2. Kimmel ● Weygandt ● Kieso Financial Accounting, Eighth Edition4
Accrual Accounting Concepts
Kimmel ● Weygandt ● Kieso
Financial Accounting, Eighth Edition

3. Learning Objectives
After studying this chapter, you should be able to:
Explain the accrual basis of accounting and the reasons for adjusting entries
Prepare adjusting entries for deferrals
Prepare adjusting entries for accruals
Prepare an adjusted trial balance and closing entries

4. Timing Issues
Accountants divide the economic life of a business into artificial time periods (Periodicity Assumption).
Jan.
Feb.
Mar.
Apr.
Dec.
Generally a month, a quarter, or a year.
Fiscal year vs. calendar year
▼ HELPFUL HINT
An accounting time period that is one year long is called a fiscal year.
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5. Timing Issues The Revenue Recognition Principle
Companies recognize revenue in the accounting period in which it is earned.
A service entity earns its revenue when it performs the service.
A merchant or manufacturer earns its revenue when it delivers the goods.
TEACHING TIP
Service businesses recognize revenue when the services are performed, although many customers may have been billed for the services (on account). The cash has not been received; however, the services have been performed. Therefore, revenue should be recognized.
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6. “Let the expenses follow the revenues.”
Timing Issues
The Expense Recognition Principle
Companies match expenses with the revenues they help generate.
“Let the expenses follow the revenues.”
Most expenses cannot be matched with revenues, and thus are recognized in the period in which they are incurred (e.g., salaries and utilities) or over time (e.g., insurance and interest).
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8. Timing Issues Accrual versus Cash Basis of Accounting
Accrual-Basis Accounting
Transactions recorded in the periods in which the related economic events occur.
Revenues are recognized when earned, even if cash is received in a different period.
Expenses are recognized when incurred, even if cash is paid in a different period.
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9. Timing Issues Accrual versus Cash Basis of Accounting
Cash-Basis Accounting
Revenues are recognized only when cash is received.
Expenses are recognized only when cash is paid.
Prohibited under generally accepted accounting principles (GAAP).
TEACHING TIP
Explain to students that many businesses use the cash basis of accounting. These businesses outgrow the method when accounts receivable and accounts payable become substantial. Also, if the businesses need audited financial statements, they must comply with GAAP and use the accrual basis. Remind them that companies can use the cash method and that its use does not mean that income is being manipulated. Without this discussion, some students may unfairly criticize an employer, relative or friend who is using the cash basis of accounting.
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10. Timing Issues
Illustration: Suppose that Fresh Colors paints a large building in In 2016, it incurs and pays total expenses (salaries and paint costs) of $50,000. It bills the customer $80,000, but does not receive payment until 2017.
Illustration 4-2
2016
2017
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11. Timing Issues Review Question
Which one of these statements about the accrual basis of accounting is false?
Companies record events that change their financial statements in the period in which events occur, even if cash was not exchanged.
Companies recognize revenue in the period in which the performance obligation is satisfied.
This basis is in accord with generally accepted accounting principles.
Companies record revenue only when they receive cash, and record expense only when they pay out cash.
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12. The Basics of Adjusting Entries
Journalize and Post Adjusting Entries
Analyze business transactions
Journalize
Post
Trial Balance
Adjusted Trial Balance
Financial Statements
Closing Entries
Post-Closing Trial Balance
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13. The Basics of Adjusting Entries
ensure that the revenue recognition and expense recognition principles are followed, and the amounts on balance sheet and income statement are correct.
are required every time a company prepares financial statements.
includes one income statement account and one balance sheet account.
never include cash.
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14. The Basics of Adjusting Entries
Review Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they are incurred.
b. revenues are recognized in the period in which the performance obligation is satisfied.
c. balance sheet and income statement accounts have correct balances at the end of an accounting period.
d. All of the above.
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15. Types of Adjusting Entries
Illustration 4-3
Categories of adjusting entries
Deferrals:
Prepaid expenses: Expenses paid but not yet used or consumed.
Unearned revenues: Revenues received but not yet earned.
Accruals:
Accrued expenses: Expenses incurred but not yet paid or recorded.
Accrued revenues: Revenues earned but not yet received or recorded.
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16. Types of Adjusting Entries
Trial Balance – Each account in the trial balance is analyzed to determine whether it is complete and up-to-date.
Illustration 4-4
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17. Adjusting Entries for “Prepaid Expenses”
Expenses are paid for but not yet used or consumed.
Cash Payment
Expense Incurred
BEFORE
Prepayments often occur in regard to:
insurance
supplies
advertising
rent
equipment
buildings
