1. The Accounting Cycle: Accruals and Deferrals
Chapter 4
Chapter 4: The Accounting Cycle—Accruals and Deferrals.

2. Adjusting Entries Adjusting entries are Every adjusting
needed whenever
revenue or expenses affect more than one
accounting period.
Every adjusting
entry involves a change in either a revenue or expense
and an asset
or liability.
At the end of the period, we need to make adjusting entries to get the accounts up to date for the financial statements.
The accrual basis dictates that revenues be recognized when earned and expenses be recognized when incurred. The accrual basis of accounting is considered to be in compliance with generally accepted accounting principles, GAAP. Every adjusting entry involves a revenue or expense and an asset or liability. 4

3. Types of Adjusting Entries
Converting assets to expenses
Converting liabilities to revenue
There are two broad categories of adjustments.
The first is when payments are made or cash is received before the expense or revenue is recognized. This category includes prepaid or deferred expenses (including depreciation), and unearned or deferred revenues.
The second major category of adjustments is when cash is paid or received after the expense or revenue is recognized. These are very common adjustments. This category includes accrued expenses and accrued revenues.
Accruing unpaid expenses
Accruing uncollected revenue 4

4. Converting Assets to Expenses
End of Current Period
Prior Periods
Current Period
Future Periods
Adjusting Entry
Recognizes portion of asset consumed as expense, and
Reduces balance of asset account.
Transaction
Paid cash in advance of incurring expense
(creates an asset).
Part I When an adjusting entry is used to convert an asset to expense, a transaction took place in a prior period that involved the advance payment of an expense. Three common examples of adjusting entries to convert assets to expenses are the recognition of depreciation expense on plant assets, the using up of office supplies during the period, and the expiration of prepaid insurance. Part II The adjusting entry is made at the end of the current period to recognize the converting of the prepaid asset into an expense. The asset account is reduced and the expense account is increased. 4

5. Converting Assets to Expenses
$2,400 Insurance Policy Coverage for 12 Months
$200 Monthly Insurance Expense
On 1 January of the current year, Webb Company purchased a one-year insurance policy paying $2,400 in advance. The amount was charged to an asset account, unexpired insurance. Each month should reflect $200 of insurance expense assuming Webb prepares monthly financial statements.
1 Jan.
31 Dec.
On 1 January, Webb Co. purchased a one-year insurance policy for $2,400. 4

6. Converting Assets to Expenses
Initially, costs that benefit more than one accounting period are recorded as assets.
Here is the entry made by Webb on 1 January to record the purchase of the policy. A debit, or increase, is made to the asset Unexpired Insurance, and a credit, or decrease, is made to the asset account Cash for $2,400. 4

7. Converting Assets to Expenses
The costs are expensed as they are used to generate revenue.
At the end of January, Webb is going to prepare its financial statements.
The proper adjusting entry is to debit, or increase, the expense account Insurance Expense and to credit, or decrease, the asset account Unexpired Insurance for $200. Webb will make this adjusting entry at the end of each month. 4

8. Converting Assets to Expenses
Income Statement
Cost of assets used this period to generate revenue.
Balance Sheet
Cost of assets that benefit future periods.
After posting the adjusting entry to the general ledger accounts, it’s clear that the asset, Unexpired Insurance, has been partially converted into the expense account Insurance Expense. Both the asset account and the expense account are now carried at their proper balances. 4

9. The Concept of Depreciation
Depreciation is the systematic allocation of the cost of a depreciable asset to expense.
Cash (credit)
Fixed Asset (debit)
On date when initial payment is made . . .
The asset’s usefulness is partially consumed during the period.
At end of period . . .
Depreciation Expense (debit)
Accumulated Depreciation (credit)
Depreciation is the systematic and rational allocation of the cost of a depreciable asset to expense over its estimated useful life. There are many methods of depreciation; the straight-line method will be examined in this chapter.
As a depreciable asset is used to produce revenue, the asset loses some of its utility and part of the asset is consumed. At the end of the accounting period, the expense relating to the consumption of the depreciable asset must be recorded.

