Chapter 3: Accrual Accounting and the Financial Statements

Vocabulary flashcards covering key terms, formulas, and rules from Chapter 3 on accrual accounting, adjusting journal entries, financial statements, closing entries, and liquidity/solvency measures.

Cash basis accounting

An accounting method that recognizes revenues when cash is RECEIVED and recognizes expenses when cash is PAID.

Accrual basis accounting

An accounting method that recognizes revenues when the revenue recognition principle is met and expenses when the expense recognition principle is met, regardless of when cash moves.

Five-step revenue recognition model

A model requiring businesses to: 1. Identify the contract, 2. Identify separate performance obligations, 3. Determine transaction price, 4. Allocate transaction price, and 5. Recognize revenue when obligations are satisfied.

Prepayment (Deferral)

An accounting timing difference that occurs when cash is collected or paid BEFORE the revenue is earned or the expense is incurred.

Accrual

An accounting timing difference that occurs when cash is collected or paid AFTER the revenue is earned or the expense is incurred.

Prepaid expense

An asset created when cash is paid before an expense is incurred; adjusted by debiting Expense and crediting Prepaid asset.

Unearned revenue

A liability created when cash is collected before service is delivered; adjusted by debiting Unearned revenue and crediting Revenue.

Accrued expense

An expense that has been incurred but not yet paid or recorded; adjusted by debiting Expense and crediting Payable.

Accrued revenue

Revenue that has been earned but not yet collected or billed; adjusted by debiting Receivable and crediting Revenue.

Rules governing adjusting entries

Every adjusting entry involves EXACTLY ONE balance sheet account and EXACTLY ONE income statement account, and NO adjusting entry ever touches Cash.

Principal

The face amount stated on a note payable or receivable, due at maturity.

Maturity date

The date on which the principal amount of a note is due to be paid.

Term (of a note)

The duration of time from the issue date of a note to its maturity date.

Interest rate (on a note)

The stated rate on a note, which is ALWAYS expressed as an annual rate regardless of the note's term.

Interest accrued formula

$$\text{Interest accrued} = \text{Principal} \times \text{annual interest rate} \times \frac{\text{months}}{12}$$

Depreciation

The systematic allocation of an asset's cost over its useful life (excluding land, which is not depreciated).

Annual depreciation formula

$$\text{Annual depreciation expense} = \frac{\text{Cost} - \text{salvage value}}{\text{useful life}}$$

Contra-asset

An account with a normal credit balance (such as Accumulated depreciation) reported on the balance sheet as a deduction from its related asset account.

Supplies expense formula

$$\text{Supplies expense} = \text{Beginning supplies} + \text{purchases} - \text{supplies on hand}$$

Permanent (real) accounts

Asset, liability, and equity accounts whose balances carry forward into the next accounting period.

Temporary (nominal) accounts

Revenue, expense, gain, loss, and dividend accounts that are reduced to zero at period end and closed to Retained earnings.

Current ratio

A short-term liquidity ratio calculated as $\frac{\text{Current assets}}{\text{Current liabilities}}$.

Working capital

A dollar measure of short-term liquidity cushion calculated as $\text{Current assets} - \text{Current liabilities}$.

Debt ratio

A long-term solvency ratio calculated as $\frac{\text{Total liabilities}}{\text{Total assets}}$, representing the proportion of assets financed by creditors.