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18. Adjusting Entries for “Prepaid Expenses”
The objective is to record the costs that have expired either with the passage of time or through use and to show the assets that remain.
Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit) to an asset account.
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19. Adjusting Entries for “Prepaid Expenses”
Illustration 4-5
Increases (debits) an expense account and
Decreases (credits) an asset account.
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20. Adjusting Entries for “Prepaid Expenses”
Illustration: Sierra Corporation purchased supplies costing $2,500 on October 5. Sierra recorded the purchase 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
($2,500 – 1,000 = $1,500)
Illustration 4-6
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21. Adjusting Entries for “Prepaid Expenses”
Depreciation
Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an expense, in the year acquired.
Companies report a portion of the cost of a long-lived asset as an expense (depreciation) during each period of the asset’s useful life.
Depreciation does not attempt to report the actual change in the value of the asset.
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22. Adjusting Entries for “Prepaid Expenses”
Illustration: For Sierra Corporation, assume that depreciation on the office equipment is $480 a year, or $40 per month.
Oct. 31
Depreciation Expense 40
Accumulated Depreciation-Equipment 40
Illustration 4-8
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23. Adjusting Entries for “Prepaid Expenses”
Statement Presentation
Accumulated Depreciation- Equipment is a contra asset account.
Appears just after the account it offsets (Equipment) on the balance sheet.
▼ HELPFUL HINT
All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate.
Illustration 4-9
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24. Adjusting Entries for “Prepaid Expenses”
Summary
Illustration 4-10
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25. Adjusting Entries for “Unearned Revenues”
Revenues received but not yet earned.
Cash Receipt
Revenue Earned
BEFORE
Unearned revenues often occur in regard to:
rent
airline tickets
magazine subscriptions
customer deposits
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26. Adjusting Entries for “Unearned Revenues”
The objective is to record the revenue that has been earned and to show the liability that remains.
Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
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27. Adjusting Entries for “Unearned Revenues”
Illustration 4-11
Decrease (a debit) to a liability account and
Increase (a credit) to a revenue account.
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28. Adjusting Entries for “Unearned Revenues”
Illustration: Sierra Corporation received $1,200 on October 2 from R. Knox for guide services for multi-day trips expected to be completed by December 31. Unearned Service Revenue shows a balance of $1,200 in the October 31 trial balance. From an evaluation of the service Sierra performed for Knox during October, the company determines that it has earned $400 in October.
Oct. 31
Unearned Service Revenue
400
Service Revenue
400
Illustration 4-12
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29. ACCOUNTING FOR UNEARNED REVENUES
Adjusting Entries for “Unearned Revenues”
Summary
Illustration 4-13
ACCOUNTING FOR UNEARNED REVENUES
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Examples
Rent, magazine subscriptions, customer deposits for future service
Unearned Revenues recorded in liability accounts are now recognized as revenue for services performed
Liabilities overstated.
Revenues understated.
Dr. Liabilities
Cr. Revenues
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30. Adjusting Entries for “Accrued Expenses”
Expenses incurred but not yet paid in cash or recorded.
Expense Incurred
Cash Payment
BEFORE
Accrued expenses often occur in regard to:
rent
interest
taxes
salaries
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31. Adjusting Entries for “Accrued Expenses”
An adjusting entry serves two purposes:
(1) Records the obligations, and
(2) Recognizes the expenses.
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32. Adjusting Entries for “Accrued Expenses”
Illustration 4-17
Increases (debits) an expense account and
Increases (credits) a liability account.
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33. Adjusting Entries for “Accrued Expenses”
Illustration: Sierra Corporation signed a three-month note payable in the amount of $5,000 on October 1. The note requires Sierra to pay interest at an annual rate of 12%.
Illustration 4-18
Oct. 31
Interest Expense 50
Interest Payable 50
Illustration 4-19 (Partial)
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34. Adjusting Entries for “Accrued Expenses”
Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 × 3 days).
Illustration 4-20
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35. Adjusting Entries for “Accrued Expenses”
Illustration: Sierra Corporation last paid salaries on October 26; the next payment of salaries will not occur until November 9. The employees receive total salaries of $2,000 for a five-day work week, or $400 per day. Thus, accrued salaries at October 31 are $1,200 ($400 x 3 days).
Oct. 31
Salaries and Wages Expense
1,200
Salaries and Wages Payable
1,200
Illustration 4-21
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36. Adjusting Entries for “Accrued Expenses”
Summary
Illustration 4-22
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37. Adjusting Entries for “Accrued Revenues”
Revenues earned but not yet received in cash or recorded.
Revenue Earned
Cash Receipt
BEFORE
Accrued revenues often occur in regard to:
rent
interest
services performed
LO 3

