Accrual Accounting

Overview

Accrual accounting is a foundational concept in financial accounting, requiring the recognition of revenues and expenses when they are earned or incurred, regardless of when cash is exchanged. This approach provides a more accurate picture of a company's financial position than cash accounting.

• Cash transactions: Involve the actual movement of cash (e.g., collecting payments, paying salaries).

• Non-cash transactions: Include sales or purchases on account, accruals, and depreciation.

The Accrual Principle

Recognition and Measurement

• When are income/expenses to be recognised? Income and expenses are recognised when earned or incurred, not necessarily when cash is received or paid.

• How are income/expenses to be measured? They must be measured reliably and objectively, often at fair value.

Revenue Recognition

IAS 18 Criteria for Sale of Goods

• The seller has transferred to the buyer the significant risks and rewards of ownership.

• The seller retains neither continuing managerial involvement nor effective control over the goods sold.

• The amount of revenue and/or costs incurred can be measured reliably.

• It is probable that the economic benefits associated with the transaction will flow to the seller.

Critical Event and Measurability

• Critical event: The enterprise has completed its performance (e.g., delivery of goods).

• Measurability: The amount of revenue can be measured reliably, and the customer will probably pay.

Both criteria must be fulfilled for revenue recognition. Recognition should occur at the earliest possible date when both are met.

Application Example

• Revenue from most goods is recognised at the date the goods are delivered.

• If goods are shipped via a forwarding agent, the transfer of title (as per delivery terms) determines the recognition date.

• Revenue is recorded at fair value, considering trade discounts and volume rebates.

Matching Principle

Expense Recognition

The matching principle requires that expenses be matched with the revenues they help to generate in the same accounting period.

• Identify expenses incurred

• Measure the expenses

• Match against revenues earned

Expenses are recognised as:

• A decrease in assets (e.g., use of supplies, cash payments)

• An increase in liabilities (e.g., accrued liabilities for expenses incurred but not yet paid)

Accounting and Ethics: Fraud

Definition and Examples

• Fraud: Intentional misrepresentation of facts causing injury or damage to another party. It is the ultimate unethical act in business.

• Revenue recognition is the most susceptible area for fraud (e.g., recording fictitious revenue, recognising revenue before delivery, incomplete delivery, or without customer acceptance).

Notable cases: WorldCom (2002), Enron (2002), IT Factory (2008), HESA Light (2018).

Adjusting Entries

Purpose and Process

Adjusting entries are made at the end of an accounting period to update account balances before preparing financial statements. This ensures that all revenues and expenses are properly recognised in the correct period.

• Financial statements are issued at the end of the period.

• Accounts such as Accounts Receivable, Supplies, and Prepaid Rent may need adjustments because certain transactions have not yet been recorded.

Categories of Adjustments

1. Deferral: Adjustment for items paid or received in advance.

   • Prepaid expense: Recorded as an asset when purchased, expensed when used or expired.

   • Unearned revenue: Recorded as a liability when payment is received, recognised as revenue when earned.

2. Accrual: Opposite of deferral; records expenses before paying cash or revenue before collecting cash.

   • Accrued expenses: Salaries, interest, and income taxes incurred but not yet paid.

   • Accrued revenues: Revenue earned but not yet received.

3. Depreciation: Allocates the cost of property, plant, and equipment (PPE) to expense over the asset's useful life.

Examples of Adjusting Entries

• Prepaid Rent:

  • On June 1, prepaid rent of $3,000 is recorded as an asset.

  • On June 30, $1,000 is expensed, reducing prepaid rent.

• Supplies:

  • On June 2, $700 of supplies purchased; at month-end, $400 remains, so $300 is expensed.

• Unearned Revenue:

  • On June 15, $400 received for services to be performed; at month-end, $200 earned and recognised as revenue.

• Accrued Salaries:

  • At June 30, $900 salary expense accrued for payment on July 1.

• Accrued Revenue:

  • At June 30, $300 revenue earned but not yet received is accrued.

• Depreciation:

  • Equipment purchased for $24,000; monthly depreciation of $400 recorded.

Summary Table: Adjusting Entries

Closing the Financial Statements

Steps in the Closing Process

1. Prepare a trial balance on the worksheet: Enter all ledger accounts with balances.

2. Enter the adjustments in the adjustment columns: Record all necessary adjusting entries.

3. Extend trial balance and adjustments to appropriate financial statements columns: Allocate balances to the income statement and balance sheet.

These steps ensure that all revenues and expenses are properly matched and that the financial statements reflect the true financial position of the company at period-end.

Key Formulas

• Book Value of PPE:

Additional info: The notes also reference VAT (Value Added Tax) journal entries and settlements, which are relevant for transaction analysis and adjusting entries in financial accounting.