Chapter 4

The
Accounting
Cycle:
Accruals and
Deferrals

Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
4-1
Introduction
In Chapter 3, you learned that we record
revenue when it is earned.
For example, when a hairdresser cuts a
customer’s hair, revenue is earned when the hair
is cut and the fee is collected.

4-2
Timing Differences
For most companies, revenue is not always
earned as cash is received, nor is an expense
necessarily incurred as cash is disbursed.
Timing differences between cash flows and the
recognition of revenue and expenses are referred
to as accruals and deferrals.
In this chapter, we examine how accounting
information must be adjusted for accruals and
deferrals prior to the preparation of financial
statements.

4-3
 Step 4 in the Accounting Cycle
We covered the first three steps of the
accounting cycle in Chapter 3:
◦ Recording transactions
◦ Posting transactions
◦ Preparing a trial balance
KEY POINT
In this chapter, we focus solely upon the fourth step of the accounting
cycle—performing the end-of-period adjustments required to measure
business income.

4-4
The Need for Adjusting Entries
Certain transactions affect the revenue or
expenses of two or more accounting periods.
Adjusting entries are needed at the end of each
accounting period to make certain that
appropriate amounts or revenue and expense are
reported in the company’s income statement.

4-5
Categories of Adjusting Entries
Most adjusting entries fall into one of four general
categories:
1. Converting assets to expenses.
2. Converting liabilities to revenue.
3. Accruing unpaid expenses.
4. Accruing uncollected revenue.

4-6
Introduction: Converting Assets to
Expenses
 A cash expenditure (or cost) that will benefit more than one
accounting period usually is recorded by debiting an asset
account (for example, Supplies, Unexpired Insurance, and so
on) and by crediting Cash.
 The asset account created actually represents the deferral (or
the postponement) of an expense.
 In each future period that benefits from the use of this asset,
an adjusting entry is made to allocate a portion of the asset’s
cost from the balance sheet to the income statement as an
expense.
 This adjusting entry is recorded by debiting the appropriate
expense account (for example, Supplies Expense or Insurance
Expense) and crediting the related asset account (for example,
Supplies or Unexpired Insurance).
4-7
Introduction: Converting Liabilities to
Revenue
 A business may collect cash in advance for services to be
rendered in future accounting periods.
 Transactions of this nature are usually recorded by debiting
Cash and by crediting a liability account (typically called
Unearned Revenue or Customer Deposits). Here, the liability
account created represents the deferral (or the postponement) of
a revenue.
 In the period that services are actually rendered (or that goods
are sold), an adjusting entry is made to allocate a portion of the
liability from the balance sheet to the income statement to
recognize the revenue earned during the period.
 The adjusting entry is recorded by debiting the liability
(Unearned Revenue or Customer Deposits) and by crediting
Revenue Earned (or a similar account) for the value of the
services.
4-8
Introduction: Accruing Unpaid
Expenses
 An expense may be incurred in the current accounting
period even though no cash payment will occur until a
future period.
 These accrued expenses are recorded by an adjusting
entry made at the end of each accounting period.
 The adjusting entry is recorded by debiting the
appropriate expense account (for example, Interest
Expense or Salary Expense) and by crediting the related
liability (for example, Interest Payable or Salaries
Payable).

4-9
Introduction: Accruing Uncollected
Revenue
 Revenue may be earned (or accrued) during the current
period, even though the collection of cash will not occur
until a future period.
 Unrecorded earned revenue, for which no cash has been
received, requires an adjusting entry at the end of the
accounting period.
 The adjusting entry is recorded by debiting the
appropriate asset (for example, Accounts Receivable or
Interest Receivable) and by crediting the appropriate
revenue account (for example, Service Revenue Earned
or Interest Earned).

4-10
Adjusting Entries and Timing
Differences
In an accrual accounting system, there are often
timing differences between cash flows and the
recognition of expenses or revenue.
A company can pay cash in advance of incurring
certain expenses or receive cash before revenue
has been earned.
Likewise, it can incur certain expenses before
paying any cash or it can earn revenue before
any cash is received.

