RMIT Classification: Trusted

Lecture Notes - Accrual Accounting Concepts

Topic and Topic Learning Objectives

Accrual Accounting Concepts

Building on your knowledge established in Introductory Accounting you are required to be able to
process balance day adjustments and prepare the ledger for the commencement of a new reporting
period.

In particular you will need to be able to determine the need for and process adjustments for
expenses and revenues that have not previously been recorded (accruals) and expenses and
revenues that have been recorded (prepaid expenses and revenues received in advance).

In addition you will be required to be able to prepare correctly classified financial statements, post
balance day adjustments to the ledger, discuss the need for balance day adjustments, prepare
general journal entries to close the ledger, post these journal entries to the general ledger, complete
ledger accounts showing the impact of the closing entries and prepare a post closing trial balance.
You will also be required to be able to use a multi-column worksheet as an alternative method of
preparing financial statements. You will need to be able to demonstrate an understanding of the
need for reversing entries.

Accrual Accounting Concepts

Learning objectives

1. Differentiate between the cash basis and the accrual basis of accounting.

2. Explain criteria for revenue recognition and expense recognition.

3. Explain why adjusting entries are needed and identify the major types of adjusting
entries.

4. Prepare adjusting entries for prepayments and accruals.

5. Describe the nature and purpose of the adjusted trial balance.

6. Explain the purpose of closing entries.

7. Describe the required steps in the accounting cycle.

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ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Cash-based accounting

Revenue is recognised based on the cash received.

Expense is recognised based on cash paid.

Accrual-based accounting

Revenue is recognised when it is earned.

Expense is recognised when it is incurred.

Timing Issues

Accounting divides the economic life of a business into artificial time periods, known as the
accounting period concept.

Accounting periods are generally a month, a quarter, six months, or a year.

Many business transactions affect more than one of these arbitrary time periods. Therefore,
it is necessary to determine the impact of each transaction on specific accounting periods.

Revenue recognition

The Framework provides revenue recognition criteria.

Revenue should be recognised when:

(a) it is probable that any future economic benefits associated with the revenue will flow
to the entity and
(b) the revenue can be measured reliably.

Expense recognition

The Framework provides expense recognition criteria.

Expenses should be recognised when:

(a) the outflow of future economic benefits associated with the expense is probable and
(b) the expense can be measured reliably.

These revenue and expense recognition criteria help determine the amount of revenues and
expenses to be reported in each accounting period.

The diagram below shows relationship between revenue recognition, expense recognition
and the accounting period concepts.

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THE BASICS OF ADJUSTING ENTRIES

Adjusting entries are necessary to make sure:

- revenues and expenses are recorded in the correct accounting period (matching
principle)
- recognition criterion are followed for assets, liabilities, revenues and expenses
(revenue recognition principle and expense recognition principle)

The use of adjusting entries ensures that accurate financial statements are produced at the
end of the accounting period.

Types of adjusting entries

Prepayments/deferrals

1. Prepaid expenses: amounts paid in cash and recorded as assets until used.
2. Deferred revenues/revenue received in advance: amounts received from customers
and recorded as liabilities until the services are performed or the goods delivered.

Accruals

1. Accrued revenues: amounts not yet received and recorded for which goods or
services have been provided
2. Accrued expenses: amounts not yet paid or recorded for goods or services already
received

ADJUSTING ENTRIES FOR PREPAYMENTS

Adjusting entries for prepayments are required at balance date to record the portion of the
prepayment that represents the expense or the revenue in the current accounting period.

Prepayments are either:

(a) Prepaid expenses

(b) Deferred revenues/revenues received in advance

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(a) Prepaid expenses

Amounts paid in cash and recorded as assets until used.

The initial transaction is recorded as an asset to show the service or benefit that will be
received in the future i.e. insurance, rent, advertising, supplies.

At each balance date, adjusting entries are made to:

- record the increase in expense applicable to the current accounting period (Dr expense
account)
- to show the remaining amount in the asset account (Cr asset account).

If the initial transaction was mistakenly recorded as an expense, the adjusting entry made is
to:

- increase the asset account for the future benefit which is unexpired (Dr asset account) and
- record the decrease in the expense (Cr expense account)

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Lecture Illustration 1

Refer to the Eagle Golf Academy discussed in Lecture 2.

An accounting period of 1 month is used; adjusting entries will be dated 31 December.

Eagle Golf Academy

Trial Balance as at December 31

No. Account Title Debit Credit

100 Cash 6,900

104 Accounts receivable 2,000
105 Supplies 2,300
112 Prepaid rent 6,000
130 Equipment 24,000
200 Accounts payable 2,300
215 Deferred revenue 600
230 Notes payable 10,000
300 Common stock 25,000
320 Dividends 200
400 Service revenue 6,300
515 Salaries expense 2,800
44,200 44,200

Remember in Lecture 2 classroom exercise, you closed every single ledger account and
transfer each balance into trial balance above. That was done so that you get used to the
process of posting.

