Store supplies of $160 are on hand. the supplies account shows a $1,900 balance.

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 accounting.

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.

chapter

ACCRUAL ACCOUNTING CONCEPTS

4

● 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 WileyPLUS for practice and tutorials

● Read A Look at IFRS p. 224

● the navigator

Do it!

Do it!

✓

162

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feature story

163

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)

INSIDE CHAPTER 4 . . .

W HAT WAS YOU R P RO F IT?

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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

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 principle

• Expense recognition principle

• Accrual versus cash basis of accounting

Timing Issues

• Types of adjusting entries

• Adjusting entries for deferrals

• Adjusting entries for accruals

• Summary of basic relationships

The Basics of Adjusting Entries

• Preparing the adjusted trial balance

• Preparing financial statements

The Adjusted Trial Balance and Financial

Statements

• Preparing closing entries

• Preparing a post- closing trial balance

• Summary of the accounting cycle

Closing the Books

• Earnings management • Sarbanes-Oxley

Quality of Earnings

164

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

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

performed).

Revenue Recognition

Customer requests service

Service performed

Cash received

study objective

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June Accounts Receivable xxx Service Revenue xxx

July Cash xxx Accounts Receivable xxx

THE EXPENSE RECOGNITION PRINCIPLE

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

DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

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.

INFO NEEDED FOR DECISION

Revenue and Expense Recognition

In accordance with generally accepted accounting principles

(GAAP)

Expense Recognition Principle

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 Principle

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 VERSUS CASH BASIS OF ACCOUNTING

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.

DECISION TOOLKIT DECISION CHECKPOINTS TOOL TO USE FOR DECISION HOW TO EVALUATE RESULTS

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 (revenue).

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

INFO NEEDED FOR DECISION

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.

2 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

$ 0

Revenue Expense Net loss

$80,000 0

$80,000

Revenue Expense Net income

Cash basis

$80,000 50,000

$30,000

Revenue Expense Net income

Revenue Expense Net income

Accrual basis

Purchased paint, painted building, paid employees

2011

Received payment for work done in 2011

Activity

2012

PAINT

Fresh Colors

PAINT

PAINT

Bob's Bait Ba rnBob's Bait Barn

$ 0 50,000

$ 50,000

$

$

Bob's Bait Barn

Illustration 4-2 Accrual- versus cash-basis accounting

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.