CHAPTER 3
LEARNING OBJECTIVES
1. EXPLAIN THE ACCRUAL BASIS OF ACCOUNTING
AND THE REASONS FOR ADJUSTING ENTRIES.
2. PREPARE ADJUSTING ENTRIES FOR DEFERRALS.
CHAPTER REVIEW
Accrual Basis Accounting
1. (L.O. 1) The time period (or periodicity) assumption assumes that the economic life of a
business can be divided into artificial time periods.
2. Accounting time periods are generally a month, a quarter, or a year. An accounting time period
that is one year in length is a fiscal year.
Revenue Recognition Principle
5. The revenue recognition principle requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied.
The Expense Recognition Principle
Adjusting Entries
7. Adjusting entries are made in order for:
a. Revenues to be recorded in the period in which services are performed, and for expenses to
be recognized in the period in which they are incurred.
b. The revenue recognition and expense recognition principles are followed.
Adjusting Entries for Deferrals
9. (L.O. 2) Prepaid expenses are expenses paid in cash before they are used or consumed.
a. Prepaid expenses expire with the passage of time or through use and consumption.
b. An asset-expense account relationship exists with prepaid expenses.
10. Depreciation is the process of allocating the cost of an asset to expense over its useful life in a
rational and systematic manner.
a. The purchase of equipment or a building is viewed as a long-term prepayment of services
and, therefore, is allocated in the same manner as other prepaid expenses.
b. Depreciation is an estimate rather than a factual measurement of the cost that has expired.
e. To illustrate an adjusting entry for depreciation, assume Resch Co. purchases equipment for
$6,000 cash on January 1, 2017. Assuming that annual depreciation is $1,200, the adjusting
entry at December 31, 2017 is:
11. Unearned revenues are cash received before services are performed.
a. Unearned revenues are subsequently recognized by performing the service for a customer.
b. A liability-revenue account relationship exists with unearned revenues.
c. Prior to adjustment, liabilities are overstated and revenues are understated.
d. The adjusting entry results in a debit to a liability account and a credit to a revenue account.
e. Examples of unearned revenues include rent, magazine subscriptions, and customer deposits
for future service.
Adjusting Entries for Accruals
12. (L.O. 3) Accrued revenues are revenues for services performed but not yet received in cash or
recorded.
a. Accrued revenues may accumulate with the passing of time as in the case of interest and rent,
or through services performed but for which payment has not been collected.
13. Accrued expenses are expenses incurred but not yet paid in cash or recorded.
a. Accrued expenses result from the same causes as accrued revenues and include interest,
rent, taxes, and salaries.
b. A liability-expense account relationship exists with accrued expenses.
c. Prior to adjustment, both liabilities and expenses are understated.
d. The adjusting entry results in an increase (a debit) to an expense account and an increase
(a credit) to a liability account.
e. To illustrate an accrued expense adjusting entry, assume Schwenk Company incurs salaries
Adjusted Trial Balance
15. (L.O. 4) After all adjusting entries have been journalized and posted an adjusted trial balance
is prepared. This trial balance shows the balances of all accounts, including those that have been
adjusted, at the end of the accounting period.
16. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and
the total credit balances in the ledger after all adjustments have been made.
Alternative Treatment
*18. (L.O. 5) Under the alternative treatment, at the time an expense is prepaid, an expense account
is debited, and when unearned revenues are received a revenue account is credited.
*19. The alternative treatment of prepaid expenses and unearned revenues has the same effect on the
financial statements as the procedures described in the chapter.
*20. When a prepaid expense is initially debited to an expense account,
a. No adjusting entry will be required if the prepayment is fully expired or consumed before the
next financial statement date.
b. If the prepayment is not fully expired or consumed, an adjusting entry is required.
to an expense account.
e. To illustrate the adjusting entry, assume Gonzalez Company purchases $1,200 of supplies
and debits Supplies Expense. At the next financial statement date, $300 of supplies are on
hand. The adjusting entry is:
*21. When an unearned revenue is initially credited to a revenue account, the procedures are similar to
those described above for prepaid expenses. In this case, however,
a. Prior to adjustment, a revenue account is overstated and a liability account is understated.
b. The adjusting entry results in a debit to a revenue account and a credit to a liability account.
