Financial Accounting: Tools for Business

Decision-Making
Seventh Canadian Edition
Kimmel Weygandt Kieso Trenholm Irvine Burnley

Chapter 4
Accrual Accounting Concepts
Learning Objectives
LO 1: Explain the accrual basis of accounting and the
reasons for adjusting entries.
LO 2: Prepare adjusting entries for prepayments.
LO 3: Prepare adjusting entries for accruals.
LO 4: Prepare an adjusted trial balance.
LO 5: Prepare closing entries and a post-closing trial
balance.

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Timing Issues
• Users require financial information on a regular basis
• Accounting divides the economic life of a business into
time periods
• Month, quarter (three months), year
o One-year period is known as the fiscal year
o Shorter periods are known as interim periods
• Many transactions affect more than one time period

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Revenue Recognition (1 of 2)
• Revenue: Increase in assets (or settlement of liabilities)
o Income that results from a company’s ordinary activities
• In general, revenue is recognized
o In a merchandising company when merchandise is sold and
delivered (point of sale)
o In a service company when the service is performed
• Under ASPE, revenue can be recognized when:
o Performance of an obligation is substantially complete
o Revenue can be reliably measured
o Collection is reasonably certain

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Revenue Recognition (2 of 2)
Under IFRS, new revenue standard (effective January 1,
2018)
Five-step process to measure and report revenue:
1. Identify the contract with the client or customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance
obligations in the contract
5. Recognize revenue when (or as) the company satisfies
the performance obligation

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Discussion Question 1
How might revenue be recognized for a large, publicly-
traded transportation company?
Compare this to how revenue might be recorded for a
small convenience store.

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Expense Recognition
• Expenses are recognized when:
o Due to ordinary activity, a decrease in future economic
benefits occurs
o A decrease in an asset or an increase in a liability
o Can be measured reliably
• Tied to changes in assets and liabilities
• Often coincides with revenue recognition
• Recognized, whenever possible, in the period in which
effort is made to generate revenue
o Sometimes known as matching
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Discussion Question 2
Identify some expenses that can be easily matched to
revenue and some that aren’t as easily directly matched
to the revenue they help produce.

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Accrual Basis Accounting
• Transactions affecting a company’s financial statements
are recorded in the period the events occur, rather than
when cash is received or paid
o Revenue is recorded when earned, rather than when cash is
received
o Expenses are recorded when goods or services are consumed
or used, rather than when cash is paid

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Cash Basis Accounting
• Revenue is recorded only when cash is received
• Expenses are recorded only when cash is paid
• Can lead to misleading information for decision-
making:
o Timing differences between the occurrence of the actual event
and its related cash flows
o Revenue and expenses can be manipulated by timing the
receipt and payment of cash

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Adjusting Entries
• Entries made to adjust or update accounts at the end
of the accounting period
• Required because the trial balance may not contain
complete and up-to-date data
o Some items are not recorded daily
o Some costs are not recorded during the accounting period,
as they expire due to the passage of time
o Some items may be unrecorded

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Types of Adjusting Entries
Prepayments
Begin underline end underline

Prepaid expenses
Unearned revenues
Accruals
Begin underline end underline

Accrued expenses
Accrued revenues

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Prepaid Expenses
• Cash payments of expenses that will benefit more than
one accounting period recorded as assets
o When expenses are prepaid, an asset (prepaid expenses) is
increased (debited) to show the future service or benefit, and
cash is decreased (credited)
• Expire with the passage of time or through use
o Not practical to record this expiration on a daily basis, so done
when statements are prepared
• Adjusting entry increases an expense account and
decreases the asset (prepaid) account

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Unearned Revenue
• Cash received and recorded as liabilities before revenue
is earned
o When the cash is received, cash is increased (debited), and a
liability account (unearned revenue) is increased (credited)
• The opposite of prepaid expenses
• Adjusting entry decreases the liability (unearned
revenue) account and increases a revenue account
o Reflects amount of revenue earned in the period and the
remaining liability at the end of the period

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Discussion Question 3
Why are prepaid expenses a current asset?
Why are unearned revenues a current liability?

