1. Accrual Accounting and Financial Statements
Lecture 8
(CHAPTER 4)

2. Learning Objectives (LO)
After studying this chapter, you should be able to
Understand the role of adjustments in accrual accounting
Make adjustments for the expiration or consumption of assets
Make adjustments for the earning of unearned revenues
Make adjustments for accrual of unrecorded expenses
Make adjustments for the accrual of unrecorded revenues

3. Learning Objectives (LO)
After studying this chapter, you should be able to
Describe the sequence of the final steps in the recording process and relate cash flows to adjusting entries
Prepare a classified balance sheet and use it to assess short-term liquidity
Prepare single- and multiple-step income statements
Use ratios to assess profitability

4. LO 1 - Adjustments to the Accounts
Explicit transactions are
Observable events that trigger nearly all day-to-day routine entries
Supported by source documents
Implicit transactions
Do not generate source documents or any visible evidence that the event actually occurred
Are recorded in end-of-period entries called adjustments

5. LO 1 - Adjustments to the Accounts
Adjustments help assign the financial effects of implicit transactions to the appropriate time periods
Accrue means to accumulate a receivable (asset) or payable (liability) during a given period even though no explicit transaction occurs. For example, interest receivable or payable builds with the passage of time.

6. LO 1 - Adjustments to the Accounts
Adjustments arise from four basic types of implicit transactions:
Accrual of unrecorded expenses
Expiration of unexpired (deferred) costs
Accrual of unrecorded revenues
Earning of revenues received in advance

7. LO 2 - Expiration of Unexpired Costs
Assets
(Prepaid-
unexpired-
Expense)
Expenses
Incurred
Need adjustments to reflect consumption
Appear in the
Balance Sheet
Appear in the
Income Statement

8. LO 2 - Expiration of Unexpired Costs
Situation: After purchasing $2,000 of office supplies, (explicit event) the company determines that at month-end $1,500 were used.
Adjustment required:
How would assets and equity be affected if this adjustment is not made?
Office Supplies Inventory ,000
Cash ,000
Office Supplies Expense ,500
Office Supplies Inventory 1,500

9. LO 3 - Earning of Revenues Received in Advance
Liabilities
(Funds
received
but not
earned)
Revenues
(When
funds
have been
earned)
Adjustments to reflect earning
Appear in the
Balance Sheet
Appear in the
Income Statement

10. LO 3 - Earning of Revenues Received in Advance
Situation: Receive $6,000 for 3 months’ rent on July 1 (explicit event)
Adjustment required after 1 month passes:
How would liabilities and equity be affected if this adjustment is not made?
Cash ,000
Unearned Rent Revenue ,000
Unearned Rent Revenue ,000
Rent Revenue ,000

11. LO 4 - Accrual of Unrecorded Expenses
Need
adjustments to reflect consumption and debt
Expenses
are
incurred
but are
not
yet
recorded
Liabilities
need
to be shown
for the
unrecorded
expenses
Need to appear in the
Income Statement
Need to appear in the Balance Sheet

12. LO 4 - Accrual of Unrecorded Expenses
Situation: Payment for last week’s wages (explicit event)
Adjustment required for last 3 days of the fiscal year (payday is next Friday) (implicit event):
How would liabilities and equity be affected if this adjustment is not made?
Wage Expense ,000
Cash ,000
Wage Expense ,000
Accrued wages payable 120,000

13. LO 4 - Accrual of Unrecorded Expenses
Other examples where expenses liabilities arise but are unrecorded include
Wages
Income taxes
Utilities
Interest
Adjustments are necessary to accurately
Match expense to the period in the books of the entity that will have to pay
Record revenue in the books of the provider or recipient of those services when earned

14. LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest)
Interest is the “rent” paid for the use of money
Interest accumulates (accrues) as time passes, regardless of when a company actually pays cash for interest
Situation: A company borrows $100,000 on December 31, Terms of the loan require repayment of the loan amount of $100,000 plus interest on December 31, 2011

15. LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest)
Calculation of interest for any part of a year is as follows:
For the full year, the interest is:
Principal x Interest rate x Fraction of a year = Interest
$100,000 x .09 x 12/12 = $9,000

16. LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest)
As of January 31, 2011, the amount of interest owed is 1/12 x .09 x $100,000 = $750
Adjustment on borrower’s books required after 1 month passes:
How would liabilities and equity be affected if this adjustment is not made?
Interest expense
Accrued interest payable

17. LO 4 and LO5 - Accrual of Unrecorded Expenses and Revenues (interest)
As of January 31, 2011, the amount of interest owed is 1/12 x .09 x $100,000 = $750
Adjustment on lender’s books required after
1 month passes:
How would assets and equity be affected if this adjustment is not made?
Accrued Interest Receivable 750
Interest Revenue