Financial Reporting Concepts
*22. (L.O.6) According to the FASB, to be useful, information should have two fundamental
qualities: relevance and faithful representation. Accounting information has relevance if it makes
a difference in a business decision. If relevant, accounting information has predictive value
and confirmatory value. In addition, materiality is a company-specific aspect of relevance.
*23. Accounting information is comparable when different companies use the same accounting
principles. Accounting information is consistent when one company uses the same
financial statements.
*24. To be relevant, accounting information must be presented on a timely basis, meaning that it must
be available to decision makers before it loses its capacity to influence decisions. Accounting
*25. The monetary unit assumption states that only those things that can be expressed in monetary
terms are included in the accounting records. The economic entity assumption states that every
economic entity should be separately identified and accounted for.
*26. The time period assumption states that the life of a business can be divided into artificial time
periods and that reports covering those periods can be prepared for the business. Most
*27. GAAP generally uses one of two measurement principles. The historical cost principle
states that assets are record at their cost. Cost is used because it is easy to verify: usually there is
*28. The full disclosure principle requires that companies must disclose all circumstances and
events that would make a difference to financial statement users. If a piece of information is not
disclosed in one of the four financial statements, then it should be included in the notes to the
statements.
LECTURE OUTLINE
A. Accrual Basis Accounting.
1. The assumption that the economic life of a business can be divided into
artificial time periods.
B. Accrual- vs. Cash-Basis Accounting.
1. Using the accrual basis to determine net income means companies rec-
ognize revenues when they actually perform the services (rather than
C. Recognizing Revenues and Expenses.
1. The revenue recognition principle requires that companies recognize reve-
nue in the accounting period in which the performance obligation is
satisfied.
ETHICS INSIGHT
Allegations of abuse of the revenue recognition principle have become all too
common in recent years. One company was accused of saying that a sale that
occurred at the beginning of one quarter occurred at the end of the previous
quarter in order to achieve the previous quarters sales targets.
What motivates sales executives and finance and accounting executives to
participate in activities that result in inaccurate reporting of revenues?
Answer: Sales executives typically receive bonuses based on their ability to
meet quarterly sales targets. In addition, they often face the possibility
of losing their jobs if they miss those targets. Executives in accounting
D. The Need for Adjusting Entries.
1. In order for revenues and expenses to be reported in the correct period,
companies make adjusting entries at the end of the accounting period.
Adjusting entries ensure that revenues are recognized in the period in
which services are performed, and that expenses are recognized in the
period in which they are incurred.
2. A company must make adjusting entries every time it prepares financial
statements.
3. Deferrals (prepaid expenses and unearned revenues).
b. Depreciation Adjustment.
(1) Depreciation is the process of allocating the cost of an asset to
expense over its useful life in a rational and systematic manner.
(2) Depreciation expense is computed by dividing the cost of an asset
by its useful life.
ACCOUNTING ACROSS THE ORGANIZATION
Gift cards are popular with marketing executives, but they create accounting
questions. Should revenue be recorded at the time the gift card is sold, or when it
is used by the customer?
Suppose a customer purchases a $100 gift card at Best Buy on December 24,
2016, and gives it to his wife on December 25, 2016. On January 3, 2017, the
customer’s wife uses the card to purchase CDs. When do you think Best Buy
should recognize revenue, and why?
Answer: According to the revenue recognition principle, companies should
recognize revenue when the performance obligation is satisfied. In
this case revenue is not recognized until Best Buy provides the
4. Accruals (accrued revenues and accrued expenses).
a. Revenues for services performed but not yet recorded at the
statement date are accrued revenues (interest, rent, commissions).
b. Expenses incurred but not yet paid or recorded at the statement date
are accrued expenses (interest, salaries, taxes).
E. The Adjusted Trial Balance and Financial Statements.
1. The adjusted trial balance is prepared after all adjusting entries have
been journalized and posted.
2. The adjusted trial balance proves the equality of the total debit balances
and the total credit balances in the ledger after all adjustments.
*F. Alternative Treatment of Prepaid Expenses and Unearned Revenue.
1. Companies may initially debit prepaid expenses to an expense account
instead of an asset account. The adjusting entry requires recording an
asset for the unexpired portion and crediting the expense account so
that its balance will reflect the amount consumed.
2. Companies may initially credit revenues received in cash before being
recognized to a revenue account instead of a liability account. The
adjusting entry requires recording a liability for the portion still to be
*G. Discuss Financial Reporting Concepts.