4-11
Adjusting Entries and Timing
Differences (cont.)
 These timing differences, and the adjusting entries that
result from them, are summarized as follows.
◦ Adjusting entries to convert assets to expenses result
from cash being paid prior to an expense being
incurred.
◦ Adjusting entries to convert liabilities to revenue result
from cash being received prior to revenue being earned.
◦ Adjusting entries to accrue unpaid expenses result from
expenses being incurred before cash is paid.
◦ Adjusting entries to accrue uncollected revenue result
from revenue being earned before cash is received.

4-12
Adjusting Entries

Adjusting Every
entries are adjusting
needed whenever entry involves a
revenue or expenses change in either a
affect more than one revenue or expense
accounting and an asset
period. or liability.

4-13
Converting Assets to Expenses
End of Current Period

Prior Periods Current Period Future Periods

Transaction
Transaction Adjusting
AdjustingEntry
Entry
Pay
Paycash
cashin in 
 Recognizes
Recognizesportion
portionofof
advance
advanceof of asset
assetconsumed
consumedas as
incurring
incurring expenses,
expenses,and
and
expense
expense 
 Reduces
Reducesbalance
balanceofof
(creates
(createsan an asset
assetaccount
account
asset)
asset)
4-14
Example: Insurance Policy

$18,000 Insurance Policy

Coverage for 12 Months

$1,500 Monthly Insurance Expense

Mar. 1 Feb.28

On
On March
March 1,
1, Overnight
Overnight Auto
Auto Service
Service
purchased
purchased aa one-year
one-year insurance
insurance policy
policy
for
for $18,000.
$18,000.
4-15
 Insurance Policy: Initial Entry

Initially,
Initially, costs
costs that
that benefit
benefit more
more than
than one
one
accounting
accounting period
period are
are recorded
recorded as
as assets.
assets.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre dit
Mar. 1 Une xpire d Ins urance 18,000
Cas h 18,000
Purc has e d a o ne -ye ar ins uranc e po lic y.

4-16
Insurance: Adjusting Entry

The
The costs
costs are
are expensed
expensed asas they
they are
are
used
used to
to generate
generate revenue.
revenue.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Monthly Adjusting Entry for Insurance
Mar. 31 Insurance Expense 1,500
Unexpired Insurance 1,500
Adjusting entry to record insurance expense for March.
4-17
Insurance: Financial Statement Impact

Balance
Balance Sheet
Sheet Income
Income Statement
Statement
Cost
Cost of
of assets
assets Cost
Cost of
of assets
assets
that
that benefit
benefit used
used this
this period
period to
to
future
future periods.
periods. generate
generate revenue.
revenue.

Unexpired Insurance Insurance Expense

3/1 18,000 3/31 1,500 3/31 1,500
Bal. 16,500

4-18
 The Concept of Depreciation
Depreciation
Depreciation is is the
the systematic
systematic allocation
allocation of
of
the
the cost
cost of
of aa depreciable
depreciable asset
asset to
to expense.
expense.

The asset’s
Fixed
Fixed Depreciation
usefulness is Depreciation
Asset
Asset Expense
partially Expense
(debit)
(debit) (debit)
consumed (debit)
during the
On date At the end of
period.
when initial the period . . .
payment is
made . . . Accumulated
Accumulated
Cash
Cash Depreciation
Depreciation
(credit)
(credit) (credit)
(credit)
4-19
Depreciation Is Only an Estimate
On Jan. 22, 2018, Overnight Auto Service
purchased a building with a useful life of
240 months for $36,000.
Using the straight-line method, calculate the
monthly depreciation expense.
Depreciation
Cost of the asset
expense (per =
Estimated useful life
period)

$150/month = $36,000
240
4-20
 Example: Depreciation Expense

Overnight
Overnight Auto
Auto Service
Service would
would make
make the
the
following
following adjusting
adjusting entry.
entry.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre dit
Fe b. 28 De pre c iatio n Expe ns e : Building 150
Ac c umulate d De pre c iatio n: Building 150
To re c o rd o ne mo nth's de pre c iatio n.

