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Chapter 4: Accrual Accounting Concepts for
Accounting (1234)
University of Karachi
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CHAPTER 4
Accrual Accounting Concepts
Study Objectives
Explain the revenue recognition principle and the matching principle.
Differentiate between the cash basis and the accrual basis of accounting.
Explain why adjusting entries are needed, and identify the major types of adjusting entries.
Prepare adjusting entries for deferrals.
Prepare adjusting entries for accruals.
Describe the nature and purpose of the adjusted trial balance.
Explain the purpose of closing entries.
Describe the required steps in the accounting cycle.
Understand the causes of differences between net income and cash provided by operating activities.
Describe the purpose of the basic form of a worksheet.
Chapter Outline
Study Objective 1 - Explain the Revenue Recognition Principle and the
Matching Principle
Determining the amount of revenues and expenses to report in a given
accounting period can be difficult.
Proper reporting requires an understanding of the nature of the
companys business.
Two principles are used as guidelines:
1. revenue recognition principle
2. matching principle
The revenue recognition principle requires that revenue be recognized in the accounting period in which it is earned. A service company recognizes (records) revenue when the services are performed.
The matching principle requires that efforts ( expenses) be matched with accomplishments ( revenues ). The critical issue is determining when the expense makes its contribution to revenue.
Study Objective 2 - Differentiate Between the Cash Basis and the Accrual Basis of Accounting
With cash basis accounting , revenue is recognized (recorded) when cash is received. Expenses are recognized (recorded) only when cash is paid.
Accrual basis accounting requires accountants to adhere to the revenue recognition principle and the matching principle.
Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting Principles (GAAP) , whereas accrual basis accounting does. Accrual basis accounting provides an objective measurement of net income.
Study Objective 5 - Prepare Adjusting Entries for Accruals
Accruals fall into two categories-- accrued revenues and accrued expenses. Accrued revenues - revenues earned but not yet received in cash or recorded at the statement date. an adjusting entry for accrued revenues will result in an increase (a debit) in an asset account and an increase (a credit) to a revenue account. Accrued expenses - expenses incurred but not yet paid in cash or recorded at the statement date. an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account. an adjusting entry for accruals (accrued revenues or accrued expenses) increases both a balance sheet and an income statement account.
Summary of basic relationships: Type of Adjustment Accounts Before Adjustment Adjusting Entry Prepaid expenses Assets overstated Expenses understated
Dr. Expenses Cr. Assets Unearned Revenues Liabilities overstated Revenues understated
Dr. Liabilities Cr. Revenues Accrued revenues Assets understated Revenues understated
Dr. Assets Cr. Revenues Accrued expenses Expenses understated Liabilities understated
Dr. Expenses Cr. Liabilities
Study Objective 6 - Describe the Nature and Purpose of the Adjusted Trial Balance
The adjusted trial balance is prepared after all adjusting entries have been journalized and posted.
The adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period.
The purpose of the adjusted trial balance is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments.
Financial statements are prepared from the adjusted trial balance.
Study Objective 7 - Explain the Purpose of Closing Entries
Closing entries transfer net income (or net loss) and dividends to Retained Earnings. This causes the ending balance of Retained Earnings (amount shown on the Balance Sheet) to agree with the balance shown on the Retained Earnings Statement. Close the revenue accounts to the Income Summary account. Close the expense accounts to the Income Summary account. Close the Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. Closing entries produce a zero balance in each temporary account (revenues, expenses, and dividends) These accounts are then ready to accumulate data for the next accounting period. Permanent accounts (assets, liabilities, common stock and retained earnings) are not closed.
After the closing entries have been journalized and posted, a post-closing
trial balance is prepared.
The post-closing trial balance shows the balances of all of the
permanent accounts.
The permanent account balances are carried forward to the next
accounting period.
Study Objective 9
Understand the Causes of Differences Between Net
Income and Cash Provided by Operating Activities
Net income is based on accrual basis accounting and is accomplished through the adjusting entry process. Cash provided by operating activities is determined by comparing cash received from operating activities to cash expenditures from operating activities.
Cash provided by operating activities is essentially net income determined under the cash-basis of accounting.
Chapter 4 Review
What is the revenue recognition principle? What is the matching principle?
What are the differences in the cash basis and the accrual basis of accounting? Which is required by GAAP? Why?
Why are adjusting entries needed? What are the major types of adjusting entries?
Identify types of prepayments and discuss the adjusting entry for each. What happens if the adjusting entry is not made?
Identify types of accruals and discuss the adjusting entry for each. What happens if the adjusting entry is not made? .
Describe the nature and purpose of the adjusted trial balance.
Discuss the purpose of closing entries.
List the required steps in the accounting cycle. Discuss quality of earnings issues.
Discuss the differences between net income and cash provided by operating activities. How do cash-basis and accrual-basis accounting apply?
Chapter 4: Accrual Accounting Concepts for
Course: Accounting (1234)
University: University of Karachi
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