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Resource: Ch. 4 of Financial Accounting

Complete Exercise BE4-1.

Complete Problems 4-2A & 4-3A. 

Answer the following:

·  Commercial accounting and generally accepted accounting principles, generally prescribe the accrual basis of accounting over the cash basis.

·  Describe both bases of accounting and explain the differences.

Submit as either a Microsoft® Excel® or Microsoft® Word document

study objectives

After studying this chapter, you should be able to:

1 Explain the revenue recognition principle and the expense
recognition principle.

2 Differentiate between the cash basis and the accrual basis of

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

4 Prepare adjusting entries for deferrals.

5 Prepare adjusting entries for accruals.

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

7 Explain the purpose of closing entries.

8 Describe the required steps in the accounting cycle.

9 Understand the causes of differences between net
income and cash provided by operating activities.




● Scan Study Objectives

● Read Feature Story

● Scan Preview

● Read Text and Answer
p. 175 p. 180 p. 185 p. 189

● Work Using the Decision Toolkit

● Review Summary of Study Objectives

● Work Comprehensive p. 197

● Answer Self-Test Questions

● Complete Assignments

● Go to WileyPLU S for practice and tutorials

● Read A Look at I FR S p. 224

● the navigator

Do it!

Do it!


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feature story


The accuracy of the financial reporting system de-

pends on answers to a few fundamental questions. At

what point has revenue been earned? At what point

is the earnings process complete? When have ex-

penses really been incurred?

During the 1990s, the stock prices of dot-com com-

panies boomed. Many dot-com companies earned most

of their revenue from selling advertising

space on their websites. To boost re-

ported revenue, some dot-coms began

swapping website ad space. Company

A would put an ad for its website on company B’s web-

site, and company B would put an ad for its website on

company A’s website. No money ever changed hands,

but each company recorded revenue (for the value of

the space that it gave up on its site). This practice did

little to boost net income and resulted in no additional

cash flow—but it did boost reported revenue. Regula-

tors eventually put an end to the practice.

Another type of transgression results from compa-

nies recording revenue or expenses in the wrong year.

In fact, shifting revenues and expenses is one of the

most common abuses of financial accounting. Xerox

admitted reporting billions of dollars of lease revenue

in periods earlier than it should have been reported.

And WorldCom stunned the financial markets with its

admission that it had boosted net income by billions

of dollars by delaying the recognition of expenses un-

til later years.

Unfortunately, revelations such as

these have become all too common in

the corporate world. It is no wonder that

the U.S. Trust Survey of affluent Ameri-

cans reported that 85 percent of its respondents be-

lieved that there should be tighter regulation of finan-

cial disclosures, and 66 percent said they did not trust

the management of publicly traded companies.

Why did so many companies violate basic financial

reporting rules and sound ethics? Many speculate that

as stock prices climbed, executives were under increas-

ing pressure to meet higher and higher earnings expec-

tations. If actual results weren’t as good as hoped for,

some gave in to temptation and “adjusted” their num-

bers to meet market expectations.

● Cooking the Books? (p. 166)
● Reporting Revenue Accurately (p. 167)
● Turning Gift Cards into Revenue (p. 174)
● Cashing In on Accrual Accounting (p. 178)


Y O U R P R O F I T ?

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Accrual Accounting Concepts

As indicated in the Feature Story, making adjustments is necessary to avoid misstatement of revenues and
expenses such as those at Xerox and WorldCom. In this chapter, we introduce you to the accrual accounting
concepts that make such adjustments possible.

The organization and content of the chapter are as follows.

Timing Issues
Most businesses need immediate feedback about how well they are doing. For
example, management usually wants monthly reports on financial results, most
large corporations are required to present quarterly and annual financial state-
ments to stockholders, and the Internal Revenue Service requires all businesses
to file annual tax returns. Accounting divides the economic life of a business
into artificial time periods. As indicated in Chapter 2, this is the periodicity
assumption. Accounting time periods are generally a month, a quarter, or
a year.

