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CHAPTER 4Accrual Accounting ConceptsStudy Objectives1.Explain the revenue recognition principle and the matching 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 prepayments.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.4-1
1.revenue recognition principle2.matching principle♦The revenue recognition principlerequires that revenuebe recognized in the accounting period in which it is earned.A service company recognizes (records) revenue when the services are performed.Service businesses recognize revenue when the services are performed, although many customers may have been billed for the services (on account). The cash has not been received; however, the services have been performed. Therefore, revenue should be recognized. Does Delta Airlines record revenue when you buy a plane ticket on May 1 for a flight on June 15? Has the service been provided? The answer to both of these questions is no.Delta cannot recognize revenue on May 1 because the service has not been provided. The revenue will be recognized on June 15 when the ticket holder takes the flight.♦The matching principlerequires that efforts (expenses)be matched with accomplishments (revenues).♦The critical issue is determining when the expense makes its contribution to revenue.Returning to the service business example, suppose employees are paid every two weeks. When preparing financial statements for May, the accountant realizes that employees were last paid on Friday, May 22. By May 31, nine days have elapsed and many of the employees have worked seven or more days. The wages of these employees must be included in expenses.The same accountant, however, notices that on May 1 the business renewed its insurance coverage by paying the $12,000 premium on a one-year insurance policy. Is all of the $12,000 an expense of May? No. The insurance policy will be in effect for 12 months. Therefore, $1,000 ($12,000/12 months) should be recognized as expense each month. 4-2
Study Objective 2 - Differentiate Between the Cash Basis and the Accrual Basis of Accounting♦With cash basis accounting, revenueis recognized (recorded) when cash is received. Expensesare recognized (recorded) only when cash is paid.