Accrual Accounting

Accrual accounting is an accounting method

wherein

revenue and expenses are recorded when they are earned or incurred,
regardless of when cash transactions occur.

It is often referred to as the matching rule.

This approach provides a more accurate picture of a company's financial status during a specific period, as it
recognizes economic events regardless of cash flow.
Accrual Accounting
Key principles:

[Link] Recognition Principle:

The process of determining when and what amount of revenue should be recorded is called revenue
recognition.

Revenue is recognized when it is earned, meaning when goods are delivered or services are
performed, rather than when payment is received.

The Securities and Exchange Commission (SEC) requires that all the following conditions be met
before revenue is recognized:
o Persuasive evidence of an arrangement exists.
o A product or service has been delivered.
o The seller’s price to the buyer is fixed or determinable.
o Collectability is reasonably ensured.
Accrual Accounting
2. Expense Recognition :

Expenses are recorded when they are incurred, regardless of when cash is paid. This means that expenses
related to a certain period are matched with the revenues earned in that same period.

• Expenses are recorded when all of the following conditions are met:
o There is an agreement to purchase goods or services.
o The goods have been delivered or the services rendered.
o A price has been established or can be determined.
o The goods or services have been used to produce revenue.

• The recognition of the expense does not depend on the payment of cash.
Accrual Accounting

3. Matching Principle : Accrual accounting adheres to the matching principle, which aligns revenues earned with
the expenses incurred to generate those revenues in the same accounting period.

Measure the expenses and recognize them in the same period in which any related revenues are earned
= matching
(Matched Revenues and Expenses)

To recognize an expense along with related revenues means to subtract expenses from related revenues to
compute net income or net loss.
Accrual Accounting- Example Scenario

A consulting company named "ABC Consulting.”

Revenue Recognition:

ABC Consulting provides consulting services to a client in December.

•Service Provided : The company completes a project worth $10,000 on December 15, and the invoice is issued at
that time. However, the client will pay for the services in January.

•Accrual Accounting Treatment : Under accrual accounting, ABC Consulting recognizes the $10,000 revenue in
December (the period the service was provided), even though the cash will not be received until January.
(Recorded as Accounts Receivable)
Accrual Accounting- Example Scenario
Expense Recognition:

ABC Consulting incurs expenses related to the project.

•Expense Occurrence : The company hires a subcontractor to assist on the project and receives a bill for $4,000
on December 20. The payment is due in January.

•Accrual Accounting Treatment : Under accrual accounting, ABC Consulting recognizes the $4,000 expense in
December, the same month the service was rendered, even though the payment will be made later.

Summary:
•Revenue Recognized : $10,000 in December for consulting services provided.
•Expense Recognized : $4,000 in December for subcontractor costs incurred.

This example highlights how accrual accounting provides a clearer view of

financial performance by aligning revenues and expenses with the period in
which they are earned or incurred, rather than relying solely on cash flows.
Cash-Basis Accounting

The cash basis of accounting is the practice of accounting for revenues in the period in which cash
is received and for expenses in the period in which cash is paid.

o With this method, taxable income is calculated as the difference between cash receipts from
revenues and cash payments for expenses.
o Taxable income is calculated based on (Revenues generated as Cash – Expenses Generated as
Cash)
Cash-Basis Accounting

Cash-basis accounting can sometimes produce misleading profits, particularly in situations where revenues
are recognized when cash is received, and expenses are recognized when cash is paid.

Imagine a company that performs services for clients

throughout the summer but receives payment on different Cash-Basis Accounting
schedules, some of which extend into the fall. Outcome

[Link] Services Rendered : The company completes Revenues : $30,000 (cash

$50,000 worth of services in July and August but only received by the end of August)
receives $30,000 in cash by the end of August, with the
remaining $20,000 due to be paid later in the fall. Expenses : $25,000 (cash paid in
September)
[Link] Expenses : In September, the company incurs and
pays $25,000 in expenses for equipment maintenance and Profit : $5,000 (30,000 - 25,000)
staff wages.
Cash-Basis Accounting

