Accrual Accounting and End-of-Period Adjustments: Study Notes

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Tailored notes based on your materials, expanded with key definitions, examples, and context.

Accrual Accounting and End-of-Period Adjustments

Overview of Financial Accounting Course Structure

This course covers the foundational principles and practices of financial accounting, including the conceptual framework, transaction recording, accrual accounting, financial statement presentation, internal controls, inventory, property and equipment, liabilities, equity, and cash flows.

Chapter 1: Conceptual Framework and Financial Statements
Chapter 2: Recording Business Transactions
Chapter 3: Accrual Accounting (focus of these notes)
Chapter 4: Presentation of Financial Statements
Chapter 5: Internal Control, Cash, and Receivables
Chapter 6: Inventory and Merchandising Operations
Chapter 7: Property, Plant, and Equipment (PPE) and Intangibles
Chapter 9: Liabilities
Chapter 10: Stockholders’ Equity
Chapter 11: Cash Flows

Accrual Accounting

Accrual vs. Cash Basis Accounting

There are two primary methods for measuring income in accounting: the accrual basis and the cash basis. Understanding the distinction is fundamental for preparing accurate financial statements.

Cash Basis: Recognizes the impact of transactions only when cash is received or paid. For example, revenue is recorded when cash is collected from customers, and expenses are recorded when cash is paid to suppliers or employees.
Accrual Basis: Recognizes the impact of transactions in the periods when revenues and expenses occur, regardless of when cash is exchanged. For example, sales made on credit are recorded as revenue when the goods are delivered, not when cash is received.

Revenue Recognition Principle

Under the accrual basis, revenues are recognized when:

Transfer: Goods are delivered or a service is performed, including the transfer of risks and rewards of ownership.
Realized: Cash or a claim to cash (such as accounts receivable) is received in exchange for goods or services.

Examples:

A sale on account is recorded as revenue when the goods are delivered, even if the seller receives no cash at that moment.
Supplies sent to customers throughout the month are not recognized as revenue until the customer formally promises to accept and pay for them.

Expense Recognition (Matching Principle)

Expenses are recognized in the same period as the related revenues are earned. This is known as the matching principle.

Expenses are the costs of assets used up or services consumed in the process of earning revenue.
For example, the cost of inventory sold is recorded as an expense (cost of goods sold) in the same period as the related sales revenue.
Prepaid expenses (such as insurance paid in advance) are recorded as assets and expensed over the periods benefited.

End-of-Period Adjustments

Purpose and Process

End-of-period adjustments ensure that all revenues and expenses are recorded in the correct accounting period, in accordance with the accrual basis of accounting. The process involves:

Journalizing and posting transactions throughout the period.
Preparing an unadjusted trial balance.
Making adjusting entries for accruals and deferrals.
Preparing an adjusted trial balance.
Preparing financial statements.
Closing the books (resetting temporary accounts for the next period).

Types of Adjusting Entries

Adjusting entries are classified into three main categories:

Deferrals: Adjustments for cash received or paid before goods or services are delivered (e.g., prepaid expenses, unearned revenue).
Accruals: Adjustments for revenues earned or expenses incurred before cash is received or paid (e.g., accrued expenses, accrued revenues).
Depreciation: Allocation of the cost of long-lived assets (Property, Plant, and Equipment) over their useful lives.

Summary Table: Types of Adjusting Entries

Type	Example	When Cash Flows	Account Affected
Prepaid Expense (Deferral)	Insurance paid in advance	Before expense is recognized	Asset decreases, Expense increases
Unearned Revenue (Deferral)	Cash received before service	Before revenue is recognized	Liability decreases, Revenue increases
Accrued Expense (Accrual)	Wages owed but not yet paid	After expense is recognized	Liability increases, Expense increases
Accrued Revenue (Accrual)	Service performed, cash not yet received	After revenue is recognized	Asset increases, Revenue increases
Depreciation	Allocation of equipment cost	Over asset's useful life	Contra-asset increases, Expense increases

Depreciation of Plant Assets

Depreciation is the systematic allocation of the cost of a tangible long-lived asset (such as equipment) over its useful life. This process matches the cost of the asset to the periods benefiting from its use.

The most common method is straight-line depreciation:

For example, if equipment costs $24,000 and has a useful life of 5 years:

Depreciation is recorded by debiting Depreciation Expense and crediting Accumulated Depreciation (a contra-asset account).
Book Value is calculated as:

Closing the Books

At the end of the accounting period, temporary accounts (revenues, expenses, and dividends) are closed to prepare the accounts for the next period. Permanent accounts (assets, liabilities, and shareholders’ equity) are not closed.

Temporary accounts: Income statement accounts (revenues, expenses) and dividends.
Permanent accounts: Balance sheet accounts (assets, liabilities, shareholders’ equity).
Closing entries transfer the balances of temporary accounts to Retained Earnings.

Note: Dividends are not considered expenses; they are distributions of earnings to shareholders.

Summary of the Adjusting and Closing Process

Record transactions throughout the period.
Prepare an unadjusted trial balance.
Make adjusting entries for accruals, deferrals, and depreciation.
Prepare an adjusted trial balance.
Prepare financial statements.
Close temporary accounts to Retained Earnings.

Additional info: These notes are based on slides and textbook content for a college-level Financial Accounting course, focusing on accrual accounting and end-of-period adjustments. Examples and formulas have been expanded for clarity and completeness.