Week 4 · Chapter

Chapter 4 — Accrual Accounting and Adjusting Entries

Financial Accounting Free sample edition

The module's primary reading · ~35–45 minutes · Objective 3 (apply accrual accounting: recognize revenue and expenses in the right period, prepare adjusting entries for deferrals and accruals, and prepare an adjusted trial balance), with Objective 2 (analyze business transactions with the accounting equation and record them in a journal using double-entry bookkeeping, post them to the ledger, and prepare a trial balance) called back · Read it first this week; the lecture, the slides, the tutorial, the quiz, and the workshop all build on it.

In plain language

A business does not earn money on the day cash shows up, and it does not use things up on the day it pays for them. This week you learn the accrual basis (recording revenue when it is earned and expenses when they are incurred, whatever day the cash moves). You will follow the FASB's five steps for revenue recognition (deciding when a business has earned its revenue). At the end of each month, a business makes adjusting entries (small corrections that put each revenue and expense in the month it belongs to). You will make six of them for the bicycle shop and check that its books still balance.

Why you already care about this

Picture the bicycle shop on the last day of Month 1. Its Cash account says $17,100. Its unadjusted trial balance shows $36,800 on each side. Yet a cycling club paid $1,200 for tune-ups the shop has mostly not done. The mechanic worked the last days of the month and has not been paid. Some supplies on the shelf are gone. The books do not know any of this yet.

You have met this problem in your own life. A gym sells a 12-month membership and collects the whole price on the first day. Did the gym earn a year of revenue that day? A small software firm pays for a year of cloud service in advance. Did it use up a year of service on the day it paid? Your gut already says no. This chapter turns that gut feeling into the rules accountants follow.

By the end of this chapter you will be able to:

tell the cash basis from the accrual basis and say which one GAAP requires;
apply the five steps of revenue recognition to a customer contract;
record an expense in the period it helps earn revenue;
sort an adjusting entry into a deferral or an accrual;
prepare the bicycle shop's six month-end adjusting entries;
prepare its adjusted trial balance at $37,650 on each side.

Carry this sentence with you: the cash day is not the earning day; check the work.

Where we are

Already covered: Week 1 set out who uses financial statements and who sets GAAP. Week 2 analyzed the bicycle shop's twelve Month 1 transactions in the accounting equation. Week 3 journalized and posted them and proved the unadjusted trial balance at $36,800.
This week: the accrual basis, revenue and expense recognition, the four kinds of adjustment plus depreciation, the shop's six month-end adjustments, and its adjusted trial balance.
How they connect: every adjusting entry is a journal entry, so it uses Week 3's debits, credits, and normal balances, and it keeps Week 2's equation in balance.
Where we're going next: Week 5, Completing the Accounting Cycle, prepares the statements from this week's adjusted trial balance and closes the books.

Week 1 told you that GAAP is set by the FASB, a private-sector standard setter, so this week's rules come from the FASB's own standards. Week 2 taught you that revenues increase retained earnings and expenses decrease it. Week 3 taught you the normal balances: assets and expenses increase with debits; liabilities and revenues increase with credits. It also warned you that a balanced trial balance does not prove the books are right. That warning matters again this week, because the shop's balanced $36,800 trial balance is still missing six things.

1. Compare the cash basis and the accrual basis

Think about a food truck owner you might know, who counts the cash box every night and calls that the day's profit. That is a natural way to think. It is also incomplete. If a catering client pays next month for tonight's event, the cash-box count misses tonight's revenue completely.

You have two ways to decide when revenue and expenses count:

Under the cash basis, revenues are recorded only when cash is received and expenses only when cash is paid.
Under the accrual basis, revenues are recorded when earned and expenses when incurred, regardless of when cash moves.

GAAP requires accrual-basis statements. The cash basis is easier to keep, but it can make your month look rich because a customer paid early, or poor because a bill came due. The accrual basis ties each dollar to the work that produced it.

Accrual accounting needs one more idea. The time period assumption says a business's life is divided into periods such as months, quarters, and years so it can report on each. The bicycle shop reports on Month 1. Any event that crosses the month's edge has to be split at that edge. That is why you adjust the books at the month's end.

