Chapter 3: Using Accrual Accounting to Measure Income

Introduction

This chapter introduces the principles of accrual accounting, focusing on how revenues and expenses are recognized and measured to determine net income. The notes cover the accounting period concept, the recognition of revenues and expenses, and the impact on financial statements.

Revenues

Revenues represent the inflow of assets or reduction of liabilities resulting from the sale of goods or services. In accrual accounting, revenues are recognized when earned, regardless of when cash is received.

• Assets: When revenue is earned, assets such as Cash or Accounts Receivable (A/R) increase.

• Journal Entry Example: Cash or A/R    xx Fees Earned    xx

• Liabilities: When previously unearned fees are earned, liabilities decrease and revenue is recognized. Unearned Fees    xx Fees Earned    xx

Key Point: Revenue recognition is based on the completion of the earning process, not the receipt of cash.

Expenses

Expenses are the outflows or using up of assets or incurrences of liabilities from delivering goods, rendering services, or carrying out other activities. Expenses are recognized when incurred, not necessarily when paid.

• Decrease in Assets: When an expense is incurred, assets such as Cash decrease. Expense    xx Cash    xx

• Increase in Liabilities: If an expense is incurred but not yet paid, a liability is created. Expense    xx Liabilities Payable    xx

Key Point: Expense recognition follows the matching principle, which matches expenses to the revenues they help generate.

Accounting Period

The accounting period is the time frame for which financial statements are prepared. Most commonly, this is one year, known as the fiscal year, which may coincide with the calendar year.

• Fiscal Year: The annual period selected by a company for reporting purposes.

• Natural Business Year: Some companies choose a fiscal year that aligns with their business cycle, such as the end of inventory or activity peaks.

• Assignment of Revenues and Expenses: Accountants allocate revenues and expenses to the appropriate accounting periods to ensure accurate measurement of net income.

Example: A company with a fiscal year ending December 31 will report all revenues and expenses earned or incurred between January 1 and December 31 in that year's financial statements.

Additional info:

• Matching Principle: Expenses are matched to the revenues they help generate, ensuring that income is measured accurately for each period.

• Accrual vs. Cash Accounting: Accrual accounting recognizes transactions when they occur, while cash accounting recognizes them only when cash changes hands.