Financial Accounting: Accrual Accounting Concepts

Accrual Accounting Concepts

• Accrual Accounting and Adjusting Entries
  • Accrual vs. cash basis accounting.
  • Revenue and expense recognition.
  • Adjusting entries.
• Adjusting Entries
  • Prepaid Expenses.
  • Deferred Revenues.
  • Accrued Expenses.
  • Accrued Revenues.
• Adjusted Trial Balance and Financial Statements
• Closing the Books
  • Post-closing Trial Balance

Accrual Accounting

• Users need financial information regularly.
• Accounting divides a business's economic life into time periods (year, quarter, month).
  • One-year period: fiscal year.
  • Shorter periods: interim periods.
• Many transactions span multiple periods.

Accrual Basis Accounting

• Transactions are recorded when events occur, not when cash changes hands.
  • Revenue is recorded when earned, even if cash isn't received.
  • Expenses are recorded when goods/services are used, not when cash is paid.

Cash Basis Accounting

• Revenue: recorded only when cash is received.
• Expenses: recorded only when cash is paid.
• Drawbacks:
  • Misleading information because of timing differences between events and cash flows.
  • Potential to manipulate revenue/expenses by timing cash receipts/payments.

Revenue Recognition

• Revenue: Increase in assets or settlement of liabilities from ordinary activities.
• Generally, revenue is recognized:
  • Merchandising company: when merchandise is sold and delivered (point of sale).
  • Service company: when the service is performed.
• Under ASPE (Accounting Standards for Private Enterprises), revenue is recognized when:
  • Services are provided or risks/rewards of ownership transfer to the buyer.
  • Revenue can be reliably measured (e.g., software companies, law firms with hourly billing).
    1. Time spent.
    2. Rate.
  • Collection is reasonably certain.
• Under IFRS (International Financial Financial Reporting Standards), revenue is recognized when a company satisfies a performance obligation.
• Five-Step Process (IFRS):
  1. Identify the contract with the customer.
  2. Identify performance obligations in the contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to performance obligations.
  5. Recognize revenue when the performance obligation is satisfied.

Expense Recognition

• Expenses are recognized when economic resources decrease (assets are consumed or liabilities increase).
• Tied to company's ordinary revenue-generating activities.
• Often coincides with revenue recognition.
• Recognized in the period effort is made to generate revenue (matching principle).

Need for Adjusting Entries

• Made at the end of the accounting period to update accounts.
• Required because the trial balance may be incomplete:
  • Some events aren't recorded daily.
  • Some costs expire over time and aren't recorded immediately.
  • Some items are unrecorded because amounts are unknown.

Types of Adjusting Entries

• Prepayments
  • Prepaid Expenses.
  • Deferred Revenues.
• Accruals
  • Accrued Expenses.
  • Accrued Revenues.

Prepaid Expenses

• Expenses paid before use/consumption, recorded as an asset.
  • Asset (prepaid expenses) increases (debit), cash decreases (credit).
• Expire with time or use.
• Adjusting entry: increase (debit) an expense account, decrease (credit) the prepaid asset account.

Deferred Revenues

• Cash received before providing goods/services.
• Recorded as a liability (deferred revenue) to recognize the performance obligation.
  • Cash increases (debit), deferred revenue increases (credit).
• Opposite of prepaid expenses.
• Adjusting entry: decrease the liability (deferred revenue), increase revenue account.

Accrued Expenses

• Expenses incurred but not yet recorded.
• Adjusting entries record obligations at the end of the period and recognize incurred expenses.
• Adjusting entry: increase (debit) to an expense account, increase (credit) to a liability (payable) account.

Accrued Revenues

• Revenues earned but not yet recorded.
• Adjustment needed to record the receivable and the earned revenue.
• Adjusting entry: increase (debit) to an asset account, increase (credit) to a revenue account.

Summary of Basic Relationships

• Prepayments
  • