trial Balance as of October 31, 2025 (in Liras ₺):
    • Cash: $₺15,200$ (Debit)
    • Supplies: $₺2,500$ (Debit)
    • Prepaid Insurance: $₺600$ (Debit)
    • Equipment: $₺5,000$ (Debit)
    • Notes Payable: $₺5,000$ (Credit)
    • Accounts Payable: $₺2,500$ (Credit)
    • Unearned Service Revenue: $₺1,200$ (Credit)
    • Share Capital-Ordinary: $₺10,000$ (Credit)
    • Retained Earnings: $₺0$
    • Dividends: $₺500$ (Debit)
    • Service Revenue: $₺10,000$ (Credit)
    • Salaries and Wages Expense: $₺4,000$ (Debit)
    • Rent Expense: $₺900$ (Debit)
    • Totals: $₺28,700$ (Debit) / $₺28,700$ (Credit)

Adjusting Entries for Deferrals

• Prepaid Expenses

  • Costs that expire through the passage of time (rent, insurance) or use (supplies).
  • Adjustment Logic: Prior to adjustment, assets are overstated and expenses are understated.
  • Supplies Example: Yazici Advertising purchased supplies costing $₺2,500$ on Oct 5. On Oct 31, an inventory count shows $₺1,000$ of supplies on hand.
    • Calculation: $2,500 - 1,000 = 1,500$ used.
    • Entry: Debit Supplies Expense $₺1,500$; Credit Supplies $₺1,500$.
  • Insurance Example: On Oct 4, Yazici paid $₺600$ for a one-year policy starting Oct 1.
    • Calculation: $600 \div 12 = 50$ per month.
    • Entry: Debit Insurance Expense $₺50$; Credit Prepaid Insurance $₺50$.

• Depreciation

  • Depreciation is an allocation concept, not a valuation concept. It allocates an asset's cost to the periods it is used.
  • Contra Asset Account: Accumulated Depreciation is used to record total cost expensed to date without losing the original cost of the asset on the books.
  • Book Value (Carrying Value): The difference between the cost of the depreciable asset and its related accumulated depreciation.
  • Depreciation Example: Equipment depreciation is $₺480$ per year, or $₺40$ per month.
    • Entry: Debit Depreciation Expense $₺40$; Credit Accumulated Depreciation—Equipment $₺40$.
  • Statement Presentation of Equipment:
    • Equipment: $₺5,000$
    • Less: Accumulated Depreciation—Equipment: $(40)$
    • Book Value: $₺4,960$

• Unearned Revenues

  • Occurs when cash is received before services are performed (e.g., rent, magazine subscriptions, gift cards).
  • Adjustment Logic: Prior to adjustment, liabilities are overstated and revenues are understated.
  • Example (Gift Cards - Marks & Spencer plc):
    • Dec 24, 2024: Purchase of $€100$ gift card. Recognition: Liability (Unearned Sales Revenue).
    • Jan 3, 2025: Card used to buy merchandise. Recognition: Revenue recognized, Liability decreased.
  • Advertising Service Example: Yazici received $₺1,200$ on Oct 2 for services to be completed by Oct 31. By month-end, the performance obligation is satisfied.
    • Entry: Debit Unearned Service Revenue $₺400$ (based on specific service level performed); Credit Service Revenue $₺400$.

Adjusting Entries for Accruals

• Accrued Revenues

  • Revenues for services performed but not yet recorded or billed.
  • Adjustment Logic: Prior to adjustment, both assets and revenues are understated.
  • Example: Yazici performed services worth $₺200$ in October that were not billed by Oct 31.
    • Entry: Debit Accounts Receivable $₺200$; Credit Service Revenue $₺200$.
    • Collection on Nov 10: Debit Cash $₺200$; Credit Accounts Receivable $₺200$.

• Accrued Expenses

  • Expenses incurred but not yet paid or recorded.
  • Adjustment Logic: Prior to adjustment, both liabilities and expenses are understated.

• Accrued Interest

  • Formula for Interest:     $\text{Face Value of Note} \times \text{Annual Interest Rate} \times \text{Time in Terms of One Year} = \text{Interest}$
  • Example: Yazici signed a $₺5,000$, 3-month note at $12\%$ annual interest on Oct 1.
    • Calculation for 1 month: $5,000 \times 0.12 \times \frac{1}{12} = 50$
    • Entry: Debit Interest Expense $₺50$; Credit Interest Payable $₺50$.