Worked example — the club's $1,200. On Day 6, the cycling club paid the shop $1,200 for a season of group tune-ups.

Under the cash basis, the shop would call all $1,200 Month 1 revenue on Day 6.
Under the accrual basis, the shop records Cash +$1,200 and Unearned Revenue +$1,200 on Day 6. That is what Week 3's journal did. The revenue waits until the tune-ups are done.

In words: on the accrual basis, the club's $1,200 is a liability until the shop does the tune-ups, because the shop has been paid but has not yet earned it.

Misconception check. Students often think revenue is earned when the cash arrives. It is tempting, because cash is the most visible thing that happens. The cure is to ask what the business did, not what it received. The shop received $1,200 on Day 6, but it had done no tune-ups yet, so it had earned nothing.

2. Apply the five steps of revenue recognition

The gym from the hook collects a year of membership fees on the first day. Each month, it delivers one month of access to the treadmills and classes. The gym earns its revenue a month at a time, as it delivers. The FASB turned that common-sense idea into a five-step model.

The five steps of the FASB's Accounting Standards Update No. 2014-09 (May 2014), quoted in the standard's own words, are:

"identify the contract(s) with a customer"
"identify the performance obligations in the contract"
"determine the transaction price"
"allocate the transaction price to the performance obligations in the contract"
"recognize revenue when (or as) the entity satisfies a performance obligation"

Your next two terms need a gloss. A performance obligation is a promise in a contract to provide a good or a service to a customer. The transaction price is the amount the business expects to receive in exchange. Revenue recognition is recording revenue in the period it is earned, through these five steps.

Worked example — the club's tune-ups, step by step. You walk the club's season through the five steps in order.

The contract: the cycling club agreed to buy a season of group tune-ups and paid in advance on Day 6.
The performance obligation: the shop promised one service, the season of group tune-ups.
The transaction price: $1,200.
The allocation: with one performance obligation, all $1,200 goes to the season of tune-ups.
Recognize revenue as the shop satisfies the obligation. By the end of Month 1, the shop has performed one quarter of the tune-ups. So it has earned 1,200 ÷ 4 = $300.

In words: the shop has earned $300 of the club's $1,200, and it still owes the club the other $900 of tune-ups.

Misconception check. Students often think unearned revenue is a kind of revenue, because the word "revenue" is in its name. It is a liability. Unearned revenue is cash a customer has paid for work the business has not done yet, which the business owes until it does the work. The name tells you what it will become, not what it is now.

Pause and think (choose one). (a) Name a time you paid in advance for something, such as a phone plan, a class, or a concert ticket. When did the seller earn your money? (b) Name a time someone paid you before you did the work, such as babysitting or a repair. When did you earn it?

3. Use expense recognition to match each expense to its month

Think about the landscaping crew that mows lawns all week and gets paid the following week. Their hours on the last days of the month helped earn that month's revenue, even though payday falls next month. The cost belongs with the work it helped produce.

Expense recognition records an expense in the period in which the business uses the resources to produce that period's revenues. It is often called matching, because each expense is matched to the revenue it helped earn.

Worked example — the mechanic's last days. The bicycle shop's part-time mechanic worked the last days of Month 1 and earned $400 that the shop has not yet paid. Those hours helped the shop earn Month 1's repair revenue. So the $400 is a Month 1 expense, recorded at the month's end, even though the cash moves in Month 2. The other side of the entry is a liability, Wages Payable, because the shop owes the mechanic $400.

The software firm from the hook shows the same idea from the other direction. It paid for a year of cloud service up front, so most of that cost is not yet an expense. It becomes an expense one month at a time, as the firm uses the service to serve its own customers.

Misconception check. Students often think an expense counts on the day it is paid. That is the cash basis talking. Under expense recognition, an expense counts in the month the business uses the resource. The mechanic's $400 is a Month 1 expense whether the shop pays it on the last day of Month 1 or a week later.

4. Sort each adjustment: deferral or accrual

Think of two kinds of timing gaps. In one, the money moves first and the work comes later, like the gym's annual fee. In the other, the work comes first and the money moves later, like the mechanic's unpaid hours. Every adjustment fits one of these shapes.

