Chapter four: accrual accounting concepts
Under current accounting standards, revenue is recognized or recorded when, due to ordinary activities, an
increase in future economic benefits arising from an increase in an asset or a decrease in a liability has occurred.
Ordinary activities could include sales, rent, interests, and other form of revenues
Revenue recognition: occurs when sales or performance effort is substantially complete, the amount is
determinable (measurable) and collection is reasonably assured.
For Merchandise Company, revenue is considered to be earned when the merchandise is sold and for Service
Company, revenue is considered armed and that time service is performed.
Expense and recognized in income statement when, due to an ordinary activity, there is a decrease in future
economic benefits related to a decrease in an asset or an increase in a liability and this change can be measured
Expense recognition: is tied to changes in assets and liabilities.
Expense recognition will often concerned with the revenue recognition but not always
Accrual verses cash basis of accounting
The command application of revenue recognition and expense recognition results in accrual basis accounting
Accrual basis accounting: means that transactions affecting the company’s financial statements are reported in
the periods in which the events occur, rather than when the company actually receives or pays cash
This means that recognizing and revenues when they are and rather than when cash is received, and expenses
are recognized in the period in which goods and services are used are consumed rather than when cash is paid
Cash basis accounting: revenue is only recorded when cash is received, and expenses is recorded only when
cash is paid.
Use a cash basis of accounting can lead to misleading financial statements. Because management can change
the revenue and expenses that are reported by timing the receipt and payment of cash. Profits can be increased
by paying expenses in the following year. Profit can be lower and income tax reduced by asking customers to
pay in the following year.
A cash basis income statement fails to report revenues and expenses when a related assets like accounts
receivable and related liabilities like accounts payable a rise.
The basic of adjusting entries
For revenues to be recorded in the period in which they are earned, and for expenses to be recoded when
incurred, accountants may have to record, adjusting entries to update accounts at the end of the accounting
Adjusting entries makes is possible to produce relevant financial information at the end of the accounting
period. Thus, statement of financial position reports appropriate assets, liabilities and shareholder’s equity at
the statement date, and the income statement shows the proper revenues, expenses, and profit or loss for the
Adjusting entries are necessary because the trial balance may not contain come for eight and up to date data for
1. Some events are not recorded dearly, because it would not be useful or efficient to do so, for example, the
use of supply and the earnings of salaries by employees
2. 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. For example rent, insurance, and depreciation
3. Some items may be on reported for example and utility service bill that will not be received until the next
accounting. The bill, however, covers services that delivered in the current accounting period.
As a company is public and reporting under IFRS, quantity financial statements must be prepared. As a result,
existing entries will be prepared at the end of each quarter although many companies will prepare them
monthly If the company is private and porting under ASPE, adjusting interest me to be done only annually but mainly
done frequently if management wishes.
Each account in the trial balance needs to be analyzed to see if it is complete and up to date, which are requires
an understanding of the company’s operation and the interrelationship of accounts
Types of adjusting entries
Adjusting entries can be classified as either prepayments or accruals. Each of these classes has 2 subcategories
1. Prepaid expenses: expenses paid in cash and recorded as assets before they are used or consumed
2. Unearned revenues: cash received and recorded as liabilities before revenue is an
1. Accrued revenues: revenues earned but not yet received in cash or recorded.
2. Accrued Expenses: expenses incurred but not yet paid in cash or recorded
See the illustration 4-2 in page 169
Adjusting entries for prepayments
Prepayment increases current assets such as prepaid expenses and certain type non-current assets such as
buildings and equipments. It can also be received rather than paid, and in this case prepayment received
increase current liabilities such as unearned revenues.
Adjusting entries for prepayments allocated cost from an asset or liability account to an expense for revenue
This means for prepayments me, the adjusting entry records and expects that applies to the current period and
reduces the asset account that was originally recorded. This type of adjustment is necessary because the
prepayment no longer has been to benefit or consequently is no longer an asset—it has been used.
For the prepayment received, the adjusting entry records the revenue earned in the period and reduces the
liability account where the unearned revenue was originally recorded. This type of adjustment is necessary
because the unearned revenue is no longer owed and consequently is not longer in liability—the service has
been provided at the revenue is earned.
Costs that are paid for in cash before they are used are recorded as prepaid expenses.
And when such a cost is incurred, and asset (prepaid) account should be increased by debiting—to show all the
service for benefits that will be received in the future—and cash should be decreased by crediting. In some
cases, the assets are purchased on an account but ultimately cash is paid.
Prepaid expenses are cost that expired either with the passage of time (for example insurance, rent, and to
depreciable assets) or through use (supplies).
It’s not practical to record the expiration of these costs on a daily basis instead these are recorded when
financial statements are prepared.
At each statement date, adjusting entries are made for two purposes, one to record the expense which is
expired cost, applicable to the current accounting and second to show all the remaining amounts which is
unexpired cost in the asset accounts.
Until prepaid expenses are adjusted assets and overstated and expenses are over stated which leads to profits
to be overstated
An adjusting entry for prepaid expenses results in an increase (a debit) an expense account and a decrease in
assets (a credit)
- The purchase of supplies results in increase of assets such as a supply account by debiting. during the
accounting period, supplies are used. Rather than recording supplies expense as they were used, supplies
expense is recognized at the end of the accounting period. At that time the company must count the
remaining supplies and the difference between the balance in the supplies (assets) account and the actual
cost of supplies on the other hand gives the supplies use (an expense) for that period.
-companies purchase insurance to protect themselves from losses caused by fire, theft, and unforeseen
accidents. Insurance must be paid in advance, often for one year. Insurance payments (premiums) made in advance are normally recoded in the assets account as prepaid insurance. At the financial statement date, it is
necessary to make an adjustment to increase (debit) insurance expanse and decrease (credit) prepaid insurance
for the cost of insurance that has expired.
- A company typically owns variety assets that have long lives, such as building and equipments. Each one is
recoded as assets, rather than an expense, in the year it is acquired because these long lived assets provide
a service for many years. The period of service is called the useful life.
- From accounting viewpoint, the acquisition of certain types of long-term assets is essentially a long-term
payment of service. There is a need to recognize the cost that has been used (an expense) during the period
and report the unused cost (An assets) at the end of the period. Depreciation is the process of allocating
the cost of long-lived and long current assets such as property, plant and equipment. To expense over its
useful life. Only assets with specified lives are depreciated and they are called depreciable assets and assets
such as land which has unlimited life is not depreciated.
- In terms of depreciation, the term amortization is used in relation to intangible assets and depletion is used
in relation to tangible or natural resources.
- Depreciation is an allocation concept not valuation concept because we depreciate an assets to allocate its
cost over the period over which we use.
- Calculation of depreciation: straight line method of depreciation: cost/useful life (in years) = annual
-a contra account is an account that is offset against (deducted from) a related account on the income
statement or statement of financial position, its normal balance is a credit which is the opposite of the normal
balance of its related account, equipment. By using contra account instead of crediting from the equipment
account, discloses both the original cost of equipment and the total estimate cost that has expired till the date.
This helps to separate the actual amount which is the cost from the estimated amount which is the accumulated
-the difference between the cost of a depreciable asset and its related accumulated depreciation is referred to
as the carrying amount of that asset, this amount is also known as the net book value.
Unearned revenues: cash received before revenues is earned is recorded by increasing (crediting) a liability
account for unearned revenues. For unearned revenues, the cash account should be debited and unearned
revenue as a liability account should be debited.
Until the adjustment is made, liabilities account is overstated and revenue account is understated which lead to
profit being understated.
Adjusting process is decreasing liability account by deb