CHAPTER 3

ACCRUAL ACCOUNTING
 Learning Objectives
 Explain how Accrual Accounting differs from Cash Basis Accounting

 Apply the Revenue and Expense Recognition Principles

 Adjust the accounts

 Prepare Updated Financial Statements

 Close the books

• Revenue recognition. A company sells $10,000 of green widgets to a customer in March, which
pays the invoice in April. Under the cash basis, the seller recognizes the sale in April, when the
cash is received. Under the accrual basis, the seller recognizes the sale in March, when it issues
the invoice.
• Expense recognition. A company buys $500 of office supplies in May, which it pays for in June.
Under the cash basis, the buyer recognizes the purchase in June, when it pays the bill. Under the
accrual basis, the buyer recognizes the purchase in May, when it receives the supplier's invoice.
 Basis of Accounting

Records the impact of

business transactions and
Accrual events on the entity’s
basis assets and liabilities over
the period in which they
occur

Records only cash

Cash basis transactions – cash
receipts and cash
payments
How accrual accounting differs from cash
basis accounting
Accrual
basis
•Includes all the cash basis
transaction along with the
following
•Sales on account
•Purchase of stock on
account
•Depreciation expense
•Accrued expenses
•Prepaid rent & insurance
Cash
basis
•Collecting cash from
customers
•Receiving cash from
interest earned
•Payment of salaries
•Borrowing money
•Paying off loans
•Issuing shares
 Time period concept

• Going concern assumption. Firm will go-on

and on and on

• It ensures that accounting information is

reported at regular intervals.
 Revenue Recognition Principle

• It provides the direction like “when” to

recognize a transaction.

• It states that when the income or the expense is

accrued, the entry has to be made regardless of
whether cash is received or not.
When a company receives money in advance of earning it, the accounting entry is a debit to the
asset Cash for the amount received and a credit to the liability account such as Customer
Advances or Unearned Revenues
Revenue is recognized when

The entity has transferred to the buyer the significant

risks and rewards of ownership of goods.

The entity neither retains nor continues managerial

involvement to the degree usually associated with
ownership

The amount of revenue can be measured reliably

It is probable that the economic benefits associated with

the transaction will flow to the entity

The cost incurred or to be incurred in respect of a

transaction can be measured reliably
 Revenue recognition

Sales revenue should be measured at

Goods
fair value of the consideration received.

Interest is recognized on a time-

Interest proportion basis using the effective
income interest method

Recognized on accrual basis in

Royalty accordance with the substance of the
income relevant agreements.

Dividend Recognized when the right to receive

income payment is established.
The Expense Recognition Principle

• It is the basis for recording expenses.

• Expenses are the cost of assets used up or

liabilities incurred in earning income.
 Matching concept
• This is used to explain the relationship
between expenses and revenues.

• This process is commonly referred as

“matching of costs with revenues”.

• All costs expensed should have a

corresponding revenue entry.
How does it work?
 Adjusting the Accounts?

• Trial balance is an unadjusted balances of

accounts.

• Hence all the accounts have to be adjusted

before it is being published as financial
statements.
 Categories of Adjusting entries
Deferrals
A deferral is an adjustment for an item for which the business paid or
received cash in advance.
Ex: Prepaid rent, prepaid insurance etc…
Accruals
Which is exactly the reverse of deferrals where an organization records the
expense or revenue before paying or collecting it

Depreciation
It allocates the cost of PPE to expense over the asset’s useful life.
Decreases assets carrying value.
 Forms of Prepaid expenses
Prepaid rent
Ex: Mr. X has paid rent in advance for rent for his residence at $2000
per month.
– June 1 Prepaid rent ($2000*3) 6000
Cash 6000
(Paid rent in advance for 3 months)

Entry to record the adjustment when the actual rent accrues.

June 30 Rent Expense(6000/3) 2000
Prepaid rent 2000
( To record rent expense)
 Forms of Prepaid expenses
Supplies
– Paid cash in advance for the supply to be made in the future time
period.
– Ex: M/s Raman has paid cash for supplies in advance.
– June 2 Supplies 700
Cash 700
Paid cash for Supplies
– When the actual supply is accrued.
– June 30 Supplies Expense($700-$400) 300
Supplies 300
To record supplies expense
 Unearned revenue
Sometimes business collect cash from customer in advance before
actually earning the revenue which is known as Unearned revenue.
When cash is received in advance
June 15 Cash 400
Unearned Service Revenue 400
Received cash revenue in advance
When revenue actually accrued.
June 30 Unearned Service Revenue (400*1/2) 200
Service Revenue 200
To record unearned service revenue that has been
earned.
 Accrued Expenses
It refers to the liability that arises from an expense that has not
yet been paid.
Ex: When salary is paid
June 12 Salary Expense 900
Cash 900
To pay salary
When salary accrues
June 30 Salary Expense 900
Salary Payable 900
To accrue salary expense
 Accrued Revenues

• Business may earn revenue before they receive

the cash.

• Revenue that has been earned but not yet

collected is called an accrued revenue.
Prepaid & Accruals adjustment
 Depreciation on Property Plant
& Equipment (PPE)
• PPE are long lived assets such as Land,
Building, furniture and equipment.

• Accountants allocate the cost of each PPE item

over its useful life.

• Such process of allocating cost to expense for

PPE is referred as Depreciation.
Accumulated Depreciation Account
• This account shows the sum of all depreciation
expense from using the asset.
• It is a contra asset account.
Adjusted Trial Balance
 Close the books

• It means to prepare the accounts for the next

period’s transaction.

• The closing entries set the revenue, expense

and dividends balances back to zero at the end
of the period.
 Accounts

Temporary
Permanent Accounts
Accounts

They are the

accounts which are
As income and not closed at the end
expenses relate to of the period
a limited period because they carry
they are over for the next
temporary period such as
accounts. Assets, Liabilities
and Shareholder’s
Equity.
 Quick check
• On October 1, Seaview Apartments received $6,000
from a tenant for four months rent. The receipt was
credited to Unearned Rent Revenue. What
adjusting entry is needed on December 31?
A) Unearned Rent Revenue 1500
Rent Revenue 1500
B) Cash 4500
Rent Revenue 4500
c) Rent Revenue 1500
Unearned Revenue 1500
d) Unearned Rent Revenue 4500
Rent revenue 4500
 Solution
• D) Unearned Rent Revenue 4500
Rent Revenue 4500
 Question
The account unearned is a(n)

A) Revenue
B) Asset
C) Liability
D) Expense
 Solution
C) Liability
 Question
Interest is recognized on _____________ basis.

A) Cash
B) Time proportion
C) Non cash
D) Fair Value
 Solution
C) Time Proportion
 Question
Under cash basis of accounting, whether “cash
yet to receive” is recorded?

A) Yes
B) No
C) Both of these
D) None of these
 Solution
B) No, because cash is not actually received by
the business.
 Question
Cash flow statement is prepared on _________
basis.

A) Cash
B)Accrual
C) Both a & b
D) None of these
 Solution

A)Cash basis
 Question
Depreciation can be calculated using the
following:

A) Original Cost of asset/Useful life of asset

B) Market Value of asset/Useful life of asset
C) Market Value of asset/Entire life of the asset
D) Original Cost of asset/Entire life of the asset.
 Solution
A) Original Cost of asset/Useful life of asset
END OF CHAPTER
3