An adjusting entry is an entry made at the end of a period so that revenues and expenses land in the period they belong to. Adjusting entries fall into two groups:

Deferrals are the adjustments where cash moved first. A prepaid expense is a cost paid in advance for something the business will use later, such as insurance or supplies. An unearned revenue is cash received before the work is done.
Accruals are the adjustments where cash moves later. An accrued revenue is revenue earned by doing the work but not yet billed or collected. An accrued expense is an expense incurred but not yet paid.

One more adjustment fits the deferral shape. Depreciation is the allocation of a long-lived asset's cost to the periods that use the asset. The shop paid for its equipment on Day 2, and it will use that equipment for years. Depreciation is the deferral of that cost, spread across the months that use it. The credit side goes to Accumulated Depreciation, a contra asset account with a credit balance. The asset's cost minus its accumulated depreciation is its book value.

Here is the rule that checks every adjustment you make, and you will use it all term: an accrual or deferral adjusting entry affects one income statement account and one balance sheet account, and never Cash. Cash already moved, or it has not moved yet. Either way, the adjustment is about the other account.

The four kinds of adjustment and depreciation: when cash moves and the accounts each kind touches
Kind	Group	When cash moves	Income statement account	Balance sheet account
Prepaid expense	Deferral	Before the expense is incurred	An expense rises	An asset falls
Unearned revenue	Deferral	Before the revenue is earned	A revenue rises	A liability falls
Depreciation	Deferral of an asset's cost	When the asset was bought	Depreciation Expense rises	Accumulated Depreciation rises, so book value falls
Accrued revenue	Accrual	After the revenue is earned	A revenue rises	A receivable rises
Accrued expense	Accrual	After the expense is incurred	An expense rises	A payable rises

Misconception check. Students often read Accumulated Depreciation as a liability, because it has a credit balance and sits near the liabilities. It is a contra asset: it reduces the Equipment account on the asset side. A second trap sits beside it. Depreciation is not the fall in the equipment's market value. It is cost allocation, and it uses no cash.

5. Work the six month-end adjustments

Now you put your whole toolkit to work on the bicycle shop (illustrative). Dataset B lists six adjustments, (a) to (f). You will walk each one in the same order: what happened, which accounts change and in which direction, the debit and the credit, and the effect on the statements.

Worked example — adjustment (a), supplies used. The shop bought $900 of supplies on Day 3. A count on Day 31 finds $350 on hand, so 900 − 350 = $550 was used. Supplies Expense rises and Supplies falls. Debit Supplies Expense 550; credit Supplies 550. This is a prepaid expense (deferral). The income statement shows $550 more expense, and Supplies falls from $900 to $350 on the balance sheet.

Worked example — adjustment (b), insurance expired. The 12-month policy cost $2,400, so one month is 2,400 ÷ 12 = $200. Insurance Expense rises and Prepaid Insurance falls. Debit Insurance Expense 200; credit Prepaid Insurance 200. This is a prepaid expense (deferral). Prepaid Insurance falls from $2,400 to 2,400 − 200 = $2,200.

Worked example — adjustment (c), depreciation. The $12,000 of equipment is expected to last 5 years, or 5 × 12 = 60 months, with no residual value. So the shop records 12,000 ÷ 60 = $200 a month. Depreciation Expense rises and Accumulated Depreciation rises. Debit Depreciation Expense 200; credit Accumulated Depreciation 200. The book value of the equipment becomes 12,000 − 200 = $11,800.

Worked example — adjustment (d), unearned revenue earned. The shop performs one quarter of the club's tune-ups, so 1,200 ÷ 4 = $300 is earned. Unearned Revenue falls and Service Revenue rises. Debit Unearned Revenue 300; credit Service Revenue 300. This is an unearned revenue (deferral). Unearned Revenue falls from $1,200 to 1,200 − 300 = $900.

Worked example — adjustment (e), wages accrued. The mechanic worked the last days of the month for $400 not yet paid. Wages Expense rises and Wages Payable rises. Debit Wages Expense 400; credit Wages Payable 400. This is an accrued expense. Wages Expense rises from $1,600 to 1,600 + 400 = $2,000.