Now, you know some ledger balances are not final yet because we may have period end
adjustments. Therefore, if you use T format and you find out a ledger account is affected due
to period end adjustment, re-open the account and finalize a new balance. Well, there is no
such issue if you use running balance. You just need to continue.

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1. Pay one year of rent in advance, $6,000

Journal entry:

General Ledger entry:

Rent expense No. 500

Prepaid rent No. 112

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2. Balance of supplies is worth $1,300

Journal entry:

General ledger:

Supplies expense No. 505

Supplies No. 105

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3. Equipment purchased on Dec 1 has useful life of 5 years (60 months)

Journal entry:

General Ledger:

Equipment No. 130

Accumulated Depreciation – Office Equipment No. 131

Depreciation Expense- Office Equipment No. 510

Statement of Financial Position:

Equipment
Less: Accumulated depreciation
Net book value

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(c) Deferred revenue/revenue received in advance

Cash received before the revenue recognition criteria have been met is recorded by
increasing (crediting) a liability account called Revenue Received in Advance to recognise
the obligation that exists i.e. rent, magazine subscriptions. Revenues received in advance
are subsequently recognised as revenue when the service is provided to a customer.

4. The cash received in advance of $600 is meant for 12 sessions. Assume at the end
of the period under review, 4 sessions have been completed.

Journal entry:

General Ledger:

Deferred revenue No. 213

Service Revenue No. 400

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ADJUSTING ENTRIES FOR ACCRUALS

Adjusting entries for accruals are required in order to record revenues and expenses in the
current accounting period that have not been recognised through daily entries and are thus
not yet reflected in the accounts.

Accruals may be either:

(a) accrued revenues

(b) accrued expenses

(a) Accrued revenues

Revenues earned from providing goods or services that have not as yet been recorded i.e.
interest, commission, fees.
An adjusting entry is required to show the receivable that exists at balance date and to
record the revenue for the period.
Once cash is received, the receivable is reduced.

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5. The Company provides golf training to customers from Dec 28 to Dec 31 amounting
to $700. It takes normally until January next year to mail the bills to these customers
and receive money.

Journal entry:

General Ledger:

Accounts receivable No. 104

Service Revenue No. 400

(b) Accrued expenses

Expenses not yet paid or recorded at balance date i.e. interest, rent and salaries.
Adjustments for accrued expenses are necessary to record the obligations that exist at
balance date and to recognise the expenses that apply to the current accounting period.
An adjusting entry for accrued expenses results in an increase (debit) to an expense account
and an increase (credit) to a liability account.

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6. Accrued Salaries. The Company pays $100 per day to its employees. For the first 4
weeks until 28 Dec, Eagle pays $2,800. The next weekly payment date is 4 Jan next
month.

Journal entry:

Note that salaries payable account is newly created in the chart of accounts.

General Ledger:

Salaries Expense No. 515

Salaries Payable No. 220

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7. Accrued utility cost. Eagle received utility bill for December. Though the payment is
to be made next Jan, the amount has to be accrued.

Journal entry:

General Ledger:

Utilities Expense No. 518

Utilities Payable No. 213

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8. Accrued interest. The bank charges interest 12% per annum.

Journal entry:

General Ledger:

Interest Expense No. 518

Interest Payable No. 210

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SUMMARY OF ADJUSTING ENTRIES

Fill in the adjusting entry column to update the ledger balances:

Type of adjustment and/or Accounts before Adjusting entry

initial entry adjustment

Prepaid expenses

If amount paid is initially Assets overstated

recorded as an asset Expenses understated

If amount paid is initially Expenses overstated

recorded as an expense Assets understated

Revenues received in advance

If amount received is initially Liabilities overstated

recorded as a liability Revenues understated

If amount received is initially Revenues overstated

recorded as a revenue Liabilities understated

Accrued revenues

Assets understated
Revenues understated

Accrued expenses

Expenses understated
Liabilities understated

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PREPARING THE ADJUSTED TRIAL BALANCE

The adjusted trial balance is prepared after all adjusting entries have been made.
It is used to prove the equality of total debit balances and total credit balances after the
adjusting entries have been made.

The adjusted trial balance is the main basis for preparation of the financial statements.

Fill in the revised general ledger balance in after adjustment column.

EAGLE GOLF ACADEMY

Trial Balance as at 31 December

Before adjustment After adjustment

Dr Cr Dr Cr

Cash 6,900
Accounts receivable 2,000
Supplies 2,300
Prepaid rent 6,000
Equipment 24,000
Accumulated depreciation - Equipment
Accounts payable 2,300
Salaries payable
Utilities payable
Interest payable
Deferred revenue 600
Notes payable 10,000
Common stock 25,000
Dividends 200
Service revenues 6,300
Salaries expense 2,800
Rent expense
Supplies expense
Depreciation expense
Utilities expense
Interest expense

44,200 44,200

So, what’s next? Ask yourself, does trial balance carry any meaning if we just stop here?
Certainly it’s not. A trial balance is used to prepare income statement, statement of financial
position (balance sheet), statement of stockholders’ equity etc. At this stage, we’re going to
relax cash flow statement and will address in its own chapter. Cash flow requires more
techniques of preparing.

