101 Concepts for the Level I Exam

Concept 40: Accruals and Valuation Adjustments

Accruals: The accrual accounting principle requires that a firm recognize revenue when they are earned and expenses when they are incurred. At times, there is a timing difference between the cash movements and the recognition of revenues or expenses. In such cases accrual entries are required. If cash is transferred at the same time when the revenue or expense is incurred, there is no need for accrual entries. The four types of accrual entries are:

Unearned revenue: (Cash is received first, and the goods/services will be delivered later.) Increase cash and create a liability for the goods/services that the firm has to provide in future.

In December, a newspaper company receives $200 from a customer for the next year’s subscription.

Accounting entry on Dec 31^st: Cash (asset) ↑$200 and Unearned subscription income (liability) ↑$200

Accrued revenue: (Goods/services are delivered first, and cash will be received later). Record revenue for the credit sale, and increase account receivables.

In December, a laundry company provided $300 worth of services to a customer. The payment will be received next month.

Accounting entry on Dec 31^st: Revenue (income) ↑$300 and Accounts receivable (asset) ↑$300.

Prepaid expenses: (Cash is paid first, and the expense will be recognized later). Decrease cash and create an asset prepaid expense.

In December, a retail store paid $12,000 as advance rent for the next year.

Accounting entry on Dec 31^st: Rent prepaid (asset) ↑$12,000 and Cash (asset) ↓ $12,000

Accrued expenses: (Expense is recognized first, cash will be paid later). Record expenses for the credit purchase, and increase accounts payable.

A company owes its employees $1,000 in wages for work performed in the month of December. The wages will be paid on 5^th January.

Accounting entry on Dec 31^st: Wages (expense) ↑$1,000 and Wages payable (liability) ↑$1,000

Valuation adjustments: Most assets are recorded on the balance sheet at historical cost. However, accounting standards require that certain assets be shown at current market values. The adjustment required to bring the asset value to the current market value is called valuation adjustment. The accounting equation must be kept in balance. So any valuation adjustment must be offset with an equal change to owner’s equity. This is done either through the income statement or through other comprehensive income.

If an asset of $100 falls to $80, then a valuation adjustment of -$20 must be recorded. Also, a loss of $20 must be recorded either on the income statement or in other compressive income.