Worked example — adjustment (f), revenue accrued. The shop finished $250 of repairs for the delivery company that it has not yet billed. Accounts Receivable rises and Service Revenue rises. Debit Accounts Receivable 250; credit Service Revenue 250. This is an accrued revenue. Accounts Receivable rises from $800 to 800 + 250 = $1,050.

Here are the six entries in journal form, each with its debit first and its credit indented below it.

The bicycle shop's six adjusting entries at the end of Month 1, in dollars (illustrative, Dataset B)
Adjustment	Account	Debit	Credit
(a)	Supplies Expense	550
	Supplies		550
	Supplies used: $900 bought, $350 on hand at the count.
(b)	Insurance Expense	200
	Prepaid Insurance		200
	One month of the 12-month, $2,400 policy expired.
(c)	Depreciation Expense	200
	Accumulated Depreciation		200
	One month of the equipment's 60-month life.
(d)	Unearned Revenue	300
	Service Revenue		300
	One quarter of the club's tune-ups performed.
(e)	Wages Expense	400
	Wages Payable		400
	Wages earned by the mechanic and not yet paid.
(f)	Accounts Receivable	250
	Service Revenue		250
	Repairs finished for the delivery company, not yet billed.

Service Revenue picks up two of these entries. After (d) and (f), it is 5,300 + 300 + 250 = $5,850.

Now you run the no-Cash check. Each of the six entries debits one account and credits one account. In each one, one account sits on the income statement and one on the balance sheet. Cash stays at $17,100.

Misconception check. Students often think an adjusting entry involves Cash, because so many Week 2 transactions did. Look back at the six entries: none of them touches Cash. If you find Cash in an accrual or deferral adjustment, stop and look again; you have probably recorded the later payment instead of the adjustment.

6. Build and check the adjusted trial balance

After a long day, a careful shop owner counts the register drawer twice before going home. You do the same thing after posting adjustments. You post the six entries to the ledger and list every balance again.

The adjusted trial balance is a list of every ledger account and its balance after the adjusting entries are posted, checking that total debits still equal total credits. The financial statements are prepared from it.

The bicycle shop's adjusted trial balance at the end of Month 1, in dollars (illustrative, Dataset B)
Account	Debit	Credit
Cash	$17,100
Accounts Receivable	$1,050
Supplies	$350
Prepaid Insurance	$2,200
Equipment	$12,000
Accumulated Depreciation		$200
Accounts Payable		$300
Wages Payable		$400
Unearned Revenue		$900
Common Stock		$30,000
Dividends	$500
Service Revenue		$5,850
Rent Expense	$1,500
Wages Expense	$2,000
Supplies Expense	$550
Insurance Expense	$200
Depreciation Expense	$200
Totals	$37,650	$37,650

Worked example — footing both columns. The debits are Cash 17,100 + Accounts Receivable 1,050 + Supplies 350 + Prepaid Insurance 2,200 + Equipment 12,000 + Dividends 500 + Rent Expense 1,500 + Wages Expense 2,000 + Supplies Expense 550 + Insurance Expense 200 + Depreciation Expense 200 = $37,650. The credits are Accumulated Depreciation 200 + Accounts Payable 300 + Wages Payable 400 + Unearned Revenue 900 + Common Stock 30,000 + Service Revenue 5,850 = $37,650.

Why did the total grow from $36,800 to $37,650? Three adjustments, (c), (e), and (f), each add a new amount to both sides, so 36,800 + 200 + 400 + 250 = 37,650. The other three, (a), (b), and (d), move amounts between accounts on the same side. They change no total.

In practice (your tools). In a free spreadsheet such as Google Sheets, list the accounts in column A, debits in column B, and credits in column C. Total each column with a formula, such as =SUM(B2:B18) and =SUM(C2:C18), and add a check cell, =B19-C19, that should show 0. Type every balance once and let the formulas do the adding, so a typing slip shows up as a nonzero check.

In words: the adjusted trial balance still balances at $37,650 on each side, and it now holds every balance the statements need.