Cash-Basis Accounting
Outcome
July August September December January
25,000 25,000 Revenues : $30,000 (cash
received by the end of August)
30,000 20,000 will be
received received Expenses : $25,000 (cash paid in
September)
Misleading Interpretation : While the business
shows a profit of $5,000 based on cash-basis Profit : $5,000 (30,000 - 25,000)
accounting, it doesn't reflect the true performance.
The business delivered $50,000 worth of services,
but its financial statement only accounts for the
cash received. It indicates profitability while
ignoring the reality that it still has $20,000 in
receivables that will affect future cash flow.
Accrual Accounting vs. Cash-Basis Accounting

Accrual Accounting Cash-Basis Accounting

• Records only cash

• Records impact of transactions: cash receipts and
transactions when they occur cash payments
• Records revenue when earned • Ignores important information
and expenses when incurred • Results in incomplete financial
statements
How Accrual Accounting Differs From Cash-Basis Accounting

Accrual accounting records cash transactions, such as:

• Collecting cash from customers

• Receiving cash from interest earned
• Paying salaries, rent, and other expenses
• Borrowing money
• Paying loans
• Issuing shares for cash

As Cash basis accounting does.

How Accrual Accounting Differs From Cash-Basis Accounting

Accrual accounting also records noncash transactions, such as:

•Sales on account (Accounts Receivable)

•Purchases of inventory on account (Accounts Payable)
•Expenses incurred but not yet paid (Ex: Tax Payable, Wages Payable)
•Depreciation expense
•Usage of prepaid rent, insurance, and supplies
•Earning of revenue when cash was collected in advance (Accounts
Receivable)
•Issuing shares for non-cash assets (e.g. equipment)

Cash basis accounting ignores these transactions in the period.

Adjusting Accounts

• Accrual accounting involves adjusting the accounts.

o Adjustments are necessary because the accounting period, by definition, ends on a particular
day.
o Some transactions invariably span the cutoff point, and therefore, some accounts need
adjustment.
o When transactions span more than one accounting period, accrual accounting requires the use
of adjusting entries.
Adjusting Accounts
Example: A Transaction Spanning the Cutoff Point
Imagine you run a small coffee shop.
The Accounting Period End: December 31

Situation: On December 1, you pay $1,200 in cash to your landlord to rent the shop for the next three months
(December, January, and February).

This is an example of a transaction that "spans the cutoff point." On December 31, you have only used up one month
of the rent you paid for. The other two months are for future periods.
NEED AN ADJUTMENT!

400 used 800 left as assets

Dec. 1 December 31 January February

$1,200
Categories of Adjusting Entries

A deferral is the postponement of

the recognition of an expense already
An adjustment for payment of an item or
Deferrals receipt of cash in advance.
paid or of revenue received in
advance. The cash payment or receipt
is recorded before the adjusting entry
is made.
(Examples: Unearned Revenue,
Allocates the cost of a plant asset to expense Prepaid Insurance)
Depreciation over the asset’s useful life.
An accrual is the recognition of an
expense or a revenue that has arisen
but not been recorded during the
accounting period. The cash payment
Accruals The opposite of a deferral. or receipt occurs in a future
accounting period, after the adjusting
entry has been made.
(Examples: Wage Payable, Accounts
Receivable)
Categories of Adjusting Entries

In summary:

Deferral : Cash exchanged first, recognition later.

Accrual : Recognition first, cash exchanged later.

Four Types of Adjustments
Adjusting Entries-
Type 1: Prepaid Expenses

Prepaid expenses are costs that companies pay in advance, such as rent, supplies, and insurance.
• An expense paid in advance. Prepaid expenses are assets because they provide a future benefit for
the owner
• A type of deferral
• These costs are debited to an asset account.
• At the end of the accounting period, the amount of the asset that has been used is transferred
from the asset account to an expense account.
Adjusting Entries-
Type 1: Prepaid Expenses

Example: Suppose Allain Travel Inc., prepays three months’ store rent ($3,000) on June 1.
Adjusting Entries-
Type 1: Prepaid Expenses

Prepaid Rent.

Throughout June, Prepaid Rent carries the balance of $3,000.

On June 30, an adjusting entry is required to transfer $1,000 ($3,000 ÷ 3) from Prepaid Rent to Rent
Expense.
Adjusting Entries-
Type 1: Prepaid Expenses
Adjusting Entries-
Type 1: Prepaid Expenses

Supplies. On June 2, Allain Travel paid cash of $700 for cleaning supplies.
Adjusting Entries-
Type 1: Prepaid Expenses

Use of Supplies
A count on June 30 indicates that $400 of supplies remain on hand.

