Accounting - Chapter 4

Accrual Accounting Concepts

Accrual Accounting

The transactions posted don’t reflect what has happened

Periodicity Assumption

• Accounting divides the economic life of a business into artificial time periods

  • Generally, a month or a year

• Examples: retailers

Fiscal year

Accounting period one year in length (not a calendar year end)

Revenue Recognition Principle

• Requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied

  • Satisfied by performing a service or providing a good to a customer

Five-Step Revenue Recognition Process

1. Identify the contract with customers (deal between two parties)

2. Identify the separate performance obligations in the contract (priced accordingly)

3. Determine the transaction price

4. Allocate the transaction price to separate performance obligations

5. Recognize revenue when each performance obligation is satisfied

The Expense Recognition Principle

• Simple rule: “Let the expenses follow the revenues”

• Requires that companies recognize expenses in the period when they make efforts (consume assets or incur liabilities) to generate revenue

• Tied to revenue recognition

• Sometimes referred to as matching

• Critical issue in expense recognition

  • Determining when the expense makes its contribution to revenue

  • May not be the same period the expense is paid

Two basis of accounting

• Accrual Basis - is required by generally accepted accounting principles

• Cash Basis - not in accordance with GAAP; produces misleading financial statements

• Differ due to the timing of when revenues and expenses are recognized

Accrual Basis Accounting

• Is required by generally accepted accounting principles (GAAP)

• Requires making adjustments to accounts, even if cash is not received or exchanged yet

• Implies that transactions that change a company’s financial statements are recorded in the periods in which the events occur, even if cash is not exchanged

• Requires that companies:

  • Follow the revenue recognition principle

  • Follow the expense recognition principle

Cash Basis Accounting

• Not in accordance with GAAP (Generally Accepted Accounting Principles)

• Record transactions when cash is exchanged

  • Simplistic way of doing accounting

• May produce misleading financial statements

• Produces misleading financial statements

• Occurs when companies:

  • Record revenue at the time they receive cash

  • Record expenses at the time they pay out cash

• Fails to record revenue for a company that has performed services but has not yet received payment

Adjusting Entries (AJE)

• Ensure that the revenue recognition and expense recognition principles are followed

• Required every time a company prepares financial statements

• Contain one income statement account and one balance sheet account (BOTH)

• Are based on an analysis of each account in the trial balance to determine if the account is complete and up-to-date for financial statement purposes

• Classified as either deferrals or accruals

Deferrals

• Costs or revenues that are recognized at a date later than the point when cash was originally exchanged

• Prepaid Expenses

  • Expenses paid in cash and recorded as assets before they are used or consumed

• Unearned Revenues

  • Cash received and recorded as liabilities before revenue is earned

• Pay cash ahead of time before the expense is incurred or revenue is recognized

Accruals

• Accrued Revenues

  • Revenues for services performed but not yet received in cash or recorded

• Accrued Expenses

  • Expenses incurred but not yet paid in cash or recorded

Accrued expense

Interest of $200 has been incurred and unpaid on a note payable

Unearned revenue

Rent collected in advance totaling $1,100 has not been earned

Prepaid expense

Supplies of $400 are on hand. Supplies account shows $1,600 balance

Accrued revenue

Services performed but unbilled total $700

Periodicity assumption

Accountants divide the economic life of a business into artificial time periods.

Calendar year

An accounting time period that starts on January 1 and ends on December 31.

Fiscal year

An accounting period that is one year long.

Accrual-basis accounting

Companies record transactions in the period in which the events occur.

Prepaid Expenses

• Type of deferral

• Are expenses paid in cash and recorded as assets before they are used or consumed

• Often called prepayments

• Relate to payments that will benefit more than one accounting period

• Expire with the passage of time or through use and consumption

• Have an asset-expense account relationship

• Example: Loyola meal plan

Insurance

• A prepaid expense purchased to protect from losses due to fire, theft, and unforeseen events

• Must be paid in advance, often for multiple months

Depreciation

• The process of allocating the cost of a long-lived asset to expense over its useful life

  • Allocate the cost of an asset over a period of time

• Follows the expense recognition principle

• Is an allocation concept, not a valuation concept