Contra-asset
Contra-asset
4-21
 Example 2: Depreciation Expense
Overnight depreciates its $12,000 of tools
and equipment over 60 months. Calculate
monthly depreciation and make the journal
entry.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre dit
Fe b. 28 De pre c iatio n Expe ns e : To o ls and Equipme nt 200
Ac c umulate d De pre c iatio n: To o ls and Equipme nt 200
To re c o rd o ne mo nth's de pre c iatio n.

$12,00060
$12,00060 months
months == $200
$200 per
per month
month
4-22
Computing Book Value for Assets
We
Wewill
will assume
assumethatthat Overnight
Overnight did
did not
not record
record any
any
depreciation
depreciationexpense
expenseininJanuary
Januarybecause
becauseitit
operated
operated for
for only
only aasmall
small part
part of
of the
the month.
month.

December 31, 2018 Balance Sheet Presentation

Building $ 36,000
Less: Accum. depr. 1,650 34,350
Tool and Equipment $ 18,000
Less: Accum. depr. 2,200 15,800

Cost
Cost −− Accumulated
Accumulated Depreciation
Depreciation == Book
Book Value
Value

4-23
Converting Liabilities to Revenue
End of Current Period

Prior Periods Current Period Future Periods

Transaction
Transaction Adjusting
AdjustingEntry
Entry
Collect
Collectcash
cashin in 
 Recognizes
Recognizesportion
portion
advance
advanceof of earned
earnedas asrevenue,
revenue,and
and
earning
earningrevenue
revenue 
 Reduces
Reducesbalance
balanceofof
(creates
(createsaa liability
liabilityaccount
account
liability)
liability)

4-24
 Example: Rental Revenue

$3,000 Rental Contract

Coverage for 3 Months

$1,000 Monthly Rental Revenue

Dec. 1 Feb. 28

On
On December
December 1, 1, Overnight
Overnight received
received $3,000
$3,000
in
in advance
advance for
for aa three-month
three-month rental
rental contract.
contract.
4-25
 Rental Revenue: Initial Entry

Initially,
Initially, revenues
revenues that
that benefit
benefit more
more than
than one
one
accounting
accounting period
period are
are recorded
recorded as
as liabilities.
liabilities.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 1 Cash 3,000
Unearned Rent Revenue 3,000
Collected $3,000 in advance for rent.

4-26
 Rental Revenue: Adjusting Entry

Over
Over time,
time, the
the revenue
revenue is is recognized
recognized
as
as itit is
is earned.
earned.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R Debit Credit
Mo nthly Adjus ting Entry fo r Re nt Re ve nue
Dec . 31 Une arned Re nt Re ve nue 1,000
Re ntal Re ve nue 1,000
Adjus ting e ntry to re c o rd re ntal re ve nue fo r De c e mbe r.

4-27
Rental Revenue: Financial Statement
Impact

Balance Income
Income Statement
Statement
Balance Sheet
Sheet
Liability Revenue
Revenue earned
earned
Liability for
for
future this
this period.
period.
future periods.
periods.

Unearned Rental Revenue Rental Revenue

12/31 1,000 12/1 3,000 12/31 1,000
Bal. 2,000

4-28
Accruing Unpaid Expenses
End of Current Period

Prior Periods Current Period Future Periods

Adjusting
AdjustingEntry
Entry Transaction
Transaction

 Recognizes
Recognizesexpenses
expenses Pay
Paycash
cashin in
incurred,
incurred,and
and settlement
settlementof of

 Records
Recordsliability
liabilityfor
for liability.
liability.
future
futurepayment
payment

4-29
Example: Wages Owed
Friday,
$1,950 Wages Jan. 3
Expense

Monday, Tuesday,
Dec. 30 Dec. 31

On
On Dec.
Dec. 31,
31, Overnight
Overnight owes
owes wages
wages of
of
$1,950.
$1,950. Payday
Payday is
is Friday,
Friday, Jan.
Jan. 3.
3.

4-30
 Wages Owed: Initial Entry

Initially,
Initially, an
an expense
expense and
and aa liability
liability are
are
recorded.
recorded.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R Debit Cre dit
Dec . 31 Wag e s Expens e 1,950
Wag e s Payable 1,950
Adjus ting e ntry to ac c rue wag e s o we d to e mplo ye e s .