Many business transactions affect more than one of these arbitrary time pe-
riods. For example, a new building purchased by Citigroup or a new airplane
purchased by Delta Air Lines will be used for many years. It doesn’t make
sense to expense the full cost of the building or the airplane at the time of
purchase because each will be used for many subsequent periods. Instead, we
determine the impact of each transaction on specific accounting periods.

Determining the amount of revenues and expenses to report in a given ac-
counting period can be difficult. Proper reporting requires an understanding of
the nature of the company’s business. Two principles are used as guidelines: the
revenue recognition principle and the expense recognition principle.


The revenue recognition principle requires that companies recognize revenue
in the accounting period in which it is earned. In a service company, revenue
is considered to be earned at the time the service is performed. To illustrate, as-
sume Conrad Dry Cleaners cleans clothing on June 30, but customers do not
claim and pay for their clothes until the first week of July. Under the revenue
recognition principle, Conrad earns revenue in June when it performs the ser-
vice, not in July when it receives the cash. At June 30, Conrad would report a
receivable on its balance sheet and revenue in its income statement for the ser-
vice performed. The journal entries for June and July would be as follows.

preview of chapter 4

• Revenue recognition

• Expense recognition

• Accrual versus cash
basis of accounting

Timing Issues

• Types of adjusting

• Adjusting entries for

• Adjusting entries for

• Summary of basic

The Basics of
Adjusting Entries

• Preparing the
adjusted trial balance

• Preparing financial

The Adjusted Trial
Balance and Financial


• Preparing closing

• Preparing a post-
closing trial balance

• Summary of the
accounting cycle

Closing the Books

• Earnings management
• Sarbanes-Oxley

Quality of Earnings


Explain the revenue
recognition principle and
the expense recognition

Helpful Hint An accounting time
period that is one year long is
called a fiscal year.

Revenue should be recog-
nized in the accounting

period in which it is earned
(generally when service is


Revenue Recognition




study objective

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June Accounts Receivable xxx
Service Revenue xxx

July Cash xxx
Accounts Receivable xxx


In recognizing expenses, a simple rule is followed: “Let the expenses follow the
revenues.” Thus, expense recognition is tied to revenue recognition. Applied to
the preceding example, this means that the salary expense Conrad incurred in
performing the cleaning service on June 30 should be reported in the same pe-
riod in which it recognizes the service revenue. The critical issue in expense
recognition is determining when the expense makes its contribution to revenue.
This may or may not be the same period in which the expense is paid. If Con-
rad does not pay the salary incurred on June 30 until July, it would report salaries
payable on its June 30 balance sheet.

The practice of expense recognition is referred to as the expense recogni-
tion principle (often referred to as the matching principle). It dictates that
efforts (expenses) be matched with results (revenues). Illustration 4-1 shows
these relationships.

Timing Issues 165


At what point should the company
record revenue?

Need to understand the nature of
the company’s business

Record revenue when earned. A
service business earns revenue
when it performs a service.

Recognizing revenue too early
overstates current period revenue;
recognizing it too late understates
current period revenue.


Revenue and Expense

In accordance with generally
accepted accounting principles


Expense Recognition

Expenses matched with revenues
in the period when efforts are

expended to generate revenues

Periodicity Assumption

Economic life of business
can be divided into

artificial time periods

Revenue Recognition

Revenue recognized in
the accounting period in

which it is earned

Illustration 4-1 GAAP
relationships in revenue
and expense recognition

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166 chapter 4 Accrual Accounting Concepts


Accrual-basis accounting means that transactions that change a company’s fi-
nancial statements are recorded in the periods in which the events occur,
even if cash was not exchanged. For example, using the accrual basis means that
companies recognize revenues when earned (the revenue recognition princi-
ple), even if cash was not received. Likewise, under the accrual basis, com-
panies recognize expenses when incurred (the expense recognition principle),
even if cash was not paid.

