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ADM1340 (150)
Marc Tasse (11)
Chapter 4

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University of Ottawa
Marc Tasse

Chapter 4 Accrual Accounting Concepts Study Objectives 1. Explain when revenues and expenses are recognized and how this forms the basis for accrual accounting. 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. Timing Issues • 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 Recognition • 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. Expense Recognition • 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 Discussion Question 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 cash – Can increase or decrease profit Adjusting Entries • Adjusting entries are 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 – 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 • Prepayments – Prepaid expenses – Unearned revenues • Accruals – Accrued revenues – Accrued expenses Prepaid 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 – Not
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