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CHAPTER 4
Accrual Accounting
and
Completing the Accounting Cycle
CHARACTERISTICS OF THE
ACCOUNTING MODEL
Periodic Reporting
Accrual-Basis Accounting
Adjusting Entries
Closing Entries
PERIODIC REPORTING
Time Period Concept--The life of a
business is divided into distinct and short
time periods so the accounting information
can be summarized each period.
PERIODIC REPORTING
Time Period Concept--The life of a
business is divided into distinct and short
time periods so the accounting information
can be timely.
Fiscal Year--An accounting period that
lasts 12 months.
PERIODIC REPORTING
Time Period Concept--The life of a
business is divided into distinct and short
time periods so the accounting information
can be timely.
Fiscal Year--An accounting period that
lasts 12 months.
Calendar Year—A fiscal year that lasts
12 months and ends on December 31.
PERIODIC REPORTING
Fiscal Year-- For publicly traded companies,
the period covered by annual financial
statements which are prepared for the public
(Annual Report), and the SEC (Form 10K ).
PERIODIC REPORTING
Time Periods are often further divided
into Quarters and Months
Quarter--An accounting period that lasts
3 months. For publicly traded companies
quarterly financial reports are prepared
and sent to the SEC (Form 10Q).
Month--May be a calendar month or a
series of periods lasting 4 and 5 weeks.
LIFE CYCLE OF A BUSINESS ENTITY
Accounting Accounting Accounting
Period Period Period
1 2 3
Inc Statement, Inc Statement, Inc Statement,
Statement of RE, Statement of RE, Statement of RE,
Cash Flow Cash Flow Cash Flow
Statement Statement Statement
Balance Balance Balance
Sheet Sheet Sheet
ACCRUAL ACCOUNTING
Accrual-basis accounting is a concept in which
revenues and expenses are recorded when earned or
incurred, not when cash is received or paid.
Revenues and expenses must be assigned to the
proper accounting period.
―Revenue recognition principle‖ and the ―matching
principle‖ determine the accounting period items are
recorded in.
REVENUE RECOGNITION
Revenue is recognized when two criteria
are met:
1. The earning process is
―substantially complete.‖
2. An exchange has taken place.
THE MATCHING PRINCIPLE
All expenses incurred to generate
revenues must be recognized in the
same period as the related revenues.
Example: The cost of goods sold for
an item must be matched with the
sales revenue generated in any time
period.
DETERMINING ACCRUAL INCOME
Recognized Revenues of 2009
- Matched Expenses of 2009
= Net Income for 2009
STEPS IN THE ACCOUNTING CYCLE
1. Analyze transactions and business documents.
2. Journalize transactions.
3. Post journal entries to the general ledger.
4. Determine account balances and prepare a trial
balance.
5. Journalize and post adjusting entries.
6. Prepare the adjusted trial balance.
7. Prepare financial statements.
8. Journalize and post the closing entries.
9. Balance the accounts and prepare a post-
closing trial balance.
STEP 5 - ADJUSTING ENTRIES
Adjusting entries are required at the end
of each accounting period for accrual-
basis accounting, prior to preparing the
financial statements.
The purpose for adjusting entries are to:
1. Bring Balance Sheet accounts current.
2. Reflect proper amounts of revenues and
expenses on the Income Statement.
TIPS REGARDING ADJUSTING ENTRIES
Process. You must determine
Analytical
what original entry was made (if any) and
what the ending balances should be
before you know what adjusting entry to
make. You cannot memorize adjusting
entries.
entries always include a
Adjusting
Balance Sheet account and an Income
Statement account.
Adjusting entries never involve a CASH
account.
3-STEP PROCESS FOR
ADJUSTING ENTRIES
1 Identify the original entries that were made, if
any. (Original entries were only made for
unearned revenues and prepaid expenses.)
2 Determine what the correct balances should
be at this point in time.
3 Make the adjustments needed to correct the
balances.
MOST COMMON ADJUSTING ENTRIES
PrepaidExpenses--Expenses that have been
recorded (paid) but not yet incurred.
Unearned Revenues--Revenues that have been
recorded (received) but not yet earned.
AccruedRevenues--Revenues that have been
earned but not yet recorded.
Accrued Expenses--Expenses that have been
incurred but not yet recorded.