An alternative to the accrual basis is the cash basis. Under cash-basis
accounting, companies record revenue only when cash is received. They
record expense only when cash is paid. The cash basis of accounting is pro-
hibited under generally accepted accounting principles. Why? Because it
does not record revenue when earned, thus violating the revenue recognition
principle. Similarly, it does not record expenses when incurred, which violates
the expense recognition principle.

Illustration 4-2 compares accrual-based numbers and cash-based numbers.
Suppose that Fresh Colors paints a large building in 2011. In 2011, it incurs and
pays total expenses (salaries and paint costs) of $50,000. It bills the customer
$80,000, but does not receive payment until 2012. On an accrual basis, Fresh Col-
ors reports $80,000 of revenue during 2011 because that is when it is earned. The
company matches expenses of $50,000 to the $80,000 of revenue. Thus, 2011 net
income is $30,000 ($80,000 � $50,000). The $30,000 of net income reported for
2011 indicates the profitability of Fresh Colors’ efforts during that period.

If, instead, Fresh Colors were to use cash-basis accounting, it would report
$50,000 of expenses in 2011 and $80,000 of revenues during 2012. As shown in
Illustration 4-2, it would report a loss of $50,000 in 2011 and would report net
income of $80,000 in 2012. Clearly, the cash-basis measures are misleading be-
cause the financial performance of the company would be misstated for both
2011 and 2012.


At what point should the company
record expenses?

Need to understand the nature of
the company’s business

Expenses should “follow”
revenues—that is, match the
effort (expense) with the result

Recognizing expenses too early
overstates current period
expense; recognizing them too
late understates current period


What motivates sales executives and finance and accounting executives to participate
in activities that result in inaccurate reporting of revenues? (See page 223.)

Cooking the Books?

Allegations of abuse of the revenue recognition principle have become all too
common in recent years. For example, it was alleged that Krispy Kreme sometimes dou-
bled the number of doughnuts shipped to wholesale customers at the end of a quarter
to boost quarterly results. The customers shipped the unsold doughnuts back after the
beginning of the next quarter for a refund. Conversely, Computer Associates International
was accused of backdating sales—that is, saying that a sale that occurred at the begin-
ning of one quarter occurred at the end of the previous quarter in order to achieve the
previous quarter’s sales targets.

Ethics Insight


International Note Although
different accounting standards are
often used by companies in other
countries, the accrual basis of
accounting is central to all of
these standards.

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

study objective

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The Basics of Adjusting Entries
In order for revenues to be recorded in the period in which they are earned, and
for expenses to be recognized in the period in which they are incurred, compa-
nies make adjusting entries. Adjusting entries ensure that the revenue recog-
nition and expense recognition principles are followed.

Adjusting entries are necessary because the trial balance—the first pulling
together of the transaction data—may not contain up-to-date and complete data.
This is true for several reasons:

1. Some events are not recorded daily because it is not efficient to do so. Exam-
ples are the use of supplies and the earning of wages by employees.

The Basics of Adjusting Entries 167

( )

$ 0

$ 0

Net loss



Net income




Net income

Net income


Purchased paint, painted building, paid employees


Received payment for work done in 2011







Bob’s Bait B
arnBob’s Bait Barn

$ 0

$ 50,000



Bob’s Bait Barn

Illustration 4-2 Accrual-
versus cash-basis

Reporting Revenue Accurately

Until recently, electronics manufacturer Apple was required to spread the
revenues earned from iPhone sales over the two-year period following the sale of the
phone. Accounting standards required this because it was argued that Apple was ob-
ligated to provide software updates after the phone was sold. Therefore, since Apple
had service obligations after the initial date of sale, it was forced to spread the revenue
over a two-year period. However, since the company received full payment upfront, the
cash flows from iPhones significantly exceeded the revenue reported from iPhone sales
in each accounting period. It also meant that the rapid growth of iPhone sales was not
fully reflected in the revenue amounts reported in Apple’s income statement. A new ac-
counting standard now enables Apple to report nearly all of its iPhone revenue at the
point of sale. It was estimated that 2009 revenues would have been about 17% higher,
and earnings per share would have been almost 50% higher, under the new rule.