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Accruals
• Accruals have not been recognized at all until an
adjustment is made
• Expenses that have been incurred, but not yet paid or
recorded (accrued expenses)
o Adjusting entry results in an increase to both an expense and
a liability account
• Revenues that have been earned, but not received in
cash (accrued revenues)
o Adjusting entry results in an increase to both an asset and a
revenue account

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Summary of Basic Relationships
Type of Transaction Journal Entry Accounts before Adjustment Adjusting Entry
Adjustment during Period
Prepayments Blank Blank Blank
Prepaid expenses Dr. Prepaid Expenses Expenses understand and net income overstated; Dr. Expenses
Cr. Cash (or Accounts assets and shareholder’s equity overstated Cr. Prepaid
Payable) A = L + SE Expenses
O = NE + O
Unearned revenue Dr. Cash Revenues and net income understated; liabilities Dr. Unearned Revenue
Cr. Unearned Revenue overstated and shareholder’s equity understated Cr. Revenue
A = L + SE
NE = O + U
Accruals Blank Blank Blank
Accrued expenses None Expenses understated and net income overstated; Dr. Expense
liabilities understated and shareholder’s equity Cr. Payable
overstated
A = L + SE
NE = U + O
Accrued revenues None Revenue and net income understated; assets and Dr. Receivable
shareholder’s equity understated Cr. Revenue
A = L + SE
U = NE + U

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Adjusted Trial Balance
• Prepared after all adjusting entries have been recorded
and posted
• Shows the balances of all accounts at the end of the
accounting period, including those accounts that have
been adjusted
• Proves total debit balances and total credit balances are
equal after the adjusting entries have been made
• The main source for preparation of financial statements

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Closing Entries
• Revenue, expense, and dividends declared accounts are
components of retained earnings considered to be
temporary accounts.
• Statement of financial position accounts carry forward
into the future
o Considered to be permanent accounts
• Closing entries
o Temporary account balances are transferred to Retained
Earnings
o Produce a zero balance in the temporary accounts to prepare
them for the next period’s activity
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Temporary and Permanent Accounts
Temporary Accounts Normal Balances
Revenues Credit
Expenses Debit
Dividends Declared Debit

Permanent Accounts Normal Balances

Assets Debit
Liabilities Credit
Shareholder’s equity accounts:
Common Shares Credit
Retained Earnings Credit

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The Closing Process
1. Close revenue accounts:
Debit each revenue account for its balance and credit
Income Summary the total revenue amount
2. Close expense accounts:
Debit Income Summary for the total expense amount and
credit each expense account for its balance
3. Close Income Summary:
Debit (or credit) Income Summary for the balance in the
account and credit (debit) Retained Earnings
4. Close Dividends Declared account:
Debit Retained Earnings and credit Dividends Declared
account for the balance
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The Closing Process Illustrated

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Post-Closing Trial Balance
• Lists all permanent accounts and their balances after all
closing entries are journalized and posted
• Proves that total debit balances and total credit balances
are equal after the closing entries have been made

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Summary of the Accounting Cycle
Chapter 3
1. Analyze transactions
2. Journalize the transactions
3. Post to the ledger accounts
4. Prepare a trial balance
Chapter 4
5. Journalize and post adjusting entries
6. Prepare an adjusted trial balance
7. Prepare financial statements
8. Journalize and post closing entries
9. Prepare a post-closing trial balance
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Comparing IFRS and ASPE
Comparing IFRS and ASPE Review
Key Standard International Financial Reporting Accounting Standards for
Differences Standards (IFRS) Private Enterprises (A SPE)
Revenue recognition The following process is used to measure Revenue is recognized when
and reporting (pending standard effective Jan performance is substantially
1,2018): complete, revenue amount is
1. Identify the contract with the client or able to be reliably measured,
customer. and collection reasonably
2. Identify the performance obligations in certain.
the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the
performance obligations in the contract.
5. Recognize revenue when (or as) the
company satisfies the performance
obligation.

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Copyright
Copyright © 2017 John Wiley & Sons, Canada, Ltd.
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