10. Depreciation Is Only an Estimate
On 2 May 2009, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months for $2,500 cash.
Using the straight-line method, calculate the monthly depreciation expense.
Depreciation
expense (per
period) =
Cost of the asset
Estimated useful life
Part I
On 2 May, JJ’s Lawn Care Service purchased a lawn mower with a useful life of 50 months. The lawn mower cost $2,500. JJ’s Lawn Care uses the straight-line method of depreciation and records depreciation expense monthly.
Part II
Depreciation expense is equal to the cost less any anticipated salvage value divided by the estimated useful life. Part III So, JJ’s Lawn Care should record depreciation expense of $50 per month. Let’s look at the adjusting entry required.
$2,500 50 =
$50

11. Depreciation Is Only an Estimate
JJ’s Lawn Care Service would make the following adjusting entry.
Part I
The adjusting journal entry required on 31 May is to debit, or increase, Depreciation Expense on Equipment and credit, or increase, the account Accumulated Depreciation on Equipment for $50.
Part II
The account Accumulated Depreciation on Equipment is a contra asset account. A contra account is a reduction in an associated account. In this case, Accumulated Depreciation will be shown on the balance sheet as a reduction in the Equipment account.
Contra-asset 4

12. Depreciation Is Only an Estimate
JJ’s $15,000 truck is depreciated over 60 months. Calculate monthly depreciation and make the journal entry.
Part I Remember that JJ’s Lawn Care purchased a truck for $15,000 on 1 May. The truck has an estimated useful life of five years, or 60 months. Can you calculate depreciation expense for the month of May on the newly acquired truck? When you are finished, go to the next screen. Part II The proper adjusting entry is to debit Depreciation Expense on Truck for $250, and credit Accumulated Depreciation on Truck for the same amount. The Accumulated Depreciation account will appear on the balance sheet as a reduction in the Truck account.
$15,00060 months = $250 per month 4

13. Depreciation Is Only an Estimate
Accumulated depreciation would appear on the balance sheet as follows:
This slide shows how JJ’s Lawn Care shows its plant assets. Notice that the contra accounts are subtracted from the related asset account. The cost of an asset less the accumulated depreciation is equal to book value of that asset. Book value is not intended to represent an asset’s current market value.
Cost - Accumulated Depreciation = Book Value 4

14. Converting Liabilities to Revenue
End of Current Period
Prior Periods
Current Period
Future Periods
Adjusting Entry
Recognizes portion
earned as revenue, and
Reduces balance of liability account.
Transaction
Collect cash in advance of earning revenue
(creates a liability).
Part I Now let’s look at the adjusting entry associated with converting a recorded liability to a revenue. The adjusting entry is necessary when cash has been collected in advance of earning revenue. An example is when a magazine publishing company collects cash for a one- or two-year subscription. Other examples of transactions that require an adjusting entry to convert a liability to revenue are the sales of airline tickets, or season tickets for a sports team.
Part II At the end of the accounting period, an adjusting entry will need to be recorded to recognize the revenue earned during the period and to reduce the liability account. 4

15. Converting Liabilities to Revenue
$6,000 Rental Contract Coverage for 12 Months
$500 Monthly Rental Revenue
Webb Company is a landlord. On 1 January, Webb received $6,000 in advance for a one-year rental on office space it owns. Because Webb prepares monthly financial statements, it should recognize $500 per month in rental revenue. Let’s see how this transaction was recorded by Webb.
1 Jan.
31 Dec.
On January 1, Webb Co. received $6,000 in advance for a one-year rental contract. 4

16. Converting Liabilities to Revenue
Initially, revenues that benefit more than one accounting period are recorded as liabilities.
On 1 January, Webb debited Cash for $6,000 and credited the liability account called Unearned Rent Revenue for the same amount. Don’t let the word revenue in the liability account title mislead you. The important descriptor is the word Unearned. Unearned revenue is a liability. Webb must do something to earn this revenue. Let’s look at the journal entry required on 31 January to recognize the revenue earned during the month. 4