Investor Insight

? In the past, why was it argued that Apple should spread the recognition of iPhonerevenue over a two-year period, rather than recording it upfront? (See page 223.)

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

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168 chapter 4 Accrual Accounting Concepts

2. Some costs are not recorded during the accounting period because these
costs expire with the passage of time rather than as a result of recurring
daily transactions. Examples are charges related to the use of buildings and
equipment, rent, and insurance.

3. Some items may be unrecorded. An example is a utility service bill that will
not be received until the next accounting period.

Adjusting entries are required every time a company prepares financial
statements. The company analyzes each account in the trial balance to deter-
mine whether it is complete and up to date for financial statement purposes.
Every adjusting entry will include one income statement account and one
balance sheet account.


Adjusting entries are classified as either deferrals or accruals. As Illustration 4-3
shows, each of these classes has two subcategories.

International Note Internal
controls are a system of checks
and balances designed to detect
and prevent fraud and errors. The
Sarbanes-Oxley Act requires U.S.
companies to enhance their
systems of internal control.
However, many foreign companies
do not have to meet strict internal
control requirements. Some U.S.
companies believe that this gives
foreign firms an unfair advantage
because developing and maintaining
internal controls can be very


1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are
used or consumed.

2. Unearned revenues: Cash received and recorded as liabilities before revenue is


1. Accrued revenues: Revenues earned but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

Trial Balance

October 31, 2012

Debit Credit

Cash $15,200
Supplies 2,500
Prepaid Insurance 600
Equipment 5,000
Notes Payable $ 5,000
Accounts Payable 2,500
Unearned Service Revenue 1,200
Common Stock 10,000
Retained Earnings 0
Dividends 500
Service Revenue 10,000
Salaries Expense 4,000
Rent Expense 900

$28,700 $28,700

Subsequent sections give examples of each type of adjustment. Each example
is based on the October 31 trial balance of Sierra Corporation, from Chapter 3,
reproduced in Illustration 4-4. Note that Retained Earnings, with a zero balance,
has been added to this trial balance. We will explain its use later.

We assume that Sierra Corporation uses an accounting period of one month.
Thus, monthly adjusting entries are made. The entries are dated October 31.

Illustration 4-3
Categories of adjusting

Illustration 4-4 Trial

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To defer means to postpone or delay. Deferrals are costs or revenues that are
recognized at a date later than the point when cash was originally exchanged.
Companies make adjusting entries for deferrals to record the portion of the de-
ferred item that was incurred as an expense or earned as revenue during the
current accounting period. The two types of deferrals are prepaid expenses and
unearned revenues.

Prepaid Expenses
Companies record payments of expenses that will benefit more than one ac-
counting period as assets called prepaid expenses or prepayments. When ex-
penses are prepaid, an asset account is increased (debited) to show the service
or benefit that the company will receive in the future. Examples of common pre-
payments are insurance, supplies, advertising, and rent. In addition, companies
make prepayments when they purchase buildings and equipment.

Prepaid expenses are costs that expire either with the passage of time
(e.g., rent and insurance) or through use (e.g., supplies). The expiration of these
costs does not require daily entries, which would be impractical and unneces-
sary. Accordingly, companies postpone the recognition of such cost expirations
until they prepare financial statements. At each statement date, they make ad-
justing entries to record the expenses applicable to the current accounting pe-
riod and to show the remaining amounts in the asset accounts.

Prior to adjustment, assets are overstated and expenses are understated.
Therefore, as shown in Illustration 4-5, an adjusting entry for prepaid expenses
results in an increase (a debit) to an expense account and a decrease
(a credit) to an asset account.