38. Adjusting Entries for “Accrued Revenues”
An adjusting entry serves two purposes:
(1) Shows the receivable that exists, and
(2) Records the revenues earned.
LO 3

39. Adjusting Entries for “Accrued Revenues”
Illustration 4-14
Increases (debits) an asset account and
Increases (credits) a revenue account.
LO 3

40. Adjusting Entries for “Accrued Revenues”
Illustration: In October, Sierra Corporation performed guide services for $200 that were not billed to clients before October 31.
Oct. 31
Accounts Receivable
200
Service Revenue
200
Illustration 4-15
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41. ACCOUNTING FOR ACCRUED REVENUES
Adjusting Entries for “Accrued Revenues”
Summary
Illustration 4-16
Illustration 4-16
ACCOUNTING FOR ACCRUED REVENUES
Reason for
Adjustment
Accounts Before
Adjustment
Adjusting
Entry
Examples
Interest, rent, services performed but not collected
Revenues have been earned but not yet received in cash or recorded
Assets understated.
Revenues understated.
Dr. Assets
Cr. Revenues
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42. The Adjusted Trial Balance
Analyze business transactions
Journalize
Post
Trial Balance
Adjusting Entries
Adjusted trial balance
Prepare financial statements
Journalize and post closing entries
Prepare a post-closing trial balance
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43. The Adjusted Trial Balance
After all adjusting entries are journalized and posted, the company prepares another trial balance from the ledger accounts (Adjusted Trial Balance).
The adjusted trial balance’s purpose is to prove the equality of debit balances and credit balances in the ledger.
The adjusted trial balance is the primary basis for the preparation of the financial statements.
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44. ILLUSTRATION 4-26
Adjusted trial balance
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45. The Adjusted Trial Balance
Review Question
Which of the following statements is incorrect concerning the adjusted trial balance?
An adjusted trial balance proves the equality of the total debit balances and the total credit balances in the ledger after all adjustments are made.
The adjusted trial balance provides the primary basis for the preparation of financial statements.
The adjusted trial balance lists the account balances segregated by assets and liabilities.
The adjusted trial balance is prepared after the adjusting entries have been journalized and posted.
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46. Preparing Financial Statements
Financial statements are prepared directly from the Adjusted Trial Balance.
Income Statement
Retained Earnings Statement
Balance Sheet
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47. Tell students to look at the date on the income statement in Illustration The date is “For the Month Ending October 31, 2014.” How can one be sure the revenues and expenses reported on the income statement are just for that period? Closing entries transfer the temporary account balances to the stockholders’ equity account and reduce the balances in the temporary accounts to zero. Therefore, at the beginning of the period the temporary accounts have a balance of zero and the revenues and expenses accumulated are for that particular period.
ILLUSTRATION 4-27
4-68

48. ILLUSTRATION 4-28
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49. Quality of Earnings
Quality of Earnings – company provides full and transparent information.
Earnings Management - the planned timing of revenues, expenses, gains, and losses to boost or reduce, or smooth out bumps in, net income. Companies may manage earnings by:
one-time items to prop up earnings numbers.
Inflate/deflate revenue numbers in the short-run.
improper adjusting entries.
As a result of the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.
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50. Closing the Books
At the end of the accounting period, companies transfer the temporary account balances to the permanent stockholders’ equity account – Retained Earnings.
Illustration 4-29
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51. Closing the Books
In addition to updating Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account.
Illustration 4-30
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52. Closing the Books
2017
Illustration 4-31