17. Converting Liabilities to Revenue
Over time, the revenue is recognized as it is earned.
On 31 January, Webb would debit, or reduce, the liability account Unearned Rent Revenue and credit, or increase, the Rental Revenue account for $500, one-months rent earned. 4

18. Converting Liabilities to Revenue
Income Statement
Revenue earned this period.
Balance Sheet
Liability for future periods.
The balance in the Unearned Rental Revenue account represents 11 months of unearned rent at $500 per month.
The balance in the Rental Revenue account for January is $500. This amount will appear on Webb’s income statement. 4

19. Accruing Unpaid Expenses
End of Current Period
Prior Periods
Current Period
Future Periods
Adjusting Entry
Recognizes expense incurred, and
Records liability for future payment.
Transaction
Pay cash in settlement of liability.
Part I One of the keys to understanding the accrual of expenses is to realize that an expense has been incurred in the current accounting period but will not be paid until the following accounting period. For example, you may purchase gasoline from the local service station using a credit card. You have incurred the expense for the gasoline but have not recorded the cost. You probably will not record your expense until the following period when the credit card statement comes. Companies cannot follow this practice because expenses would be recorded in the wrong accounting period and thus violate the matching principle.
Part II The adjusting entry required is to debit, or increase, an expense account and credit, or increase, a liability account. Almost all expense accruals will require this type of entry. Some common accrued expenses include interest owed on loans, wages and salaries owed to employees, and property taxes owed to the local taxing authority. 4

20. Accruing Unpaid Expenses
$3,000 Wages Expense
Monday,
29 May
Wednesday,
31 May
Friday, 2 June
Here is an example of accrued wages. Webb Company pays its employees each Friday. The end of the current month, May, is on Wednesday. There have been $3,000 in wages earned by Webb’s employees from Monday, 29 May, through Wednesday, 31 May.
Can you prepare the adjusting journal entry required of Webb on 31 May?
On 31 May, Webb Co. owes wages of $3,000. Payday is Friday, 2 June. 4

21. Accruing Unpaid Expenses
Initially, an expense and a liability are recorded.
As with most expense accruals, Webb will debit an expense account, in this case Wages Expense, for $3,000 and credit a liability account, in this case Wages Payable, for $3,000. The wages earned by employees during May will be recorded in the proper period. 4

22. Accruing Unpaid Expenses
Income Statement
Cost incurred this period to generate revenue.
Balance Sheet
Liability to be paid in a future period.
The balance in the Wages Payable liability account is $3,000 and will appear on the balance sheet of Webb at 31 May. The Wages Expense account will be increased by $3,000, and this amount will be included on May’s income statement. 4

23. Accruing Unpaid Expenses
$5,000 Weekly Wages
$3,000 Wages Expense
$2,000 Wages Expense
Two thousand dollars of wages were earned by employees on Thursday, 1 June, and Friday, 2 June. Let’s look at the entry Webb will make on payday, Friday, 2 June. We need to be careful because part of the $5,000 of total wages expense has already been recognized. Try to make this entry to record the wages on 2 June before going to the next screen.
Monday,
29 May
Wednesday,
31 May
Friday, 2 June
Let’s look at the entry for 2 June. 4

24. Accruing Unpaid Expenses
The liability is extinguished when the debt is paid.
Wages Expense should have a debit for $2,000, the portion of the total payroll applicable to June. Next, eliminate the Wages Payable for $3,000. The balance in the Wages Payable account is now zero. Finally, credit the Cash account for the full cost of the payroll, $5,000. 4

25. Accruing Uncollected Revenue
End of Current Period
Prior Periods
Current Period
Future Periods
Adjusting Entry
Recognizes revenue
earned but not yet
recorded, and
Records receivable.
Transaction
Collect cash in settlement of receivable.
Part I A revenue accrual is necessary when revenue has been earned in the current accounting period but the cash will not be collected until the next period. Examples of revenue accruals include interest earned on investments or loans made to others, and work completed but not yet billed to the customer.
Part II In the adjusting entry we will record a receivable, an asset account, and recognize the revenue earned. 4

