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 transactions, resulting in incomplete financial statements.

Accrual Accounting	Cash-Basis Accounting
Records impact of transactions when they occur	Records only cash transactions
Required by IFRS and ASPE	Ignores important information
Records revenue when earned, expenses when incurred	Results in incomplete financial statements

Accrual Accounting: Cash and Noncash Transactions

Accrual accounting recognizes both cash and noncash transactions, providing a more complete picture of financial activity.

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

Revenue is recognized when it is earned, typically when goods or services have been delivered to the customer. The amount recorded is the cash value of goods or services transferred.

When to record: After revenue is earned; when good or service has been delivered.
Amount to record: Cash value of goods or 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) the business satisfies each performance obligation.

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 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 been recorded.

Categories of Adjustments

Deferrals
Depreciation
Accruals

Deferrals

Prepaid Expense: Recorded as an asset when purchased; expensed when used or expired.
Unearned Revenue: Recorded as a liability when payment is received; recorded as revenue when earned.

Prepaid Expenses

Prepaid expenses are assets until they are used or expired, at which point they become expenses.

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

Unearned Revenue

Cash received before revenue is earned creates a liability. When revenue is earned, the liability is reduced and revenue is increased.

Date	Accounts	Debit	Credit
Jun 15	Cash	400
Jun 15	Unearned Revenue		400
Jun 30	Unearned Revenue	200
Jun 30	Service Revenue		200

Depreciation

Depreciation allocates the cost of long-term, tangible assets to expense 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:

Accumulated Depreciation and Carrying Amount

Accumulated Depreciation: Sum of all depreciation expense; increases over asset's life; contra-asset account with normal credit balance.
Carrying Amount: Cost of asset less accumulated depreciation.

Partial Balance Sheet
Equipment	$24,000
Less: Accumulated Depreciation	($400)
Carrying Amount	$23,600

Accruals

Accrued Expenses: Record expense before paying cash (e.g., salaries, interest, income taxes).
Accrued Revenues: Record revenue before collecting cash; earned and will collect in a future period.

Accrued Expenses Example

Expenses incurred before cash is paid result in a liability (e.g., Salary Payable).

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

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: Summary Table

Type	First	Later
Prepaid expenses	Prepaid expense	Expense
Unearned revenues	Cash	Unearned revenue → Revenue
Accrued expenses	Expense	Payable → Cash
Accrued revenues	Receivable	Cash

Summary of the Adjusting Process

Two purposes: measure income and update the balance sheet.
Every adjusting entry affects at least one revenue or expense and one asset or 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 Solutions

Exercise 3-20: Adjusting Entries

Journalize the adjusting entry needed at December 31, 20X1, for each situation:

a. Interest expense of $9,000 related to a loan received in January 20X1.
b. Interest revenue of $3,000 has been earned but not yet received.
c. $12,000 collected in advance for two cars; one delivered in December, one to be delivered in February 20X2.
d. Salary expense is $1,000 per day, paid each Friday. December 31 falls on a Tuesday.
e. Supplies account unadjusted balance is $3,100; supplies on hand total $800.
f. Equipment purchased for $60,000, useful life 5 years, no residual value. Record depreciation and carrying amount.

Date	Accounts	Debit	Credit
(a)	Interest Expense	9,000
(a)	Interest Payable		9,000
(b)	Interest Receivable	3,000
(b)	Interest Revenue		3,000
(c)	Unearned Revenue	6,000
(c)	Revenue		6,000
(d)	Salary Expense	2,000
(d)	Salary Payable		2,000
(e)	Supplies Expense	2,300
(e)	Supplies		2,300
(f)	Depreciation Expense	12,000
(f)	Accumulated Depreciation		12,000

Carrying Amount Calculation:

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

The Adjusted Trial Balance

Prepared after 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	$$
Total assets	$$
Liabilities	$$
Common shares	$$
Retained earnings	$$
Total liabilities & shareholders’ equity	$$

Classifying Assets and Liabilities

Assets and liabilities are classified as current or long-term based on liquidity, i.e., 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 Chapter 3 of a Financial Accounting textbook and are suitable for college-level exam preparation. All tables and examples are reconstructed from the provided slides and text.