The asset account Office Supplies now

reflects the correct balance of $400 of
supplies yet to be consumed.
Adjusting Entries –
Type 1: Depreciation of Assets

• When a company buys a long-term asset—such as a building, truck, computer, or store

fixture—it is, in effect, paying for the usefulness of that asset for as long as it benefits the
company.
• The accountant must allocate the cost of the asset over its estimated useful life.
o The amount allocated to any accounting period is called depreciation.
o There are a number of methods for estimating depreciation.
Adjusting Entries –
Type 1: Depreciation of Assets

• To maintain historical costs, Accumulated Depreciation accounts are used to accumulate the
depreciation on each long-term asset.
o These accounts are called contra accounts. A contra account is paired with a related account (for
example, an asset account). The balance of a contra account is shown on a financial statement as a
deduction from its related account.
o The net amount is called the carrying value (or book value) of the asset.
Adjusting Entries –
Type 1: Depreciation of Assets

Equipment. Suppose that on June 3 Allain Travel purchased equipment on account for $24,000
Adjusting Entries –
Type 1: Depreciation of Assets

Assume a Straight-line depreciation method:

• Divide cost of the asset by its useful life
• Allain Travel Inc. Equipment:
• Cost: $24,000
• Useful life: 5 years

Annual depreciation= 24,000/5 years = 4,800 per year

Monthly depreciation = 4,800/12 months= 400 per month

Adjusting Entries –
Type 1: Depreciation of Assets
Depreciation expense for June is recorded as follows:

Contra
Account
Adjusting Entries –
Type 1: Depreciation of Assets

Accumulated Depreciation account

• Balance = sum of depreciation expenses to date

• Balance increases over the asset’s life
• Contra asset account has a credit balance
• Any contra account has two characteristics:
• Has a “companion” account
• Normal balance is opposite to that of the companion account
Adjusting Entries –
Type 1: Depreciation of Assets

Carrying Value or Book Value: Cost of the asset minus accumulated depreciation
The carrying value of the Equipments would be:
24,000-400= 23,600
Adjusting Entries –
Type 2: Accrued Expenses

• At the end of an accounting period, some expenses incurred during the period have not been recorded.
These expenses require adjusting entries. Examples include:
o Interest on borrowed money
o Wages
o Utilities

• These expenses are called accrued expenses because, as the expense and the corresponding liability
accumulate, they are said to accrue.
Adjusting Entries –
Type 2: Accrued Expenses

Accrued Salary Expense. Suppose Allain Travel, Inc. pays its employee a monthly salary of $1,800,
half on the 15th and half on the last day of the month. The following calendar for June has the
paydays circled:

Assume that if a payday falls on a Sunday, Allain’s pays the employee on the following Monday.
Adjusting Entries –
Type 2: Accrued Expenses

During June, Allain Travel paid its employee the first half-month salary of $900.
Adjusting Entries –
Type 2: Accrued Expenses
The second half-month amount of $900 will be paid on Monday, July 1. At June 30, therefore, Allain
Travel makes the adjusting entry.
Adjusting Entries –
Type 2: Accrued Expenses
Adjusting Entries –
Type 3: Unearned Revenues

When a company receives revenues in advance, it has an obligation to deliver goods or perform
services. These unearned revenues are shown in a liability account.
Receipt of cash before earning the revenue creates a liability
As a company delivers part of the goods or performs part of the services, it earns a part of the
advance receipts.
The earned portion must be transferred from the liability account to a revenue account.

A type of deferral
Adjusting Entries –
Type 3: Unearned Revenues

Assume Disney World Resort pays Allain Travel $400 monthly, beginning immediately, if it books up to
eight clients into the resort within a 30-day period. If Allain Travel collects the first amount on June 15,
then it records this transaction as follows:
Adjusting Entries –
Type 3: Unearned Revenues
During the last 15 days of the month, Allain Travel books four clients into Disneyworld Resort to earn
½ of the $400.
Adjusting Entries –
Type 3: Unearned Revenues
Adjusting Entries –
Type 4: Accrued Revenues

Accrued revenues are revenues that a company has earned by performing a service or delivering goods
but for which no entry has been made in the accounting records.
Any revenues earned but not recorded during an accounting period require an adjusting entry that
debits an asset account and credits a revenue account.
Adjusting Entries –
Type 4: Accrued Revenues