4-31
Wages Owed: Financial Statement
Impact

Balance
Balance Sheet
Sheet Income
Income Statement
Statement
Liability
Liability toto be
be Cost
Cost incurred
incurred this
this
paid
paid in
in aa future
future period
period to
to generate
generate
period.
period. revenue.
revenue.

Wages Payable Wages Expense

12/31 3,000 12/31 1,950

4-32
Wage Expense Calculation

$2,397 Weekly Wages

$1,950 Wages $447 Wages

Expense Expense

Monday, Tuesday, Friday,

Dec. 30 Dec. 31 Jan. 3

Let’s
Let’s look
look at
at the
the entry
entry for
for Jan.
Jan. 3.
3.
4-33
 Wages Owed: Payment Entry

The
The liability
liability is
is extinguished
extinguished when
when the
the
debt
debt is
is paid.
paid.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R Debit Cre dit
Jan. 3 Wag e s Expe ns e (fo r Jan.) 447
Wag e s Payable (ac c rue d in De c .) 1,950
Cas h 2,397
We e kly payro ll fo r De c . 30–Jan. 3.
4-34
Accruing Uncollected Revenue
End of Current Period

Prior Periods Current Period Future Periods

Adjusting
AdjustingEntry
Entry Transaction
Transaction

 Recognizes
Recognizesrevenue
revenue Collect
Collectcash
cashinin
earned
earnedbut
butnot
notyet
yet settlement
settlementofof
recorded,
recorded,and
and receivable
receivable

 Records
Recordsreceivable
receivable

4-35
Example: Service Revenue
$750 Repair
Service
Revenue

Dec. 15 Dec. 31 Jan. 15

On
On Dec.
Dec. 31,
31,Airport
Airport Shuttle
Shuttle Service
Service owes
owes
Overnight
Overnight half
half of
of its
its maintenance
maintenance agreement.
agreement.
The
The one-month
one-month feefee of
of $1,500
$1,500 is
is to
to be
be paid
paid on
on
the
the 15th day
15 th
day of
of January.
January.
4-36
 Accrued Service Revenue Entry

Initially,
Initially, the
the revenue
revenue isis recognized
recognized and
and
aa receivable
receivable is
is created.
created.

GENERAL JOURNAL
P
Date Ac c ount Title s and Explanation R Debit Cre dit
Dec . 31 Ac c o unts Re c e ivable 750
Re pair Se rvic e Re ve nue 750
Adjus ting e ntry to re c o rd ac c rue d s e rvic e re ve nue .

4-37
Accrued Revenue: Financial Statement
Impact

Balance
Balance Sheet
Sheet Income
Income Statement
Statement
Receivable
Receivable toto Revenue
Revenue earned
earned
be
be collected
collected in
in aa this
this period.
period.
future
future period.
period.

Accounts Receivable Repair Service Revenue

12/31 750 12/31 750

4-38
Accrued Revenue Calculation

$1,500 Total Revenue

$750 Service $750 Service

Revenue Revenue

Dec. 15 Dec. 31 Jan. 15

Let’s
Let’s look
look at
at the
the entry
entry for
for January
January 15.
15.
4-39
 Accrued Revenue: Collection Entry

The
The receivable
receivable is
is collected
collected in
in aa future
future
period.
period.

GENERAL JOURNAL
P
Date Ac c o unt Title s and Explanatio n R De bit Cre dit
Jan. 15 Cas h 1,500
Re pair S e rvic e Re ve nue (fo r Jan.) 750
Ac c o unts Re c e ivable (ac c rue d De c . 31) 750
To re c o rd c as h c o lle c te d fo r mo nthly mainte nanc e fe e .

4-40
Accruing Income Taxes Expense: The
Final Adjusting Entry
As
As aa corporation
corporation earns
earns taxable
taxable income,
income, itit
incurs
incurs income
income taxes
taxes expense,
expense, and
and also
also aa
liability
liability to
to governmental
governmental tax
tax authorities.
authorities.

