Accrual Accounting and Income

Introduction

This chapter covers the principles and procedures of accrual accounting, the process of adjusting accounts, and the preparation of financial statements. It is essential for understanding how businesses measure and report income and financial position in accordance with Generally Accepted Accounting Principles (GAAP).

Accrual vs. Cash-Basis Accounting

Key Differences

• Accrual Accounting: Records the impact of transactions when they occur, regardless of when cash is exchanged. Required by GAAP.

• Cash-Basis Accounting: Records only cash transactions (receipts and payments). Ignores non-cash transactions, resulting in incomplete financial statements. Used only by the smallest businesses.

Accrual accounting includes both cash and non-cash transactions, such as sales on account, accrual of expenses, depreciation, and usage of prepaid items.

Time-Period Concept

Reporting Intervals

• Accounting information is reported at regular intervals, typically one year (fiscal or calendar).

• Interim financial statements may be prepared for periods less than one year.

Revenue and Expense Recognition Principles

Revenue Principle

• Revenue is recognized when goods or services are delivered and the business expects to receive payment.

• The amount recorded is the cash or equivalent to be received.

Expense Recognition (Matching) Principle

• Expenses are recognized in the same period as the related revenues.

• Net income (NI) is calculated as:

Adjusting the Accounts

Purpose and Process

• Adjusting entries ensure revenues and expenses are recognized in the correct period.

• Made at the end of the accounting period; affect one income statement account and one balance sheet account (no cash involved).

Categories of Adjusting Entries

• Deferrals: Cash is exchanged before revenue or expense is recognized (e.g., prepaid expenses, unearned revenue).

• Depreciation: Allocates the cost of plant assets over their useful life.

• Accruals: Revenue or expense is recognized before cash is exchanged (e.g., accrued expenses, accrued revenues).

Prepaid (Deferred) Expenses

• Prepaid expenses are assets providing future benefit.

• As the benefit is used, the asset is reduced and an expense is recognized.

Supplies

• Supplies purchased are recorded as assets.

• At period end, used supplies are expensed; remaining supplies stay as assets.

Depreciation of Plant Assets

• Plant assets (e.g., equipment) are long-lived and depreciated over their useful life.

• Straight-line depreciation:

• Accumulated Depreciation is a contra asset account, showing total depreciation to date.

Accrued Expenses

• Expenses incurred but not yet paid are recorded as liabilities (e.g., salary payable).

• Adjusting entries recognize the expense and liability; payment reduces the liability.

Accrued Revenues

• Revenue earned but not yet collected is recorded as an asset (accounts receivable).

• Adjusting entries recognize the revenue and receivable; collection reduces the receivable.

Unearned (Deferred) Revenue

• Cash received before revenue is earned is recorded as a liability (unearned revenue).

• As services are performed, revenue is recognized and the liability is reduced.

Summary Table: Prepaids and Accruals

The following table summarizes the journal entries for prepaids and accruals:

Income Tax Accrual

• Income tax expense is accrued at period end as a liability.

Comprehensive Example: Adjusting Process

• Panel A: Information for adjustments (e.g., rent expired, supplies used, depreciation, accrued salary, service revenue, unearned revenue, income tax).

• Panel B: Corresponding adjusting entries.

Adjusted Trial Balance and Financial Statements

Adjusted Trial Balance

• Summarizes all accounts and their final balances after adjustments.

• Ensures total debits equal total credits.

Financial Statements

• Income Statement: Reports revenues and expenses for the period.

• Statement of Retained Earnings: Shows changes in retained earnings.

• Balance Sheet: Reports assets, liabilities, and equity at period end.

Closing the Books

Purpose and Steps

• Prepares accounts for the next period and updates retained earnings.

• Temporary accounts (revenues, expenses, dividends) are closed; permanent accounts (assets, liabilities, equity) are not.

• Steps: Close revenues to retained earnings, close expenses to retained earnings, close dividends to retained earnings.

Classifying Assets and Liabilities

Current vs. Long-Term

• Current Assets: Most liquid; converted to cash or used within one year (e.g., cash, receivables, supplies).

• Long-Term Assets: Not expected to be converted to cash within one year (e.g., plant assets).

• Current Liabilities: Debts due within one year (e.g., accounts payable, salary payable).

• Long-Term Liabilities: Debts due after one year (e.g., long-term notes payable).

Formats for Financial Statements

Balance Sheet and Income Statement Formats

• Balance Sheet: Report format and account format.

• Income Statement: Single-step (all revenues/expenses together) and multi-step (separates operating and non-operating items).

Analyzing Debt-Paying Ability

Key Ratios

• Net Working Capital:

• Current Ratio:

• Debt Ratio:

Data Visualization in Accounting

Charts and Graphs

• Bar Chart: Displays categorical data for comparison.

• Line Chart: Visualizes data trends over time.

Summary

Accrual accounting provides a more accurate picture of a company's financial position and performance by recognizing revenues and expenses in the period they are earned or incurred. Adjusting entries, closing the books, and preparing financial statements are essential steps in the accounting cycle. Key ratios and data visualization tools help analyze and communicate financial information effectively.