Accrual Accounting Concepts
- Explain the revenue recognition principle and the matching principle.
- Differentiate between the cash basis and the accrual basis of accounting.
- Explain why adjusting entries are needed and identify the major types of ad justing entries.
- Prepare ad justing entries for prepayments.
- Prepare ad justing entries for accruals.
- Describe the nature and purpose of the ad justed trial balance.
- Explain the purpose of closing entries.
- Describe the required steps in the accounting cycle.
Study Objective 1 - Explain the Revenue Recognition Principle and the Matching Principle
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:
- revenue recognition principle
- matching principle
The revenue recognition principle requires that revenue be recognized in the accounting period in which it is earned.
A service company recognizes (records) revenue when the services are performed.
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.
Does Delta Airlines record revenue when you buy a plane ticket on May 1 for a flight on June 15? Has the service been provided? The answer to both of these questions is no.Delta cannot recognize revenue on May 1 because the service has not been provided. The revenue will be recognized on June 15 when the ticket holder takes the flight.
The matching principle requires that efforts (expenses) be matched with accomplishments (revenues).
The critical issue is determining when the expense makes its contribution to revenue.
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 have worked seven or more days.The wages of these employees must be included in expenses.
The same accountant, however, notices that on May 1 the business renewed its insurance coverage by paying the $12,000 premium on a one-year insurance policy. Is all of the $12,000 an expense of May? No. The insurance policy will be in effect for 12 months. Therefore, $1,000 ($12,000/12 months) should be recognized as expense each month.
Study Objective 2 - Differentiate Between the Cash Basis and the Accrual Basis of Accounting
With cash basis accounting, revenue is recognized (recorded) when cash is received. Expenses are recognized (recorded) only when cash is paid.
Accrual basis accounting requires accountants to adhere to the revenue recognition principle and the matching principle.
Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting Principles (GAAP), whereas accrual basis accounting does.
Accrual basis accounting provides an ob jective measurement of net income.
Return to the illustration of the service business 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 the retail store and Delta would be recorded when cash was paid. Point out that with cash basis accounting, the net income figure is easy to manipulate.
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. Companies can use the cash method and its use does not mean that income is being manipulated. One should not unfairly criticize an employer, relative or friend who is using the cash basis of accounting.
Study Objective 3 - Explain why Ad justing Entries are Needed and Identify the Ma jor Types of Ad justing Entries
- Ad justing entries are needed to ensure that the revenue recognition and matching principles are followed.
- The trial balance may not contain up-to-date and complete data because:
- Some events are not recorded daily because it is not efficient to do so.
- Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions.
- Ad justing entries are required every time a company prepares financial statements.
- Ad justing entries can be classified as either prepayments or accruals. Each of these classes has two subcategories.
Cash is not ad justed at the end of the accounting period, thus students should not use cash in the ad justing process.
Study Objective 4 - Prepare Adjusting Entries for Prepayments
Prepayments fall into two categories--prepaid expenses and unearned revenues.
- Prepaid expenses - expenses paid in cash and recorded as assets until they are used or consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent and insurance) or through use (i. e. supplies).
- Unearned revenues – cash received and recorded as liabilities before the revenue is earned.
- 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.
- An adjusting entry for unearned revenues will result in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account.
- An adjusting entry for prepayments (prepaid expenses or unearned revenues) will decrease a balance sheet account and increase an income statement account.
Study Objective 5 - Prepare Ad justing Entries for Accruals
- Accruals fall into two categories--accrued revenues and accrued expenses.
- Accrued revenues - revenues earned but not yet received in cash or recorded at the statement date.
- an adjusting entry for accrued revenues will result in an increase (a debit) in an asset account and an increase (a credit) to a revenue account.
- Accrued expenses - expenses incurred but not yet paid in cash or recorded at the statement date.
- 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.
- an adjusting entry for accruals (accrued revenues or accrued expenses) increases both a balance sheet and an income statement account.
Summary of basic relationships:
Type of Ad justment
Accounts Before Ad justment
Ad justing Entry
Study Objective 6 - Describe the Nature and Purpose of the Ad justed Trial Balance
- The ad justed trial balance is prepared after all adjusting entries have been journalized and posted.
- The ad justed trial balance shows the balances of all accounts, including those that have been ad justed, at the end of the accounting period.
- The purpose of the adjusted trial balance is to prove the equality of the total debit balances and total credit balances in the ledger after all ad justments.
- Financial statements are prepared from the adjusted trial balance.
Study 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.
- 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 (assets, liabilities, common stock and retained earnings) are not closed.
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.
Study Objective 8 - Describe the Required Steps in the Accounting Cycle
- Analyze business transactions.
- Journalize the transactions.
- Post to ledger accounts.
- Prepare a trial balance.
- Journalize and post ad justing entries--prepayments and accruals.
- Prepare an ad justing trial balance.
- Prepare financial statements:
Retained earnings statement
- Journalize and post closing entries.
- Prepare post-closing trial balance.
Don't try to memorize the steps in the accounting cycle. Rather, you 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 information that will not confuse or mislead users of the financial statements.
- A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on relevant and reliable information.
- Companies manage earnings in a variety of ways:
- Use of one-time items to prop up earnings (i.e. nonrecurring gains)
- Inflate revenue numbers in the short-run (to the detriment of the long-run)
- Improper ad justing entries
- As the result of investor pressure and the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.