Misconception check. Students often think a balanced adjusted trial balance proves the adjustments are right. Week 3's warning still holds. If you forgot adjustment (e) entirely, both columns would be $400 smaller and would still match. The balance proves the debits equal the credits, not that every adjustment was made.

7. Explain what makes the numbers useful

Imagine a lender reading the shop's Month 1 numbers before deciding on a loan. The lender wants numbers that matter to the decision and that tell the truth about the month. The FASB names those qualities.

The qualitative characteristics of useful financial information appear in the FASB's conceptual framework, Concepts Statement No. 8. There are two fundamental ones and four enhancing ones:

Relevance is a fundamental characteristic: the information can make a difference to the decisions its readers make.
Faithful representation is the other fundamental characteristic: the information shows what it says it shows, completely, neutrally, and free from error.
The enhancing qualitative characteristics are comparability, verifiability, timeliness, and understandability. They make useful information more useful.

Here is the link to your work this week. Without the six adjustments, the shop's unadjusted Month 1 numbers would ignore the cycling club's tune-ups. They would leave out $550 of revenue the shop earned, 300 + 250 = 550, and $1,350 of expenses it incurred, 550 + 200 + 200 + 400 = 1,350. Those figures would not faithfully represent the month. The added expense, $1,350 versus $550 of added revenue, is more than 2 times as large, so a lender who saw only your unadjusted numbers would decide on a month that looked better than it was. The adjustments are what make the statements trustworthy.

One caveat: these characteristics guide your judgment; they are not a formula you compute. Another limitation is worth saying plainly. Adjustments rest on counts and estimates, such as the supplies count and the equipment's five-year life, so when you read a business's statements, you check how each estimate was made.

Misconception check. Students often treat all six characteristics as equal. The framework does not. Relevance and faithful representation are fundamental; comparability, verifiability, timeliness, and understandability enhance information that already has them. A fast report that is wrong is timely, but it is not faithful.

Pause and think (choose one). (a) Imagine you are lending the shop money. Which one adjustment would you most want to see, and why? (b) Imagine you are one of the founders. Which one adjustment would surprise you most if it were left out, and why?

Key terms

Accrual basis — A way of recording in which revenues are recorded when earned and expenses when incurred, regardless of when cash moves. (first used: 1. Compare the cash basis and the accrual basis)
Cash basis — A way of recording in which revenues are recorded only when cash is received and expenses only when cash is paid. (first used: 1. Compare the cash basis and the accrual basis)
Time period assumption — The assumption that a business's life can be divided into periods such as months, quarters, and years so that it can report on each one. (first used: 1. Compare the cash basis and the accrual basis)
Revenue recognition — Recording revenue in the period it is earned, through the five steps of the FASB's Accounting Standards Update No. 2014-09 (May 2014). (first used: 2. Apply the five steps of revenue recognition)
Performance obligation — A promise in a contract to provide a good or a service to a customer. (first used: 2. Apply the five steps of revenue recognition)
Transaction price — The amount a business expects to receive from a customer in exchange for what a contract promises. (first used: 2. Apply the five steps of revenue recognition)
Unearned revenue — Cash a customer has paid for work the business has not done yet, which the business owes until it does the work. (first used: 2. Apply the five steps of revenue recognition)
Expense recognition — Recording an expense in the period in which the business uses the resources to produce that period's revenues, often called matching. (first used: 3. Use expense recognition to match each expense to its month)
Adjusting entry — An entry made at the end of a period so that revenues and expenses land in the period they belong to. (first used: 4. Sort each adjustment: deferral or accrual)
Deferral — An adjustment for an item where cash moved first: a prepaid expense or an unearned revenue. (first used: 4. Sort each adjustment: deferral or accrual)
Prepaid expense — A cost paid in advance for something the business will use later, held as an asset until it is used up. (first used: 4. Sort each adjustment: deferral or accrual)
Accrual — An adjustment for an item where cash moves later: an accrued revenue or an accrued expense. (first used: 4. Sort each adjustment: deferral or accrual)
Accrued revenue — Revenue earned by doing the work but not yet billed or collected. (first used: 4. Sort each adjustment: deferral or accrual)
Accrued expense — An expense incurred but not yet paid. (first used: 4. Sort each adjustment: deferral or accrual)
Depreciation — The allocation of a long-lived asset's cost to the periods that use the asset; it is not market value and uses no cash. (first used: 4. Sort each adjustment: deferral or accrual)
Accumulated Depreciation — A contra asset account with a credit balance that collects the depreciation recorded on an asset so far. (first used: 4. Sort each adjustment: deferral or accrual)
Book value — An asset's cost minus its accumulated depreciation. (first used: 4. Sort each adjustment: deferral or accrual)
Adjusted trial balance — A list of every ledger account and its balance after the adjusting entries are posted, checking that total debits still equal total credits. (first used: 6. Build and check the adjusted trial balance)
Qualitative characteristics — The qualities that make financial information useful, named in the FASB's Concepts Statement No. 8. (first used: 7. Explain what makes the numbers useful)
Relevance — A fundamental qualitative characteristic: the information can make a difference to its readers' decisions. (first used: 7. Explain what makes the numbers useful)
Faithful representation — A fundamental qualitative characteristic: the information shows what it says it shows, completely, neutrally, and free from error. (first used: 7. Explain what makes the numbers useful)
Enhancing qualitative characteristics — Comparability, verifiability, timeliness, and understandability, which make useful information more useful. (first used: 7. Explain what makes the numbers useful)