EXAMPLE: PREPAID EXPENSES
On July 1, 2008 XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008 to June
30, 2009. On December 31, 2008, an adjustment
will be needed. What is the adjusting entry?
EXAMPLE: PREPAID EXPENSES
On July 1, 2008 XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008 to June
30, 2009. On December 31, 2008, an adjustment
will be needed. What is the adjusting entry?
Rent
Prepaid Rent Cash Expense
Original Entry 3,600 3,600
Correct Balances1,800 1,800
EXAMPLE: PREPAID EXPENSES
On July 1, 2008 XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008 to June
30, 2009. On December 31, 2008, an adjustment
will be needed. What is the adjusting entry?
Rent
Prepaid Rent Cash Expense
Original Entry 3,600 3,600
Adjusting Entry 1,800 1,800
Correct Balances1,800 1,800
Adjusting Entry: 12/31 Rent Expense 1,800
Prepaid Rent 1,800
PREPAID EXPENSES
On July 1, 2008, XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008, to June 30,
2009. On December 31, 2008, an adjustment will be
needed. What is the adjusting entry using the expense
approach?
PREPAID EXPENSES
On July 1, 2008, XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008, to June 30,
2009. On December 31, 2008, an adjustment will be
needed. What is the adjusting entry using the expense
approach?
Prepaid Rent Cash Rent Expense
Original Entry 3,600 3,600
Correct Balances1,800 1,800
PREPAID EXPENSES
On July 1, 2008, XYZ Company pays $3,600 for one
year’s rent in advance, covering July 1, 2008, to June 30,
2009. On December 31, 2008, an adjustment will be
needed. What is the adjusting entry using the expense
approach?
Prepaid Rent Cash Rent Expense
Original Entry 3,600 3,600
•Adjusting Entry 1,800 1,800
Correct Balances1,800 1,800
Adjusting Entry: 12/31 Prepaid Rent 1,800
Rent Expense 1,800
EXAMPLE: UNEARNED REVENUE
On July 1 XYZ Company receives $5,000 for season
tickets to a trade show they will put on every month for
the next 12 months. On December 31 an adjustment
will be needed. What is it?
EXAMPLE: UNEARNED REVENUE
On July 1 XYZ Company receives $5,000 for season
tickets to a trade show they will put on every month for
the next 12 months. On December 31 an adjustment
will be needed. What is it?
Unearned Rev Cash Show Rev
Original Entry 5,000 5,000
Correct Balances 2,500 2,500
EXAMPLE: UNEARNED REVENUE
On July 1 XYZ Company receives $5,000 for season
tickets to a trade show they will put on every month for
the next 12 months. On December 31 an adjustment
will be needed. What is it?
Unearned Rev Cash Show Rev
Original Entry 5,000 5,000
•Adjusting Entry 2,500 2,500
Correct Balances 2,500 2,500
Adjusting Entry: 12/31 Unearned Rev 2,500
Show Rev 2,500
EXAMPLE: ACCRUED REVENUE
The XYZ Company earns a rent revenue of $500
in 2008 but did not send out an invoice nor
receive the payment until January 3, 2009. An
adjustment will be needed. What is the adjusting
entry?
EXAMPLE: ACCRUED REVENUE
The XYZ Company earns a rent revenue of $500
in 2008 but did not send out an invoice nor
receive the payment until January 3, 2009. An
adjustment will be needed. What is the adjusting
entry?
Rent Receivable Rent Revenue
Original Entry none none
Correct Balances 500 500
EXAMPLE: ACCRUED REVENUE
The XYZ Company earns a rent revenue of $500
in 2008 but did not send out an invoice or
receive the payment until January 3, 2009. An
adjustment will be needed. What is the adjusting
entry?
Rent Receivable Rent Revenue
Original Entry none none
Correct Balances 500 500
Adjusting Entry:
12/31 Rent Receivable 500
Rent Revenue 500
EXAMPLE: ACCRUED EXPENSE
The XYZ Company is assessed property taxes of
$1,000 for 2008, but will not make this payment until
January 5, 2009. An adjustment will be needed.
What is the adjusting entry?
EXAMPLE: ACCRUED EXPENSE
The XYZ Company is assessed property taxes of
$1,000 for 2008, but will not make this payment until
January 5, 2009. An adjustment will be needed.
What is the adjusting entry?
