Accrual Accounting Concepts
1. Explain when revenues and expenses are recognized and how this forms the basis for
2. Describe the types of adjusting entries and when they are recorded and prepare
adjusting entries for prepayments.
3. Prepare adjusting entries for accruals and describe how adjusting entries affect the
income statement and the statement of financial position.
4. Describe the nature and purpose of the adjusted trial balance, and prepare one.
5. Prepare closing entries and a post-closing trial balance.
• Companies need immediate feedback on how well they are doing
• Accounting divides the economic life of a business into artificial time periods
– Month, quarter, year
– Many transactions affect more than one time period
• Revenue is recognized when:
– Sales or performance effort is substantially complete
– Amount is determinable (measureable)
– Collection is reasonably assured
• In a merchandising company:
– When merchandise is sold (point of sale)
• In a service company:
– When the service is performed Discussion Questions
How might revenue be recognized for a construction company?
Compare this to how revenue might be recorded for a small convenience store.
• Expenses are recognized when:
– Due to ordinary activity, a decrease in future economic benefits occurs
• Related to a decrease in an asset or an increase in a liability
– It can be measured reliably
• Tied to changes in assets and liabilities
• Often (but not always) coincides with revenue recognition
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.
Accrual Basis of Accounting
• Transactions affecting a company’s financial statements are recorded in the period the
events occur, rather than when cash is received or paid
– Revenue is recorded when earned, rather than when cash is received
– Expenses are recorded when goods or services are consumed, rather than
when cash is paid
Cash Basis of Accounting
• Revenue is recorded only when cash is received
• Expenses are recorded only when cash is paid
• Can lead to misleading financial statements:
– Revenue and expenses can be manipulated by timing the receipt and payment of
– Can increase or decrease profit Adjusting Entries
• Adjusting entries are made to adjust or update accounts at the end of the accounting
• Required because the trial balance may not contain complete and up-to-date data
– Some items are not recorded daily
– Some costs are not recorded during the accounting period, as they expire due to
the passage of time
– Some items may be unrecorded
Types of Adjusting Entries
– Prepaid expenses
– Unearned revenues
– Accrued revenues
– Accrued expenses
• Costs that are paid for in cash before they are used
– When the cost is incurred, an asset (prepaid) is increased (to show the future
service or benefit) and cash is decreased
• Expire with the passage of time or through use