The Basics of Adjusting Entries 169

Prepare adjusting entries
for deferrals.

Prepaid Expenses


Entry (–)



Entry (+)

Let’s look in more detail at some specific types of prepaid expenses, begin-
ning with supplies.

SUPPLIES. The purchase of supplies, such as paper and envelopes, results in an
increase (a debit) to an asset account. During the accounting period, the com-
pany uses supplies. Rather than record supplies expense as the supplies are used,
companies recognize supplies expense at the end of the accounting period. At
the end of the accounting period, the company counts the remaining supplies.
The difference between the unadjusted balance in the Supplies (asset) account
and the actual cost of supplies on hand represents the supplies used (an expense)
for that period.

Recall from Chapter 3 that Sierra Corporation purchased supplies cost-
ing $2,500 on October 5. Sierra recorded the purchase by increasing (debiting)
the asset Supplies. This account shows a balance of $2,500 in the October 31
trial balance. An inventory count at the close of business on October 31 reveals
that $1,000 of supplies are still on hand. Thus, the cost of supplies used is

Illustration 4-5 Adjusting
entries for prepaid expenses

Supplies used;
record supplies expense

Supplies purchased;
record asset

Oct. 31

Oct. 5


study objective

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170 chapter 4 Accrual Accounting Concepts

$1,500 ($2,500 � $1,000). This use of supplies decreases an asset, Supplies.
It also decreases stockholders’ equity by increasing an expense account, Sup-
plies Expense. This is shown in Illustration 4-6.

After adjustment, the asset account Supplies shows a balance of $1,000,
which is equal to the cost of supplies on hand at the statement date. In addi-
tion, Supplies Expense shows a balance of $1,500, which equals the cost of sup-
plies used in October. If Sierra does not make the adjusting entry, October
expenses will be understated and net income overstated by $1,500. More-
over, both assets and stockholders’ equity will be overstated by $1,500 on
the October 31 balance sheet.

INSURANCE. Companies purchase insurance to protect themselves from losses
due to fire, theft, and unforeseen events. Insurance must be paid in advance, often
for more than one year. The cost of insurance (premiums) paid in advance is
recorded as an increase (debit) in the asset account Prepaid Insurance. At the
financial statement date, companies increase (debit) Insurance Expense and
decrease (credit) Prepaid Insurance for the cost of insurance that has expired
during the period.

On October 4, Sierra Corporation paid $600 for a one-year fire insurance pol-
icy. Coverage began on October 1. Sierra recorded the payment by increasing (deb-
iting) Prepaid Insurance. This account shows a balance of $600 in the October 31
trial balance. Insurance of $50 ($600 � 12) expires each month. The expiration of
prepaid insurance decreases an asset, Prepaid Insurance. It also decreases stock-
holders’ equity by increasing an expense account, Insurance Expense.

As shown in Illustration 4-7, the asset Prepaid Insurance shows a balance of
$550, which represents the unexpired cost for the remaining 11 months of cov-
erage. At the same time, the balance in Insurance Expense equals the insurance
cost that expired in October. If Sierra does not make this adjustment, October
expenses are understated by $50 and net income is overstated by $50. Moreover,






Oct. 5 2,500

Oct. 31 Bal. 1,000

Oct. 31 Adj. 1,500


Oct. 31 Adj. 1,500

Oct. 31 Bal. 1,500

Supplies Expense

Debits increase expenses: debit Supplies Expense $1,500.
Credits decrease assets: credit Supplies $1,500.

Oct. 31 Supplies Expense
(To record supplies used)


The expense Supplies Expense is increased $1,500, and the asset
Supplies is decreased $1,500.