• Accrued Salaries and Wages

  • Example: Yazici's employees earn $₺2,000$ for a 5-day work week ($₺400$ per day). They were paid on Friday, Oct 26. The next pay period includes Oct 29, 30, and 31 (Monday, Tuesday, Wednesday).
    • Calculation: $400 \times 3 = 1,200$
    • Entry: Debit Salaries and Wages Expense $₺1,200$; Credit Salaries and Wages Payable $₺1,200$.
  • Subsequent Payment (Nov 9): Total payroll is $₺4,000$ for 10 working days.
    • Entry: Debit Salaries and Wages Payable $₺1,200$ (for Oct); Debit Salaries and Wages Expense $₺2,800$ (for Nov 1-9); Credit Cash $₺4,000$.

The Adjusted Trial Balance and Financial Statements

• Adjusted Trial Balance

  • Prepared after all adjusting entries are journalized and posted.
  • Purpose: To prove the equality of total debit and credit balances after adjustments.
  • It serves as the primary basis for preparing financial statements (Income Statement, Retained Earnings Statement, and Statement of Financial Position).

• Financial Statement Relationships

  1. Income Statement: Net income is computed by subtracting Expenses from Revenues (e.g., Yazici's Revenue $₺10,600$ - Expenses $₺7,740 = ₺2,860$ Net Income).
  2. Retained Earnings Statement: Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings.
  3. Statement of Financial Position: Reports Assets, Liabilities, and Equity. Ending Retained Earnings from the previous statement is used here.

• Summary of Adjusting Entry Effects

  • Prepaid Expenses: Dr. Expenses, Cr. Assets (or Contra Assets).
  • Unearned Revenues: Dr. Liabilities, Cr. Revenues.
  • Accrued Revenues: Dr. Assets, Cr. Revenues.
  • Accrued Expenses: Dr. Expenses, Cr. Liabilities.

Conceptual Framework of Financial Reporting

• Qualities of Useful Information

  • Relevance: Information should provide predictive value, confirmatory value, and be material.
  • Faithful Representation: Information must be complete, neutral, and free from error.
  • Enhancing Qualities: Includes Comparability (and consistency), Verifiability, Timeliness, and Understandability.

• Assumptions in Financial Reporting

  • Monetary Unit: Only things that can be expressed in money are included.
  • Economic Entity: Activities of the entity are separate from owners.
  • Time Period: Life of business divided into artificial periods.
  • Going Concern: The business will remain in operation for the foreseeable future.

• Measurement Principles

  • Historical Cost Basis: Companies record assets at their original cost.
  • Current Value Basis: Assets/liabilities reported at current value (price to sell/settle), value in use (present value of cash flows), or current cost (replacement cost).
  • Full Disclosure Principle: All circumstances/events that make a difference to users must be disclosed.

• Cost Constraint

  • Standard setters weigh the cost companies incur to provide information against the benefit users gain from it.

Ethics and Practical Exercises

• Ethics Insight (Krispy Kreme):

  • Motivations for inaccurate reporting include greed (bonuses/promotions), extravagant lifestyles, and meeting unrealistic revenue goals to avoid job loss or support failing leadership.

• DO IT! 3: Mahindra Computer Services (Accruals)

  • Salaries owed: $₹800$. Entry: Dr Salaries and Wages Expense $₹800$, Cr Salaries and Wages Payable $₹800$.
  • Mortgage: $₹30,000$ at $10\%$ interest. Monthly interest calculation:         $30,000 \times 0.10 \times \frac{1}{12} = 250$         Entry: Dr Interest Expense $₹250$, Cr Interest Payable $₹250$.
  • Accrued Service Revenue: $₹1,100$. Entry: Dr Accounts Receivable $₹1,100$, Cr Service Revenue $₹1,100$.

• DO IT! 4: Kang Company

  • Net Income = Revenues - Expenses.
  • Total Assets = Cash + Accounts Receivable + Supplies + Prepaid Insurance + Equipment - Accumulated Depreciation.
  • Ending Retained Earnings includes the net income for the period minus any dividends.