53. Closing the Books
Illustration 4-32
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54. Preparing a Post-Closing Trial Balance
The purpose of the post-closing trial balance is to prove the equality of the permanent account balances that the company carries forward into the next accounting period.
All temporary accounts will have zero balances.
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55. Summary of the Accounting Cycle
Illustration 4-33
1. Analyze business transactions
9. Prepare a post-closing trial balance
2. Journalize the transactions
8. Journalize and post closing entries
3. Post to ledger accounts
7. Prepare financial statements
4. Prepare a trial balance
6. Prepare an adjusted trial balance
Journalize and post adjusting entries:
Deferrals/Accruals

56. Keep an Eye on Cash
Sierra Corporation’s income statement shows net income of $2,860. Net income and net cash provided by operating activities often differ.
Net income on a cash basis is referred to as “Net cash provided by operating activities.”
The statement of cash flows, reports net cash provided by operating activities.
Illustration 4-27
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57. Keep an Eye on Cash
The difference for Sierra is $2,840 ($5,700 - $2,860). The following summary shows the causes of this difference.
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58. Key Points Companies applying IFRS use accrual-basis accounting.
Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
IFRS also divides the economic life of companies into artificial time periods. Under both GAAP and IFRS, this is referred to as the periodicity assumption.
IFRS requires that companies present a complete set of financial statements, including comparative information annually.
Compare the procedures for revenue recognition under GAAP and IFRS.

59. Key Points
The general revenue recognition principle required by GAAP that is used in this textbook is similar to that used under IFRS.
Revenue recognition fraud is a major issue in U.S. financial reporting. The same situation occurs in other countries, as evidenced by revenue recognition breakdowns at Dutch software company Baan NV, Japanese electronics giant NEC, and Dutch grocer AHold NV.
Compare the procedures for revenue recognition under GAAP and IFRS.

60. Key Points
Under IFRS, revaluation of items such as land and buildings is permitted. IFRS allows depreciation based on revaluation of assets, which is not permitted under GAAP.
The terminology used for revenues and gains, and expenses and losses, differs somewhat between IFRS and GAAP. For example, income under IFRS includes both revenues, which arise during the normal course of operating activities, and gains, which arise from activities outside of the normal sales of goods and services.
Compare the procedures for revenue recognition under GAAP and IFRS.

61. Looking to the Future
Under IFRS, expenses include both those costs incurred in the normal course of operations as well as losses that are not part of normal operations. This is in contrast to GAAP, which defines each separately.
Compare the procedures for revenue recognition under GAAP and IFRS.

62. IFRS Practice Which of the following statements is false?
IFRS employs the periodicity assumption.
IFRS employs accrual accounting.
IFRS requires that revenues and costs must be capable of being measured reliably.
IFRS uses the cash basis of accounting.
\Compare the procedures for revenue recognition under GAAP and IFRS.

63. IFRS Practice Accrual-basis accounting: is optional under IFRS.
results in companies recording transactions that change a company’s financial statements in the period in which events occur.
will likely be eliminated as a result of the IASB/FASB joint project on revenue recognition.
is not consistent with the IASB conceptual framework.
Compare the procedures for revenue recognition under GAAP and IFRS.

64. Under the accrual basis of accounting (GAAP), revenues are recognized when earned and expenses are matched with revenues (or recognized when incurred).
Generally, revenues are earned when goods are delivered or services are performed.
To ensure proper revenue and expense recognition, i.e., to ensure that the amounts on the balance sheet and the income statement are correct, adjustments are made for deferred & accrued expenses and revenues.

65. Deferred expenses (revenues) arise when paid (received) but not yet used or consumed (earned). Adjustment involves recognizing an expense (revenue) and a reduction in an asset (liability).
Accrued expenses (revenues) arise when the expense (revenue) is incurred (earned), but not yet paid (received) and recorded. Adjustment involves recognizing an expense (revenue) and a liability (asset).
After adjusting entries are made and posted, an adjusted trial balance is prepared to ensure adjusting entries were recorded and posted properly.

66. Financial statements are prepared directly from the Adjusted Trial Balance.
At the end of the accounting period, companies transfer the temporary account balances (i.e., revenues, expenses, and dividends) to Retained Earnings, and prepare a post-closing trial balance.
The accounting information processing is for the most part automated.
The standard setting bodies now emphasize the quality of earnings (accuracy and transparency of information).

67. Copyright
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Note: presentation somewhat modified by Reza Espahbodi