Accrual Accounting and Financial Statements – Study Notes

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Accrual Accounting and Financial Statements

Accrual vs. Cash-Basis Accounting

Understanding the difference between accrual and cash-basis accounting is fundamental in financial accounting. These methods determine when transactions are recorded in the financial statements.

Accrual Accounting: Records the impact of transactions when they occur, regardless of when cash is exchanged. Required by IFRS and ASPE.
Cash-Basis Accounting: Records only cash transactions (cash receipts and payments). Ignores important non-cash information, resulting in incomplete financial statements.

Accrual Accounting	Cash-Basis Accounting
Records revenue when earned	Records revenue when cash is received
Records expenses when incurred	Records expenses when cash is paid

Accrual Accounting: Cash and Noncash Transactions

Accrual accounting recognizes both cash and noncash transactions, providing a more complete picture of a company's financial position.

Cash Transactions	Noncash Transactions
Collecting payments from customers	Sales on account
Receiving interest earned	Purchases on account
Borrowing money	Accrual of expenses not yet paid
Paying expenses	Depreciation expense
Paying off loans	Usage of prepaid expenses
Issuing shares	Earning of revenue when cash was collected in advance

Revenue and Expense Recognition Principles

Revenue Recognition Principle

The revenue recognition principle determines when and how much revenue to record. Revenue is recognized when it is earned, typically when goods or services have been delivered to the customer.

When to record: When revenue is earned (goods/services delivered).
Amount to record: Cash value of goods/services transferred to the customer.

IFRS Revenue Recognition Criteria

Identify the contract with the customer.
Identify the separate performance obligations in the contract.
Determine the transaction price.
Allocate the transaction price to the separate performance obligations.
Recognize revenue when (or as) each performance obligation is satisfied.

Expense Recognition Principle

Expenses are recognized in the period in which they are incurred and matched with related revenues.

Identify expenses incurred
Measure the expenses
Recognize and match with related revenues

Adjusting Journal Entries

Purpose of Adjusting Entries

Adjusting entries are made at the end of an accounting period to update account balances before financial statements are prepared. They ensure that revenues and expenses are recorded in the correct period.

Bring several accounts up-to-date
Record transactions not yet entered

Categories of Adjustments

Deferrals	Depreciation	Accruals
Prepaid expenses, Unearned revenue	Allocation of asset cost over useful life	Accrued expenses, Accrued revenues

Deferrals

Prepaid Expenses: Cash paid in advance, recorded as assets, expensed when used.
Unearned Revenue: Cash received before revenue is earned, recorded as liability, recognized as revenue when earned.

Depreciation

Depreciation allocates the cost of long-term tangible assets over their useful lives, representing wear-and-tear and obsolescence.

Examples: Buildings, Equipment, Furniture
Formula for straight-line depreciation:

Accumulated Depreciation is a contra-asset account that increases over the asset's life and has a normal credit balance.

Carrying Amount: Cost of asset less accumulated depreciation.

Accruals

Accrued Expenses: Expenses incurred before cash is paid (e.g., salaries, interest).
Accrued Revenues: Revenue earned but not yet received; increases receivables and revenue.

Summary of Adjusting Entries

Category of Adjustment	Type of Account Debited	Type of Account Credited
Prepaid expense	Expense	Asset
Depreciation	Expense	Contra-asset
Accrued expense	Expense	Liability
Accrued revenue	Revenue	Asset
Unearned revenue	Liability	Revenue

Preparing Financial Statements

Types of Financial Statements

Income Statement: Lists revenues and expenses, reports net income or net loss.
Statement of Retained Earnings: Shows changes in retained earnings.
Balance Sheet: Reports assets, liabilities, and shareholders’ equity.

Sample Statement of Retained Earnings

Item	Amount
Retained earnings, beginning balance	$3,598
Plus: Net income	$8,984
Less: Dividends	($3,588)
Retained earnings, ending balance	$3,998

Sample Balance Sheet

Assets	Liabilities & Shareholders’ Equity
Current assets: $55,550	Current liabilities: $8,855
Plant assets: $8,855	Non-current liabilities: $5,855
Other assets: $5,855	Common shares: $55,555
	Retained earnings: $9,955
Total assets: $99,980	Total liabilities & equity: $99,980

Classifying Assets and Liabilities

Current assets: Converted to cash, sold, or consumed within one year.
Non-current assets: Held for longer than one year; includes long-term tangible assets.
Current liabilities: Must be paid within one year.
Non-current liabilities: Due more than one year from balance sheet date.

Balance Sheet Formats

Report Format: Assets listed at the top, liabilities and equity beneath.
Account Format: Assets on the left, liabilities and equity on the right.

Income Statement Formats

Single-Step: Revenues and expenses grouped together.
Multi-Step: Shows subtotals to emphasize relationships, includes gross profit, income from operations, income before taxes, and net income.

Closing Journal Entries

Purpose of Closing Entries

Closing entries prepare the accounts for the next period by resetting temporary accounts (revenues, expenses, dividends) to zero.

Temporary Accounts: Closed at period end (revenues, expenses, dividends).
Permanent Accounts: Not closed (assets, liabilities, equity).

Steps in Closing Journal Entries

Close revenues: Credit Retained Earnings, debit each revenue account.
Close expenses: Debit Retained Earnings, credit each expense account.
Close dividends: Debit Retained Earnings, credit Dividends.

Analyzing Debt-Paying Ability

Working Capital

Working capital measures a company's liquidity and ability to pay short-term obligations.

Current Ratio

The current ratio assesses a company's ability to pay current liabilities.

A strong current ratio is typically 1.50 or higher.

Debt Ratio

The debt ratio measures the proportion of total assets financed by debt.

A low debt ratio is considered safer than a high debt ratio.

Data Visualization in Financial Accounting

Identifying Patterns and Trends

Data visualization, such as bar charts and line graphs, makes it easier to spot patterns and trends in financial data compared to reviewing rows of numbers.

Comparing current ratios across companies can highlight relative liquidity.
Trend charts can show changes in ratios over time, revealing improvements or declines in financial health.

Example: A bar chart comparing current ratios of four hospitality companies shows which has the highest liquidity. A line chart of a company's current ratio over five years can reveal trends and fluctuations.