Accounting Chapter 4 Homework Learning Objective Explain The Purpose Closing Entries

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CHAPTER 4

Accrual Accounting Concepts

Learning Objectives

1. Explain the revenue recognition principle and the expense recognition principle.

2. Differentiate between the cash basis and the accrual basis of accounting.

3. Explain why adjusting entries are needed, and identify the major types of adjusting entries.

4. Prepare adjusting entries for deferrals.

5. Prepare adjusting entries for accruals.

6. Describe the nature and purpose of the adjusted trial balance.

7. Explain the purpose of closing entries.

8. Describe the required steps in the accounting cycle.

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Chapter Outline

Learning Objective 1 – Explain the Revenue Recognition Principle and

the Expense Recognition Principle

 Determining the amount of revenues and expenses to report in a given

accounting period can be difficult.

 Accounting divides the economic life of a business into artificial time periods.

This is the periodicity assumption.

 Many transactions affect more than one of these periods. Determining the

amount of revenues and expenses to report in a given accounting period can be

difficult.

▪ Proper reporting requires an understanding of the nature of the

company’s business.

▪ Two principles are used as guidelines:

 The revenue recognition principle requires that revenue be recognized in the

accounting period in which the performance obligation is satisfied. When a company

agrees to perform a service or sell a product to a customer, it has created a

performance obligation.

 A service company recognizes (records) revenue when the services are performed.

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

 The expense recognition principle requires that efforts (expenses) be matched with

accomplishments (revenues).

 The critical issue is determining when the expense makes its contribution to revenue.

Expenses need to be matched with the revenue in the period when the company

makes efforts to generate those revenues.

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TEACHING TIP

Returning to the service business example, suppose employees are paid every two weeks.

When preparing financial statements for May, the accountant realizes that employees were

last paid on Friday, May 22. By May 31, nine days have elapsed and many of the employees

$12,000 an expense of May? No. The insurance policy will be in effect for 12 months.

Learning Objective 2 – Differentiate Between the Cash Basis and the Accrual

Basis of Accounting

 Accrual-basis accounting means that transactions that change a firm’s

financial statements are recorded in the periods in which the events occur, even

if cash was not exchanged.

TEACHING TIP

Return to the illustration of service businesses and the airlines. If the service business used

cash basis accounting, revenue would be recognized only when cash was received. Delta

would recognize revenue on May 1 when the ticket was purchased. All expenses of both a

service business and Delta would be recorded when cash was paid. Point out that with cash

basis accounting, the net income figure is easy to manipulate.

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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

Learning Objective 3 – Explain why Adjusting Entries are Needed, and Identify the

Major Types of Adjusting Entries

 Adjusting entries are needed to ensure that the revenue recognition and expense

recognition principles are followed.

 The trial balance may not contain up-to-date and complete data for several reasons:

▪ Some events are not recorded daily because it is not efficient to do so.

 Adjusting entries are required every time a company prepares financial statements.

▪ Every adjusting entry will include one income statement account and one balance

sheet account.

 Adjusting entries can be classified as either deferrals or accruals. Each of these

classes has two subcategories.

TEACHING TIP

Explain that cash is not adjusted at the end of the accounting period, thus students should

not use cash in the adjusting process.

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Learning Objective 4 – Prepare Adjusting Entries for Deferrals

Deferrals fall into two categories—prepaid expenses and unearned revenues.

 Prepaid expenses – expenses paid in cash and recorded as assets until they are used

 Unearned revenues – cash received and recorded as liabilities before the services are

performed.

▪ An adjusting entry for prepaid expenses will result in an increase (a debit) to an

expense account and a decrease (a credit) to an asset account.

TEACHING TIP

Go through the examples of adjusting entries for the following deferrals including; insurance,

TEACHING TIP

Discuss the effects on the income statement and balance sheet if adjustments are not made.

Learning Objective 5 – Prepare Adjusting Entries for Accruals

 Accruals fall into two categories—accrued revenues and accrued expenses.

 Accrued revenues – revenues for services performed but not yet received in cash or

recorded at the statement date.

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▪ an adjusting entry for accrued expenses results in an increase (a debit) to an

expense account and an increase (a credit) to a liability account.

TEACHING TIP

Go through the examples of adjusting entries for accrued interest, accrued salaries and

accrued revenues.

TEACHING TIP

Summary of basic relationships:

Type of Adjustment

Accounts Before Adjustment

Adjusting Entry

Prepaid expenses

Assets overstated

Expenses understated

Dr. Expenses

Cr. Assets

Unearned revenues

Liabilities overstated

Revenues understated

Dr. Liabilities

Cr. Revenues

Accrued revenues

Assets understated

Revenues understated

Dr. Assets

Cr. Revenues

Accrued expenses

Expenses understated

Liabilities understated

Dr. Expenses

Cr. Liabilities

Learning Objective 6 – Describe the Nature and Purpose of the Adjusted Trial Balance

 The adjusted trial balance is prepared after all adjusting entries have been journalized

and posted.

 The adjusted trial balance shows the balances of all accounts, including those that have

been adjusted, at the end of the accounting period.

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TEACHING TIP

Show students an adjusted trial balance and demonstrate how easy it is to prepare financial

statements from the information contained in the trial balance.

Learning Objective 7 – Explain the Purpose of Closing Entries

 Closing entries transfer net income (or net loss) and dividends to Retained Earnings.

▪ This causes the ending balance of Retained Earnings (amount shown on the

Balance Sheet) to agree with the balance shown on the Retained Earnings

Statement.

▪ Close the revenue accounts to the Income Summary account.

 Closing entries produce a zero balance in each temporary account (revenues,

expenses, and dividends)

▪ These accounts are then ready to accumulate data for the next accounting period.

▪ Permanent accounts (assets, liabilities, common stock and retained earnings) are

not closed.

TEACHING TIP

Tell students to look at the date on the income statement in Illustration 4-27. The date is “For

the Month Ending October 31, 2014.” How can one be sure the revenues and expenses

 After the closing entries have been journalized and posted, a post-closing trial balance

is prepared.

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▪ All of the temporary accounts have a zero balance.

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Learning Objective 8 – Describe the Required Steps in the Accounting Cycle

 Analyze business transactions.

 Journalize the transactions.

 Post to ledger accounts.

TEACHING TIP

Encourage students not to memorize the steps in the accounting cycle. Rather, they should

think about what must be done in order to “capture” the financial transactions and to make

sure the transactions are ultimately reported in the financial statements.

 Quality of Earnings

▪ Earnings management is the planned timing of revenues, expenses, gains, and losses

to smooth out bumps in net income.

▪ The quality of earnings is greatly affected when a company manages earnings up or

down to meet some targeted earnings number.

• A company that has a high quality of earnings provides full and transparent

 Companies manage earnings in a variety of ways:

▪ Use of one-time items to prop up earnings numbers (i.e. nonrecurring gains).

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▪ Improper adjusting entries

Learning Objective 9 – Understand the Causes of Differences Between Net

Income and Cash Provided by Operating Activities

 Net income is based on accrual basis accounting and is accomplished through the

adjusting entry process.

 Cash provided by operating activities is determined by comparing cash received from

operating activities to cash expenditures from operating activities.

TEACHING TIP

Discuss the example provided, paying particular attention to the differences between cash–

basis and accrual-basis accounting when recognizing revenues and expenses.

Learning Objective 10 – Describe the Purpose and the Basic Form of a Worksheet

▪ The worksheet is a multiple-column form that may be used in the adjustment process and

TEACHING TIP

Use the worksheet, Illustration 4A-1, provided in the appendix to discuss its parts and how it

facilitates preparation of the financial statements.

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Learning Objective11- Compare the procedures for revenue recognition under GAAP

and IFRS.

 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,

as well as a revenue recognition project, 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.

 A specific standard exists for revenue recognition under IFRS (IAS 18). In general, the

standard is based on the probability that the economic benefits associated with the

transaction will flow to the company selling the goods, providing the service, or

receiving investment income. In addition, the revenues and costs must be capable of

being measured reliably.

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▪ Note that 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.

 The procedures of the closing process are applicable to all companies whether they are

using IFRS or GAAP.

 LOOKING TO THE FUTURE: The IASB and FASB are now involved in a joint project on

revenue recognition. The purpose of this project is to develop comprehensive guidance

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Chapter 4 Review

✓ What is the revenue recognition principle? What is the expense recognition principle?

✓ What are the differences in the cash basis and the accrual basis of accounting? Which is

required by GAAP? Why?

✓ Why are adjusting entries needed? What are the major types of adjusting entries?

✓ Identify types of prepayments and discuss the adjusting entry for each. What happens if

the adjusting entry is not made?

✓ Identify types of accruals and discuss the adjusting entry for each. What happens if the

adjusting entry is not made?

✓ Describe the nature and purpose of the adjusted trial balance.

✓ Discuss the purpose of closing entries.

✓ List the required steps in the accounting cycle. Discuss quality of earnings issues.

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✓ Discuss the differences between net income and cash provided by operating activities.

How do cash-basis and accrual-basis accounting apply?

✓ Discuss the use of the worksheet in the preparation of the financial statements.

✓ Define the difference between the terminology used by GAAP and IFRS for revenues and

gains, and expenses and losses.