1. To be useful, information should possess two fundamental qualities:
relevance and faithful representation.
a. Relevance – if information has the ability to make a difference in a
decision scenario, it is relevant.
b. Accounting information is considered relevant if it provides information
that has predictive value – helps provide accurate expectations about
the future, and has confirmatory value – confirms or corrects prior
expectations.
2. Enhancing Qualities – include comparability, consistency, verifiability,
timeliness, and understandability.
a. Comparability—when different companies use the same accounting
principles.
(1) To make a comparison, companies must disclose the
accounting methods used.
b. Consistency—when a company uses the same accounting principles
and methods from year to year.
3. Monetary Unit Assumption – states that only transactions expressed
in money are included in the accounting records.
4. Economic Entity Assumption
▪ Every economic entity can be separately identified and accounted for.
▪ Economic events can be identified with a particular unit of accountability.
5. Time Period Assumption – allows the business to be divided into
artificial time periods that are useful for reporting.
a. Historical Cost Principle – requires assets to be recorded at original
cost because that amount is verifiable.
b. Fair Value Principle – requires that assets and liabilities should be
reported at fair value (the price received to sell an asset or settle a
liability).
IFRS
A Look at IFRS
It is often difficult for companies to determine in what time period they should
report particular revenues and expenses. Both the IASB and FASB are working
on a joint project to develop a common conceptual framework that will enable
companies to better use the same principles to record transactions consistently
over time.
KEY POINTS
• In this chapter, you learned accrual-basis accounting applied under GAAP.
Companies applying IFRS also use accrual-basis accounting to ensure that
they record transactions that change a company’s financial statements in
the period in which events occur.
• 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 time period
assumption.
• The general revenue recognition principles required by GAAP that are used
in this textbook is similar to that 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
LOOKING TO THE FUTURE
The IASB and FASB are completing a joint project on revenue recognition. The
purpose of this project was to develop comprehensive guidance on when to
recognize revenue. It is hoped that this approach will lead to more consistent
accounting in this area.
20 MINUTE QUIZ
Circle the correct answer.
True/False
1. Since companies find it desirable and necessary to report the results of their activities
frequently, the time period assumption assumes that the economic life of a business can
be divided into artificial time periods.
True False
2. The revenue recognition principle requires that companies recognize revenue in the period
in which cash was received rather than when the performance obligation is satisfied.
True False
3. Monthly and quarterly time periods are commonly referred to as fiscal periods.
True False
4. Payments of expenses that will benefit more than one accounting period are referred to
as prepaid expenses.
True False
5. Cost less accumulated depreciation is a measurement of the current value of an asset
such as equipment or a building.
True False
6. Depreciation is the process of allocating the cost of an asset to expense over its useful
life in a rational and systematic manner.
True False
7. The adjusting entry for unearned revenues results in a debit to an asset account and a
credit to a revenue account.
True False
8. A contra-asset account is an account whose balance is deducted from a related asset in
the financial statements.
True False
9. When accrual-basis accounting is applied, adjusting entries are not necessary.
True False
10. Adjustments for accrued expenses are necessary to record the obligations that exist at
the balance sheet date and to recognize the expenses that are applicable to the current
accounting period.
True False
Multiple Choice
1. The recording of salaries and wages earned but not yet paid is an example of an
adjustment that
a. recognizes an accrued expense.
b. recognizes an unrecorded revenue.
c. apportions revenues between two or more periods.
d. apportions costs between two or more periods.
2. A list of the accounts and their balances after all adjustments have been made is known as
a. adjusting entries.
b. adjusted trial balance.
c. book values.
d. accrued accounts.
3. Prior to recording adjusting entries, revenues exceed expenses by $60,000. Adjusting
entries for accrued salaries and wages of $10,000 and depreciation expense of $10,000
were made. Net income for the year would be
a. $60,000.
b. $50,000.
c. $40,000.
d. none of the above.
4. The adjustment for depreciation is an example of
a. recognizing an accrued expense.
b. apportioning costs between two or more periods.
c. apportioning revenues between two or more periods.
d. recognizing an unrecorded revenue.
5. Most businesses choose fiscal years which correspond to
a. the calendar year.
b. any twelve-month period.
c. their natural business year.
d. any of the above.
ANSWERS TO QUIZ
True/False
1. True
2. False
Multiple Choice
1. a.