Assume that on June 15 a hotel agrees to pay Allain a commission of $600 for booking 100 clients into
its hotel over the next 30 days. Allain books 50 clients in June and 50 in July. Allain will earn half a
month’s fee, $300, for work done June 15 through June 30.
Adjusting Entries –
Type 4: Accrued Revenues
Summary of Adjusting Process

Two purposes of the adjusting process are to:

• measure income, and
• update the balance sheet

Therefore, every adjusting entry affects both of the following:

• Revenue or expense—to measure income
• Asset or liability—to update the balance sheet
Summary of Adjusting Process
Summary of Adjusting Process
Adjusting Entries – Practice

Transaction 1- Blue Design Studio paid two months' rent in advance at the beginning of July. The
advance payment resulted in an asset—the right to occupy the office for two months. As each day in
the month passed, part of the asset's cost expired and became an expense. By July 31, one-half
of the asset's cost ($1,600) had expired.
Adjusting Entries – Practice

Transaction 2- Blue Design Studio purchased $5,200 of office supplies in early July. At the end of
July, an inventory shows that office supplies costing $3,660 are still on hand. This means that of the
$5,200 of supplies originally purchased, $1,540 worth were used (became an expense) by July 31.
Adjusting Entries – Practice
Transaction 3- On July 31, Blue Design Studio records $300 of depreciation of office equipment.

The journal entry to record depreciation

increases the contra account Accumulated Depreciation—Office Equipment
with a credit
increases the expense account Depreciation Expense—Office Equipment with a
debit

The carrying value of Office Equipment is $16,020 ($16,320 — $300) and is presented on the balance sheet
as follows.
Property Plant and Equipment blank blank
Office equipment $16,320 blank
Less accumulated depreciation 300 $16,020
Adjusting Entries – Practice

Transaction 4- Suppose Blue Design Studio has two pay periods a month rather than one.
In July, its pay periods end on the 12th and the 26th, as indicated in the calendar below.
July
Sun M T W Th F Sa
blank 1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 2
28 29 30 31 blank blank blank

By the end of business on July 31, Blue’s assistant will have worked three days (Monday, Tuesday, and
Wednesday) beyond the last pay period. The employee has earned the wages for those days but will not be
paid until the first payday in August. The wages for these three days are rightfully an expense for July, and the
liabilities should reflect that the company owes the assistant for those days. Because the assistant's wage rate
is $2,400 every two weeks, or $240 per day ($2,400 ÷10 working days), the expense is $720 ($240 × 3 days).
On July 31, Blue would record the $720 accrual of unrecorded wages
Adjusting Entries – Practice
This journal entry to record the accrual of wages:
increases the owner’s equity account Wages Expense with a debit
increases the liability account Wages Payable with a credit
Note that the increase in Wages Expense will decrease owner's equity and that total wages for the month are
$5,520, of which $720 will be paid next month.
Adjusting Entries – Practice

Transaction 5- During July, Blue Design Studio received $1,400 from another firm as advance
payment for a series of brochures. By the end of the month, it had completed $800 of work on the
brochures, and the other firm had accepted the work. On July 31, Blue would record the performance
of services for which $800 cash was received in advance.
Adjusting Entries – Practice

Transaction 6- During July, Blue Design Studio agrees to create two advertisements for Maggio's Pizza
Company and to finish the first advertisement by July 31. By the end of July, Blue has earned $400 for
completing the first advertisement, but it will not bill Maggio's until the entire project has been
completed. On July 31, Blue records the accrual of $400 of unrecorded revenue.
Adjusting Entries – Practice

On December 31, the end of the current fiscal year, the following information is available to assist
Bora Company's accountants in making adjusting entries:

• a. Bora's Supplies account shows a beginning balance of $6,000.

Purchases during the year were $10,300. The end-of-year inventory
reveals supplies on hand of $3,000.
• b. On July 1, the company completed negotiations with a client and
accepted an advance of $4,800 for services to be performed monthly
for a year. The $4,800 was credited to Unearned Services Revenue.
• c. Among the assets of the company is a note receivable in the amount
of $100,000. On December 31, the accrued interest on this note
amounted to $6,000.
• d. On Saturday, January 3, the company, which is on a six-day
workweek, will pay its regular employees their weekly wages of $9,000.

Prepare adjusting entries for each item listed.

Adjusting Entries – Practice
SOLUTION