Accrual Accounting and the Financial Statements – Chapter 3 Study Notes

Study Guide - Smart Notes

Tailored notes based on your materials, expanded with key definitions, examples, and context.

Accrual Accounting and the Financial Statements

Accrual vs. Cash-Basis Accounting

Accounting systems can be based on either the accrual or cash-basis method. Understanding the differences is essential for preparing accurate 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 (receipts and payments). Ignores non-cash events, resulting in incomplete financial statements.
Key Points:
- Accrual accounting records revenue when earned and expenses when incurred.
- Cash-basis accounting records transactions only when cash changes hands.

Accrual Accounting	Cash-Basis Accounting
Records impact of transactions when they occur	Records only cash transactions
Required by IFRS and ASPE	Not accepted by IFRS/ASPE
Records revenue when earned, expenses when incurred	Records cash receipts and payments only
Provides complete financial statements	Results in incomplete financial statements

Accrual Accounting: Cash and Noncash Transactions

Accrual accounting recognizes both cash and noncash transactions, ensuring all economic events are reflected in the financial statements.

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 and the goods or services have been delivered to the customer.

When to record: After revenue is earned; when goods/services delivered.
Amount to record: Cash value of goods/services transferred to 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

The Expense Recognition Principle requires expenses to be recognized in the same period as the related revenues.

Identify expenses incurred
Measure the expenses
Recognize along with related revenues

Adjusting Journal Entries

Adjusting the Accounts

Adjusting entries are made at the end of the accounting period to update account balances before preparing financial statements.

Financial statements are issued at the end of the period.
Several accounts on the trial balance need to be brought up-to-date.
Certain transactions have not yet been recorded.

Categories of Adjustments

Deferrals
Depreciation
Accruals

Deferrals

Deferrals occur when cash is paid or received before the related expense or revenue is recognized.

Prepaid Expense	Unearned Revenue
Recorded as asset when purchased	Recorded as liability when payment is received
Expensed when used or expired	Recorded as revenue when earned

Prepaid Expenses

Prepaid expenses are assets paid in advance and expensed as they are used.

Date	Accounts	Debit	Credit
Jun 1	Prepaid Rent	3,000
Jun 1	Cash		3,000
Jun 2	Supplies	700
Jun 2	Cash		700

When expired or used:

Date	Accounts	Debit	Credit
Jun 30	Rent Expense	1,000
Jun 30	Prepaid Rent		1,000
Jun 30	Supplies Expense	300
Jun 30	Supplies		300

Prepaid Rent Example

Prepaid Rent remaining: $2,000 (Balance Sheet)
Rent Expense expired: $1,000 (Income Statement)

Supplies Example

Supplies on hand: $400 (Balance Sheet)
Supplies used: $300 (Income Statement)

Unearned Revenue

Unearned revenue is cash received before revenue is earned, creating a liability.

Date	Accounts	Debit	Credit
Jun 15	Cash	400
Jun 15	Unearned Revenue		400

When revenue is earned:

Date	Accounts	Debit	Credit
Jun 30	Unearned Revenue	200
Jun 30	Service Revenue		200

Depreciation

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

Examples: Buildings, Equipment, Furniture

Date	Accounts	Debit	Credit
Jun 3	Equipment	24,000
Jun 3	Accounts Payable		24,000
Jun 30	Depreciation Expense	400
Jun 30	Accumulated Depreciation		400

Depreciation Formula:

Annual Depreciation:
Monthly Depreciation:

Example: annual depreciation; monthly depreciation

Accumulated Depreciation

Sum of all depreciation expense; increases over asset's life
Contra-asset account with normal credit balance
Companion account is the asset
Carrying amount: Cost of asset less accumulated depreciation

Partial Balance Sheet June 30, 2020
Equipment: $24,000
Less: Accumulated Depreciation: (400)
Carrying amount: $23,600

Accruals

Accruals are adjustments for revenues earned or expenses incurred that have not yet been recorded in the accounts.

Accrued Expenses	Accrued Revenues
Record expense before paying cash	Record revenue before collecting cash
Salaries, interest, income taxes	Earned and will collect in a future period

Accrued Expenses Example

Expenses incurred before cash is paid; results in a liability
Examples: Salaries, Interest

Date	Accounts	Debit	Credit
Sept 15	Salary Expense	900
Sept 15	Cash		900
Sept 30	Salary Expense	900
Sept 30	Salary Payable		900

Salary Payable (Balance Sheet): $900 owed
Salary Expense (Income Statement): $1,800 for September

Accrued Revenue Example

Revenue earned but not yet received; increases receivables and revenue

Date	Accounts	Debit	Credit
Jun 30	Accounts Receivable	300
Jun 30	Service Revenue		300

Prepaids and Accruals Comparison

Prepaids – Cash First	Accruals – Cash Later
Prepaid expenses: Cash → Prepaid expense → Expense	Accrued expenses: Expense → Payable → Cash
Unearned revenues: Cash → Unearned revenue → Revenue	Accrued revenues: Receivable → Revenue → Cash

Summary of the Adjusting Process

Two purposes: Measure income and update the balance sheet
Every adjusting entry affects at least one revenue/expense and one asset/liability

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

Exercises and Applications

Journalizing Adjusting Entries (Exercise 3-20)

Interest Expense: Debit Interest Expense $9,000, Credit Interest Payable $9,000
Interest Revenue: Debit Interest Receivable $3,000, Credit Interest Revenue $3,000
Unearned Revenue: Debit Unearned Revenue $6,000, Credit Revenue $6,000
Salary Expense: Debit Salary Expense $2,000, Credit Salary Payable $2,000
Supplies Expense: Debit Supplies Expense $2,300, Credit Supplies $2,300
Depreciation Expense: Debit Depreciation Expense $12,000, Credit Accumulated Depreciation $12,000

Partial Balance Sheet December 31, 20X1
Equipment: $60,000
Less: Accumulated Depreciation: (12,000)
Carrying Amount: $48,000

The Adjusted Trial Balance

The adjusted trial balance is prepared after all adjustments are journalized and posted. It is a useful step in preparing financial statements.

Preparation of Financial Statements

The 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.

Flow of Data in Financial Statements

Income Statement
Revenues: $$
Less: Expenses: ($$)
Net Income: $$

Statement of Retained Earnings
Retained earnings, beginning balance: $$
Plus: Net income: $$
Less: Dividends: ($$)
Retained earnings, ending balance: $$

Balance Sheet
Current assets: $$
Plant assets: $$
Other assets: $$
Liabilities: $$
Common shares: $$
Retained earnings: $$
Total assets: $$
Total liabilities & shareholders’ equity: $$

Classifying Assets and Liabilities

Assets and liabilities are classified as current or long-term based on liquidity, which is how quickly an item can be converted to cash.

Asset	Liquidity
Cash	Most liquid
Accounts receivable	Very liquid
Inventory	Somewhat liquid
Non-current assets	Not liquid

Additional info: These notes are based on textbook slides and cover the full scope of Chapter 3, including definitions, examples, and journal entry formats for accrual accounting, adjusting entries, and financial statement preparation.