Property Tax Property Tax
Expense Payable
Original Entry none none
Correct Balances 1,000 1,000
EXAMPLE: ACCRUED EXPENSE
The XYZ Company is assessed property taxes of
$1,000 for 2008, but will not make this payment until
January 5, 2009. An adjustment will be needed.
What is the adjusting entry?
Property Tax Property Tax
Expense Payable
Original Entry none none
Correct Balances 1,000 1,000
Adjusting Entry: 12/31 Property Tax Expense 1,000
Property Tax Payable 1,000
Accrued EXPENSE
•Which of the following is not a True statement?
a) Accumulated depreciation is a contra-
asset.
b) Depreciation expense is a contra-expense.
c) Accumulated depreciation has a normal
credit balance.
d) Depreciation expense has a normal debit
balance.
There are 9 steps in the Accounting
Cycle. List them in order.
(Hint: Three of them contain the words ―Trial Balance‖)
1. __________________________
2. __________________________
3. __________________________
4. __________________________
5. __________________________
6. __________________________
7. __________________________
8. __________________________
9. __________________________
STEPS IN THE ACCOUNTING CYCLE
1. Analyze transactions and business documents.
2. Journalize transactions.
3. Post journal entries to the general ledger.
4. Determine account balances and prepare a trial
balance.
5. Journalize and post adjusting entries.
6. Prepare the adjusted trial balance.
7. Prepare financial statements.
8. Journalize and post the closing entries.
9. Balance the accounts and prepare a post-
closing trial balance.
Step 7
Preparing Financial Statements
• After all transactions have been
recorded, a trial balance prepared, and
adjusting entries made . . . the financial
statements can be prepared.
Record Prepare Make Prepare
Trans- Trial Adjusting Financial
actions Balance Entries Statements
STEP 8
THE CLOSING PROCESS
Nominal Accounts (temporary accounts) are
closed to a zero balance at the end of each
accounting period.
RealAccounts (permanent accounts) are not
closed to a zero balance at the end of the
accounting period. These accounts are carried
forward to the next period.
ClosingEntries reduce all nominal accounts to
a zero balance.
Examples
Real Accounts
Assets
Liabilities
Owners’ Equity
(Balance Sheet
Accounts)
Examples
Real Accounts Nominal Accounts
Assets Revenues
Liabilities Expenses
Owners’ Equity Dividends
(Balance Sheet (Income Statement
Accounts) Accounts)
CLOSING ENTRIES
The Goal: Move all Revenue and Expense
items (Net Income) into Retained Earnings.
Dec 31 Sales Revenue....................... 1,500
Rent Revenue........................ 100
Cost of Goods Sold............ 1,100
Salaries Expense............... 200
Other Expenses................. 150
Retained Earnings............. 150
CLOSING ENTRIES
Closing the books ALWAYS requires
4
closing entries
CLOSING ENTRIES
Closing Entry 1.
Close all revenue accounts by debiting
them.
Dr. Cr.
Sales Revenue............ 13,000
Rent Revenue………... 2,000
Income Summary... 15,000
The Closing Process
Revenues Income Summary
xxx Bal. xxx
xxx
Revenues
Since the revenue account is
a nominal account, it is
closed at the end of the
period to Income Summary.
The Closing Process
Closing Entry 2.
Close all expense accounts by crediting
them.
Dr. Cr.
Income Summary…............. 13,600
Cost of Goods Sold….... 12,800
Insurance Expense........ 500
Supplies Expense.......... 300
The Closing Process
Income Summary
xxx
Rev.
Exp.
YYY
Expenses
The expense accounts are
Bal. YYY YYY credited in order to close
the account at the end of
the period.
The Closing Process
Closing Entry 3.
Close Income Summary.
Dr. Cr.
Income Summary…............. 1,400
Retained Earnings.….... 1,400
The Closing Process
Income Summary
Retained
Earnings xxx
Rev.
Exp.
YYY
Net Income Net Income
The Income Summary
account is closed with a
debit or credit depending
on its balance.
The Closing Process
Closing Entry 4.
Close Dividends (if any).
Dr. Cr.
Retained Earnings…............ 500
Dividends………….….... 500
ABOUT DIVIDENDS
Dividends are not expenses. They are
distributions to stockholders of part of the
corporation’s earnings.
Dividends reduce Retained Earnings.
