Accruals and Presentation of Financial Statements: Key Concepts in Financial Accounting

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Accruals and Presentation of Financial Statements

Introduction

This study guide summarizes the essential concepts from a Financial Accounting lecture focused on accruals and the presentation of financial statements. The material covers foundational principles such as debits and credits, the accrual principle, revenue recognition, expense matching, and depreciation, with practical examples from real companies.

Recording Business Transactions

Debits and Credits

In double-entry accounting, every transaction affects at least two accounts, using debits and credits to keep the accounting equation in balance.

Debit (Dr.): An entry on the left side of an account. Increases assets and expenses; decreases liabilities and equity.
Credit (Cr.): An entry on the right side of an account. Increases liabilities and equity; decreases assets and expenses.

Accounting Equation:

Assets increase with debits, decrease with credits.
Liabilities and equity increase with credits, decrease with debits.

Example Journal Entries

Sell inventory for cash: Dt. Cash 100 Cr. Revenue (retained earnings) 100 Dt. Cost of goods sold (retained earnings) 80 Cr. Inventory 80 Profit is 20, increasing retained earnings.
Buy a machine: Dt. Machines 100 Cr. Cash 100
Borrow from bank: Dt. Cash 200 Cr. Bank Loan 200

Accrual Accounting

Measuring Profit: Accrual Principle

Profit is recognized when it is earned for shareholders, not necessarily when cash is received or paid.

Accrual Principle: - Recognize revenue when earned (goods/services delivered). - Recognize expenses when resources are consumed.
Cash Flow vs. Profit: - Receiving cash does not always mean revenue is earned. - Paying cash does not always mean an expense is incurred.

Deferrals and Accruals in the Balance Sheet

Type	Description	Examples
Deferrals	Cash received/paid, recognition postponed	Unearned Revenue, Prepaid Expenses
Accruals	Profit anticipated, cash to be received/paid in future	To be invoiced, Invoices to be received

Balance Sheet Presentation

Current Assets	Current Liabilities
Prepaid Expenses To be Invoiced	Unearned Revenue Invoices to be Received

Presentation of Financial Statements

Revenue Recognition: Earned and Realizable

Earned: Delivery of promised goods/services to customer; revenue belongs to shareholders.
Realizable: Amount to be collected is reasonably measurable and certain.

Examples

Unearned Revenue: - Event company receives payment in advance; at year-end, cash is received but service not yet delivered, so it is a liability (unearned revenue).
Starbucks Stamp Card: - Buy 9, get 10th free. Revenue is recognized over 10 cups, with part deferred until the free cup is redeemed.

Cash	Revenue	Deferred Revenue	Cumulative Deferred Revenue
4.00	3.60	0.40	0.40
4.00	3.60	0.40	0.80
...	...	...	...
4.00	3.60	0.40	3.60
4.00	3.60	0.40	4.00

Deferred Revenue Example: - AirFrance/KLM's FlyingBlue loyalty program: Deferred revenue is recognized as a liability until miles are redeemed.

Revenue Realizability Issues

Retroactive Accumulative Discounts: - Discounts applied after a threshold is reached; realizability may be unclear upfront.

Accrual Accounting: Expense Recognition

Matching Principle and Period Cost

Matching Principle: Expense recognized when resource is consumed in earning revenue (e.g., Cost of Goods Sold).
Period Cost: Expenses not directly matched to revenue are recognized in the period incurred (e.g., marketing, admin, R&D).

Cost of Goods Sold

Includes cost of purchased materials, labor, and machines used in production.
Unsold goods are recorded as inventory (asset) on the balance sheet.

Period Cost Example

LVMH income statement: Marketing, selling, administrative, and R&D expenses are mostly period costs.

PPE and Intangibles: Depreciation

Depreciation

Depreciation allocates the cost of a non-current asset (e.g., machine) over its useful life.

Asset is first recorded on the balance sheet.
Each year, a portion of the asset's cost is recognized as an expense in the income statement.

Depreciation Example Table

Year	Original Cost	Accumulated Depreciation – Start of Year	Net Book Value (Start of Year)	Depreciation Expense	Net Book Value (End of Year)
1	100	0	100	10	90
2	100	10	90	10	80
...	...	...	...	...	...
10	100	90	10	10	0

Formula for Straight-Line Depreciation:

Summary Table: Key Concepts

Concept	Definition	Example
Debit	Left side entry, increases assets/expenses	Debit Cash when receiving money
Credit	Right side entry, increases liabilities/equity	Credit Revenue when earning income
Accrual Principle	Recognize revenue/expense when earned/incurred	Invoice sent, revenue recognized before cash received
Matching Principle	Expense matched to related revenue	COGS matched to sales
Period Cost	Expense recognized in period incurred	Marketing expense
Depreciation	Allocation of asset cost over useful life	Machine depreciated over 10 years

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