26. Accruing Uncollected Revenue
$170 Interest Revenue
Saturday,
15 Jan.
Monday,
31 Jan.
Tuesday, 15 Feb.
Webb has deposits at a bank in an interest-bearing account. Interest is paid by the bank on the 15th of each month. The end of Webb’s accounting period falls on 31 January. From 15 January until 31 January, Webb earned $170 on its account at the bank. Let’s make the adjusting entry to recognize the interest earned from 15 January to 31 January.
On 31 Jan., the bank owes Webb Co. interest of $170. Interest is paid on the 15th day of each month. 4

27. Accruing Uncollected Revenue
Initially, the revenue is recognized and a receivable is created.
Webb will debit the asset account, Interest Receivable, for $170 and credit the revenue account, Interest Revenue, for the same amount. 4

28. Accruing Uncollected Revenue
Balance Sheet
Receivable to be collected in a future period.
Income Statement
Revenue earned this period.
The asset, Interest Receivable, will appear on Webb’s balance sheet at 31 January. The Interest Revenue account will be shown on Webb’s income statement for the month ended 31 January. 4

29. Accruing Uncollected Revenue
$320 Monthly Interest
$170 Interest Revenue
$150 Interest Revenue
Webb earned an additional $150 from the 1 February until 15 February when interest was paid. Webb will receive a total of $320 on 15 February.
Once again, be careful because part of the $320 has already been recognized as revenue. Try to record the entry for the receipt on 15 February before going to the next screen.
Saturday,
15 Jan.
Monday,
31 Jan.
Tuesday, 15 Feb.
Let’s look at the entry for 15 February. 4

30. Accruing Uncollected Revenue
The receivable is collected in a future period.
First, debit the asset account, Cash, for the full $320. Next, credit the Interest Revenue account for $150, the amount earned during the month of February. Finally, eliminate the Interest Receivable account for $170. This must be done because the cash has now been received. 4

31. Accruing Income Taxes Expense: The Final Adjusting Entry
As a corporation earns taxable income, it incurs income taxes expense, and also a liability to governmental tax authorities.
A corporation must pay income tax on its taxable income. Corporate taxes are due on 15 March of the year following the year in which the income was earned. The corporate income taxes for 2008 are due on 15 March It is always necessary to accrue income taxes for a corporation. The adjusting entry is just like the entry we record for any accrued expense. The adjusting entry is to debit Income Taxes Expense for the amount of the accrual and credit Income Taxes Payable for the same amount. In this case, the taxes due are $780. 4

32. Adjusting Entries and Accounting Principles
Costs are matched with revenue in two ways:
Direct association of costs with specific revenue transactions.
Adjusting entries help us match costs with revenues either directly by associating certain costs with specific revenues, or through the allocation process. Allocation was used to record depreciation expense in this chapter.
Systematic allocation of costs over the “useful life” of the expenditure.

33. The Concept of Materiality
An item is “material” if knowledge of the item might reasonably influence the decisions of users of financial statements.
Supplies
Light bulbs
Many companies immediately charge the cost of immaterial items to expense.
Generally, accountants are most concerned about amounts that are determined to be material in nature. An amount is material if it may influence the decision of an informed user of financial information. When amounts involved are not material, many companies have established a policy of expensing the amount immediately. We know that light bulbs may last through several accounting periods. It is not cost beneficial to record the bulbs as assets and allocate a portion of their cost to each month of operation. We normally expense the cost of these and similar items as they are incurred.

34. Effects of the Adjusting Entries
We identified four types of adjusting entries, each of which involves one income statement account and one balance sheet account. The effects of these adjustment types on the income statement and balance sheet are summarized on this slide. 3

35. Adjusted Trial Balance
All balances are taken from the ledger accounts on 31 May after preparing the two depreciation adjusting entries.
We have highlighted just a few of the adjusting entries prepared at the end of May Like the trial balance, the adjusted trial balance shows that the total of the debit balance accounts is equal to the total of the credit balance accounts. Our books are in balance after recording our adjusting entries. 4

36. End of Chapter 4
End of chapter 4.