For example: If a company earns $1,400
of Net Income, paying dividends to
shareholders does not change Income.
EXAMPLE: DIVIDENDS
Declaration of Dividends:
Dividends...................... 500
Dividends Payable.... 500
EXAMPLE: DIVIDENDS
Declaration of Dividends:
Dividends...................... 500
Dividends Payable.... 500
Payment of Dividends:
Dividends Payable......... 500
Cash........................ 500
EXAMPLE: DIVIDENDS
Declaration of Dividends:
Dividends...................... 500
Dividends Payable.... 500
Payment of Dividends:
Dividends Payable......... 500
Cash........................ 500
Closing Entry for Dividends:
Retained Earnings......... 500
Dividends................. 500
The Closing Process
Retained Earnings
Net Inc.
The dividends Div.
account, which is also
nominal, is credited to ddd
close out the balance.
Dividends
Bal. ddd ddd
The Closing Process
Retained Earnings Retained Earnings
is a real account Beg. Bal. BBB
and always carries
Rev.
a balance.
Exp.
Div.
Net Income for the End. Bal. EEE
period is added by
these two entries.
STEP 8.
POST-CLOSING TRIAL BALANCE
Provides a listing of all real account balances at the
end of the closing balance.
The Trial Balance assures that total debits equal
total credits prior to the beginning of the new
accounting period.
Revenues and expenses will not appear because
they have no balances.
Only real accounts will have a balance at this time.
Post Closing Trial Balance
Example
Jim Brewster, Inc.
Post-Closing Trial Balance
as of December 31, 2008
Debits Credits
Cash $ 8,200
Accounts Receivable 4,000
Inventory 3,000
Supplies 1,000
Accounts Payable $ 5,000
Capital Stock 10,000
Retained Earnings _____ _ 1,200
Totals $16,200 $16,200
STEPS IN THE ACCOUNTING CYCLE
1. Analyze transactions and business documents.
2. Journalize transactions.
3. Post journal entries to the general ledger.
4. Determine account balances and prepare a trial
balance.
5. Journalize and post adjusting entries.
6. Prepare the adjusted trial balance.
7. Prepare financial statements.
8. Journalize and post the closing entries.
9. Balance the accounts and prepare a post-
closing trial balance.
CASH-BASIS ACCOUNTING
Revenue and expenses are
recognized only when cash is
received or payments are made.
Mainly used by small businesses.
Not an accurate picture of true
profitability.
Example: Accrual vs. Cash-Basis
Brewster Enterprises billed their client for $48,000 during
the year. On December 31 they had received $41,000,
with the remaining $7,000 to be received in the next year.
Total expenses during the year amounted to $31,000 with
$3,000 of these costs not yet paid for at December 31.
Example: Accrual vs. Cash-Basis
Brewster Enterprises billed their client for $48,000 during
the year. On December 31 they had received $41,000,
with the remaining $7,000 to be received in the next year.
Total expenses during the year amounted to $31,000 with
$3,000 of these costs not yet paid for at December 31.
Brewster Enterprises
Reported Income for 20XX
Cash-Basis Accounting
Cash Receipts $41,000
Cash Disbursement 28,000
Income $13,000
Example: Accrual vs. Cash-Basis
Brewster Enterprises billed their client for $48,000 during
the year. On December 31 they had received $41,000,
with the remaining $7,000 to be received in the next year.
Total expenses during the year amounted to $31,000 with
$3,000 of these costs not yet paid for at December 31.
Brewster Enterprises
Reported Income for 20XX
Cash-Basis Accounting Accrual Basis Accounting
Cash Receipts $41,000 Revenues Earned $48,000
Cash Disbursement 28,000 Expenses Incurred 31,000
Income $13,000 Income $17,000
CASH BASIS IS NOT GAAP
APPENDIX -- WORKSHEETS
May be useful for you to review to clarify the Adjusting
Entry process and the surrounding Trial Balances.
Worksheets are used to simplify the process of
preparing financial statements.
Worksheets are also used to analyze end-of-period
adjustments.
Most accountants use a spreadsheet to prepare the
worksheet electronically.
Trial balances are used to test whether total debits
equal total credits.
ADJUSTING ENTRIES – USING A WORKSHEET (APPENDIX)
•Illustration 4A-1
•Form and
procedure for a
worksheet
THE END
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