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PREPARING FINANCIAL STATEMENTS

Now, fill in the blank

EAGLE GOLF ACADEMY

Income statement
For the period ended 31 December

$ $
Revenue
Service revenue

Expenses
Rent expense
Supplies expense
Depreciation expense
Salaries expense
Utilities expense
Interest expense
Total expense

Net income

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Next, let’s complete our balance sheet:

EAGLE GOLF ACADEMY

Statement of financial position
As at 31 December

$ $
Assets
Current assets:
Cash
Accounts receivable
Supplies
Prepaid rent
Total current assets

Non-current assets:
Equipment
Less: Accumulated depreciation
Total non-current assets

Total assets

Liabilities
Current liabilities:
Accounts payable
Salaries payable
Utilities payable
Deferred revenue
Interest payable
Total current liabilities

Non-current liabilities:
Notes payable

Total liabilities

Stockholders’ Equity
Common stock
Retained earnings
Total stockholders’ equity

Total liabilities and stockholders’ equity

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What about Statement of Stockholders’ Equity. We’re going to do as well.

Fill in the blank.

EAGLE GOLF ACADEMY

Statement of Stockholders’ Equity
For the period ended 31 December

Common Retained Total

stock Earnings stockhold
ers’
Equity
$ $ $
Beginning balance
Issuance of common stock
Add: Net income for the period
Less: Dividends

Ending balance

CLOSING THE BOOKS

Temporary accounts relate to only a given accounting period

i.e., revenues, expenses, dividends
Permanent accounts are carried forward to future accounting periods
i.e., assets, liabilities, equity

This shows the temporary and permanent accounts for a company.

These are the same for a sole trader except that ‘Dividends’ should be replaced with
‘Drawings’.

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Preparing closing entries

Closing entries are used to transfer the temporary account balances to the permanent equity
account, retained earnings.
They produce a zero balance in each temporary account.
As a result these accounts are ready to accumulate data about revenues, expenses and
dividends in the next accounting period that is separate from the data in the previous
periods.

Steps in the closing process:

1. Each revenue account is closed to the Income Summary, another temporary account
2. Each expense account is closed to the Income Summary
3. The Income Summary account is closed to Retained Earnings
4. Dividends are closed to Retained Earnings
This will result in all temporary accounts having a closing balance of zero.

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Lecture Illustration 2

We’re continuing from Eagle Academy case.

General Journal:

Date Account titles and explanations Post Debit Credit

Ref $ $
Closing entries
(1)
Dec 31 Service Revenues
Income Summary
To close revenue account

(2)
31 Income Summary
Salaries Expense
Rent Expense
Supplies expense
Depreciation expense
Utilities expense
Interest Expense
To close expense accounts

(3)
31 Income Summary
Retained Earnings
To close profit to retained earnings

(4)
31 Retained Earnings
Dividends
To close dividends to retained earnings

As expense accounts have debit balances, in order to make the account balance nil, we
need to credit each expense account and debit Income Summary (in total) to transfer the
total of the expense accounts to the Income Summary account.

As revenue accounts have credit balances, we need to debit revenue accounts to reduce
them to a nil balance and transfer the revenue to the Income Summary account.

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Preparing a post-closing trial balance

A post-closing trial balance is a list of all permanent accounts and their balances and is
prepared after all closing entries have been journalised and posted.

The purpose of the post-closing trial balance is to prove the equality of the permanent
accounts that are carried forward to the next accounting period.

Fill in the blank to close the books for the period.

EAGLE GOLF ACADEMY

Adjusted Trial Balance as at 31 December

Dr Cr

Cash
Accounts receivable
Supplies
Prepaid rent
Equipment
Accumulated depreciation - Equipment
Accounts payable
Salaries payable
Utilities payable
Interest payable
Deferred revenue
Notes payable
Common stock
Retained earnings

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SUMMARY OF THE ACCOUNTING CYCLE

The required steps in the accounting cycle are:

1. Analyse transactions
2. Journalise transactions
3. Post to ledger accounts
4. Prepare a trial balance
5. Journalise and post adjusting entries: prepayments/accruals
6. Prepare an adjusted trial balance
7. Prepare financial statements
• Income statement
• Statement of changes in equity
• Statement of financial position
8. Journalise and post closing entries
9. Prepare a post-closing trial balance

Steps 1 – 3 may occur daily during the accounting period.

Steps 4 – 7 are performed on a periodic basis, such as monthly, 6 monthly or annually.
Steps 8 and 9 are usually only prepared at the end of the financial year.

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