Summary

Accrual basis: revenue when earned, expense when incurred; GAAP requires it.
Revenue follows the five steps of ASU 2014-09, ending when an obligation is satisfied.
Unearned revenue is a liability until the work is done.
An expense belongs to the month whose revenue it helped earn.
Deferrals: cash moved first. Accruals: cash moves later.
Depreciation allocates cost; Accumulated Depreciation is a contra asset.
Every accrual or deferral adjustment touches one income statement account, one balance sheet account, and never Cash.
The shop's adjusted trial balance is $37,650 on each side.

Check your understanding

Work these before looking at the answers — they are ungraded, and the answers (with reasoning) are at the bottom of the page.

A tutoring business (illustrative) collects $1,920 on the first day of a month for 6 months of weekly sessions, starting that day. Write the adjusting entry at the end of the first month, and give the Unearned Revenue balance after it.
A landscaping company's crew (illustrative) earned $640 of wages in the last days of a month, to be paid the next month. Write the adjusting entry, name its kind, and say why Cash is not in it.
A food truck (illustrative) bought a $9,000 cooking trailer expected to last 3 years with no residual value. Compute one month's depreciation, write the entry, and give the trailer's book value after that first month.
A dog-grooming service's adjusted trial balance (illustrative) shows $24,600 on each side. The owner later finds that a $180 accrued revenue was never recorded. Explain how the trial balance could balance anyway, and give the correct total.

Answers (worked reasoning — read after attempting)

One month is 1,920 ÷ 6 = $320 of sessions delivered. Debit Unearned Revenue 320; credit Service Revenue 320. Unearned Revenue falls to 1,920 − 320 = $1,600. In words: the business has earned one month of the six it was paid for, and it still owes five months of sessions.
Debit Wages Expense 640; credit Wages Payable 640. It is an accrued expense: the crew's work happened this month, and the cash moves next month. Cash is not in the entry because no cash has moved yet; the payment next month will be its own entry.
Three years is 3 × 12 = 36 months, so one month's depreciation is 9,000 ÷ 36 = $250. Debit Depreciation Expense 250; credit Accumulated Depreciation 250. Book value is 9,000 − 250 = $8,750. In words: $250 of the trailer's cost is allocated to the month; the figure says nothing about what the trailer would sell for.
Leaving out the entry leaves both columns $180 too small, so they still match. The missing entry is a debit to Accounts Receivable and a credit to Service Revenue, so the correct total is 24,600 + 180 = $24,780 on each side. This is Week 3's warning in a new setting: balance proves debits equal credits, not that nothing was left out.

Next up in this module: the Readings & Resources page, the lecture tutorial, the practice set, the quiz, the discussion, and the assignment; next week the adjusted trial balance feeds the statements, and the closing entries method resets the temporary accounts.

Built with The Course Maker · samples.thecoursemaker.com