GENERAL JOURNAL
P
Date Account Titles and Explanation R Debit Credit
Dec. 31 Income Taxes Expense 4,020
Income Taxes Payable 4,020
Adjusting entry to record income taxes accrued in December.

4-41
Supporting the Matching Principle
The matching principle underlies such
accounting practices as:
◦ Depreciating plant assets.
◦ Measuring the cost of supplies used.
◦ Amortizing the cost of unexpired insurance
policies.
All end-of-the-period adjusting entries involving
expense recognition are applications of the
matching principle.

4-42
Matching Costs
Costs are matched with revenue in one of two ways.
1. Direct association of costs with specific revenue
transactions. The ideal method of matching revenue
with expenses is to determine the actual amount of
expense associated with specific revenue transactions.
However, this approach works only for those costs and
expenses that can be directly associated with specific
revenue transactions. Commissions paid to salespeople
are an example of costs that can be directly associated
with the revenue of a specific accounting period.

4-43
Matching Costs (cont.)
2. Systematic allocation of costs over the useful life of the
expenditure. Many expenditures contribute to the
earning of revenue for a number of accounting periods
but cannot be directly associated with specific revenue
transactions. Examples include the costs of insurance
policies and depreciable assets. In these cases,
accountants attempt to match revenue and expenses by
systematically allocating the cost to expense over its
useful life. Straight-line depreciation is an example of
a systematic technique used to match the cost of an
asset with the related revenue that it helps to earn over
its useful life.

4-44
Materiality Concept
Materiality refers to the relative importance of
an item or an event.
An item is considered material if knowledge of
the item might reasonably influence the
decisions of users of financial statements.
Accountants must be sure that all material items
are properly reported in financial statements.

4-45
Materiality Concept (cont.)
Immaterial items are those of little or no
consequence to decision makers.
◦ The financial reporting process should be cost-
effective—that is, the value of the information
should exceed the cost of its preparation.
◦ Immaterial items may be handled in the easiest
and most convenient manner.

4-46
Materiality and Adjusting Entries
The concept of materiality enables accountants to shorten
and simplify the process of making adjusting entries in
several ways. For example:
1. Businesses purchase many assets that have a very low
cost or that will be consumed quickly in business
operations. Examples include wastebaskets,
lightbulbs, and janitorial supplies. The materiality
concept permits charging such purchases directly to
expense accounts, rather than to asset accounts. This
treatment conveniently eliminates the need to prepare
adjusting entries to depreciate these items.

4-47
Materiality and Adjusting Entries (cont.)
2. Some expenses, such as telephone bills and utility
bills, may be charged to expenses as the bills are paid,
rather than as the services are used. Technically this
treatment violates the matching principle. However,
accounting for utility bills on a cash basis is very
convenient, as the monthly cost of utility service is not
even known until the utility bill is received. Under this
cash basis approach, the amount of utility expense
recorded each month is actually based on the prior
month’s bill.
3. Adjusting entries to accrue unrecorded expenses or
unrecorded revenue may actually be ignored if the
dollar amounts are immaterial.

4-48
Materiality and Professional Judgment
Whether a specific item or event is material is a
matter of professional judgment. In making these
judgments, accountants consider several factors:
1. The size of the organization.
2. The cumulative effect of numerous
immaterial events.
3. Nature of the item.
4. Dollar amount of the item.

4-49
 Effects of the Adjusting Entries
Income Statement Balance Sheet
Net Owners'
Adjustment Revenue Expenses Income Assets Liabilities Equity
Type I
Converting Assets to Expenses No effect Increase Decrease Decrease No effect Decrease
Type II
Converting Liabilities to Revenue Increase No effect Increase No effect Decrease Increase
Type III
Accruing Unpaid Expenses No effect Increase Decrease No effect Increase Decrease
Type IV
Accruing Uncollected Revenue Increase No effect Increase Increase No effect Increase

4-50
Overnight’s Adjusted Trial Balance
 After these
adjustments are
posted to the
ledger,
Overnight’s ledger
accounts will be
up-to-date (except
for the balance in
the Retained
Earnings account).

4-51
End of Chapter 4

4-52