22107 Lecture Notes - Lecture 4: Accrual, Deferred Income, Deferral
UTS 2014 – Accounting for Business Decisions A
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LECTURE 4 – ACCRUAL ACCOUNTING AND ADJUSTING ENTRIES
LEARNING OBJECTIVES
Describe how profit is measured and reported under the accrual and cash bases of
accounting.
The main difference between the accrual and cash bases of accounting is the timing of when
revenues and expenses are recorded.
The cash basis of accounting records revenues when cash is received and records expenses
when cash is paid.
In contrast, the accrual basis of accounting records revenues when they are earned and
records expenses when they are incurred.
This is an application of the revenue recognition and matching principles, respectively.
Accrual basis provides a better representation of income/expenses over shorter periods of
time. As a result, the accrual basis is required by Generally Accepted Accounting Principles.
Because GAAPs require the accrual basis, statements of comprehensive income report
accrual-based profits or losses.
However, cash basis info is also useful in understanding the financial condition of firms.
A company that generates accrual income but never generates cash is bound to soon fail.
As a result, cash-based income is reported on the cash flow statement.
Identify the four major circumstances in which adjusting journal entries are necessary.
Adjusting journal entries are entries made in the general journal to record revenues that
have been earned but not recorded and expenses that have been incurred but not recorded.
The process of recording and posting adjusting entries occurs at the end of each accounting
period after the trial balance is prepared.
While adjusting entries can vary across companies, they all arise as the exchange of cash
does not always coincide with the earning of revenue or incurrence of expense.
Classification of scenario
Adjusting entry
1. Cash is received before revenue
Deferred revenue is earned.
2. Cash is received after revenue.
Accrued revenue is earned.
3. Cash is paid before expense.
Deferred expense is incurred.
4. Cash is paid after expense.
Accrued expense is incurred.
Scenario 1 – Deferred Revenue [e.g. Subscription Revenue]
When a company receives cash before it provides the service, it has deferred revenue.
Term deferred is used since at time of cash receipt, company has not yet provided the
promised service and thus, cannot record revenue. Instead, it must record a liability.
General rule – company should always increase a liability account for the amount received.
As the company provides the service, the liability is adjusted down (decrease) and related
revenue is adjusted up (increased). Adjusting entry = reduced liability + increased revenue.
Scenario 2 – Accrued Revenue [e.g. Service Revenue]
When a company earns revenue before it receives cash, it has accrued revenue.
Term accrue means to accumulate/increase. Accrued revenue is a receivable.
General rule – company should increase receivable account and revenue account. The
receivable account should be adjusted up (increased) and revenue account also adjusted up.
When company collects receivable, receivable account decreases & cash account increases.
Scenario 3 – Deferred Expense [e.g. Insurance Expense, Depreciation Expense]
When company pays for a resource before it uses or consumes it, it has a deferred expense.
Document Summary
Lecture 4 accrual accounting and adjusting entries. Describe how profit is measured and reported under the accrual and cash bases of accounting. The main difference between the accrual and cash bases of accounting is the timing of when revenues and expenses are recorded. The cash basis of accounting records revenues when cash is received and records expenses when cash is paid. In contrast, the accrual basis of accounting records revenues when they are earned and records expenses when they are incurred. This is an application of the revenue recognition and matching principles, respectively. Accrual basis provides a better representation of income/expenses over shorter periods of time. As a result, the accrual basis is required by generally accepted accounting principles. Because gaaps require the accrual basis, statements of comprehensive income report accrual-based profits or losses. However, cash basis info is also useful in understanding the financial condition of firms.