+Liabilities Stockholders’ Equity
Supplies Expense



Illustration 4-6
Adjustment for supplies

Insurance expired;
record insurance expense

Insurance purchased;
record asset

Oct. 4

Oct. 31


Insurance Policy











1 YEAR $600


1 year

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DEPRECIATION. A company typically owns a variety of assets that have long lives,
such as buildings, equipment, and motor vehicles. The period of service is re-
ferred to as the useful life of the asset. Because a building is expected to pro-
vide service for many years, it is recorded as an asset, rather than an expense,
on the date it is acquired. As explained in chapter 2, companies record such as-
sets at cost, as required by the cost principle. To follow the expense recognition
principle, companies allocate a portion of this cost as an expense during each
period of the asset’s useful life. Depreciation is the process of allocating the cost
of an asset to expense over its useful life.

Need for adjustment. The acquisition of long-lived assets is essentially a
long-term prepayment for the use of an asset. An adjusting entry for depreciation
is needed to recognize the cost that has been used (an expense) during the period
and to report the unused cost (an asset) at the end of the period. One very
important point to understand: Depreciation is an allocation concept, not a
valuation concept. That is, depreciation allocates an asset’s cost to the
periods in which it is used. Depreciation does not attempt to report the
actual change in the value of the asset.

For Sierra Corporation, assume that depreciation on the equipment is $480
a year, or $40 per month. As shown in Illustration 4-8 (page 172), rather than de-
crease (credit) the asset account directly, Sierra instead credits Accumulated De-
preciation—Equipment. Accumulated Depreciation is called a contra asset account.
Such an account is offset against an asset account on the balance sheet. Thus, the
Accumulated Depreciation—Equipment account offsets the asset Equipment. This
account keeps track of the total amount of depreciation expense taken over the life
of the asset. To keep the accounting equation in balance, Sierra decreases stockhold-
ers’ equity by increasing an expense account, Depreciation Expense.

The balance in the Accumulated Depreciation—Equipment account will in-
crease $40 each month, and the balance in Equipment remains $5,000.

The Basics of Adjusting Entries 171





Debits increase expenses: debit Insurance Expense $50.
Credits decrease assets: credit Prepaid Insurance $50.

Oct. 31 Insurance Expense
Prepaid Insurance
(To record insurance expired)


The expense Insurance Expense is increased $50, and the asset
Prepaid Insurance is decreased $50.

Prepaid Insurance




+Liabilities Stockholders’ Equity
Insurance Expense



Prepaid Insurance Insurance Expense

Oct. 4 600

Oct. 31 Bal. 550

Oct. 31 Adj. 50 Oct. 31 Adj. 50

Oct. 31 Bal. 50

Illustration 4-7
Adjustment for insurance

Depreciation recognized;
record depreciation expense

Equipment purchased;
record asset

Oct. 2

Oct. 31














Depreciation = $480/year

as the accounting equation shows, both assets and stockholders’ equity will be
overstated by $50 on the October 31 balance sheet.

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172 chapter 4 Accrual Accounting Concepts

Statement presentation. As noted above, Accumulated Depreciation—
Equipment is a contra asset account. It is offset against Equipment on the
balance sheet. The normal balance of a contra asset account is a credit. A
theoretical alternative to using a contra asset account would be to decrease
(credit) the asset account by the amount of depreciation each period. But using
the contra account is preferable for a simple reason: It discloses both the original
cost of the equipment and the total cost that has expired to date. Thus, in the
balance sheet, Sierra deducts Accumulated Depreciation—Equipment from the
related asset account, as shown in Illustration 4-9.

Book value is the difference between the cost of any depreciable asset and
its related accumulated depreciation. In Illustration 4-9, the book value of the
equipment at the balance sheet date is $4,960. The book value and the fair value
of the asset are generally two different values. As noted earlier, the purpose of
depreciation is not valuation but a means of cost allocation.

Depreciation expense identifies the portion of an asset’s cost that expired
during the period (in this case, in October). The accounting equation shows that
without this adjusting entry, total assets, total stockholders’ equity, and net in-
come are overstated by $40 and depreciation expense is understated by $40.

Illustration 4-10 summarizes the accounting for prepaid expenses.

Unearned Revenues
Companies …