Accrual Accounting and Income: Chapter 3 Study Notes

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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 financial performance and position in accordance with Generally Accepted Accounting Principles (GAAP).

Accrual vs. Cash-Basis Accounting

Key Differences

Accrual Accounting: Records 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 assets.

The Time-Period Concept

Accounting information is reported at regular intervals, typically one year (fiscal or calendar). Interim statements may be prepared for periods less than a year.

Revenue and Expense Recognition Principles

The Revenue Principle

When to recognize revenue: When goods are delivered or services performed for an amount expected to be received.
Amount to record: The cash or equivalent value to be received.

The Expense Recognition (Matching) Principle

Expenses are recognized in the same period as the related revenues.
Net income (NI) is calculated as:

Net income and net loss bar chart

Adjusting the Accounts

Purpose of 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 paid or received before the expense or revenue is recognized (e.g., prepaid expenses, unearned revenue).
Depreciation: Allocates the cost of plant assets over their useful life.
Accruals: Expense or revenue is recognized before cash is paid or received (e.g., accrued expenses, accrued revenues).

Examples of Adjusting Entries

Prepaid Expenses

Prepaid rent and supplies are assets until used; then they become expenses.

Unadjusted trial balance Journal entry for prepaid rent T-account for prepaid rent Adjusting entry for rent expense T-accounts for prepaid rent and rent expense

Supplies

Supplies purchased are assets; the portion used is expensed at period end.

Journal entry for supplies purchase Adjusting entry for supplies expense T-accounts for supplies and supplies expense

Depreciation of Plant Assets

Depreciation spreads the cost of long-lived assets over their useful life, except land.
Straight-line depreciation formula:
Monthly depreciation:

Journal entry for equipment purchase T-account for equipment Adjusting entry for depreciation T-accounts for equipment, accumulated depreciation, and depreciation expense Plant assets summary table Disney property and accumulated depreciation table

Accrued Expenses

Expenses incurred but not yet paid (e.g., salaries, taxes) are recorded as liabilities.

Journal entry for salary expense T-account for salary expense Adjusting entry for accrued salary T-accounts for salary payable and salary expense T-account for salary payable Journal entry for payment of accrued salary

Accrued Revenues

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

Adjusting entry for accrued service revenue T-accounts for accounts receivable and service revenue

Unearned Revenue

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

Journal entry for unearned service revenue Accounting equation for unearned revenue T-account for unearned service revenue Adjusting entry for earned service revenue T-accounts for unearned service revenue and service revenue

Summary Table: Prepaid and Accrual Adjustments

This table summarizes the journal entries for prepaid expenses, unearned revenues, accrued expenses, and accrued revenues.

Summary table of adjusting entries

Summary of the Adjusting Process

Adjusting entries measure income and update the balance sheet.
Each entry affects a revenue or expense account and an asset or liability account.
No cash is involved in adjusting entries.

Adjusting entry for income tax expense Panel of information for adjustments and adjusting entries Ledger accounts after adjustments

The Adjusted Trial Balance

The adjusted trial balance lists all accounts and their final balances after adjustments, ensuring total debits equal total credits.

Adjusted trial balance worksheet

Constructing the Financial Statements

Income Statement: Reports revenues and expenses for a period.
Statement of Retained Earnings: Shows changes in retained earnings.
Balance Sheet: Reports assets, liabilities, and equity at a point in time.

Income statement Statement of retained earnings

Closing the Books

Purpose and Process

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.

Trial balance worksheet showing retained earnings Journalizing closing entries Posting closing entries

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., land, buildings, equipment).
Current Liabilities: Debts due within one year (e.g., accounts payable, salary payable, unearned revenue).
Long-Term Liabilities: Debts due after one year (e.g., long-term notes payable).

Classified balance sheet of Disney

Formats for Financial Statements

Balance Sheet: Report format and account format.
Income Statement: Single-step (all revenues and expenses together) and multi-step (separates operating and non-operating items).

Disney multistep income statement

Analyzing and Evaluating Debt-Paying Ability

Key Ratios

Net Working Capital:
Current Ratio:
Debt Ratio:
Higher current ratio indicates better liquidity; lower debt ratio indicates safer financial position.

Data Visualization in Accounting

Charts and Graphs

Bar Chart: Displays categorical data for comparison.
Line Chart: Shows trends over time.

Data visualization helps accountants and managers spot patterns and trends in financial data, aiding decision-making.

Summary Table: Adjusting Entries

Category	Debit	Credit
Prepaid expense	Expense	Asset
Depreciation	Expense	Contra asset
Accrued expense	Expense	Liability
Accrued revenue	Asset	Revenue
Unearned revenue	Liability	Revenue

Practice Problems

Calculate current and debt ratios after various transactions (e.g., issuing stock, purchasing assets, accruing expenses).
Analyze how transactions affect liquidity and financial position.

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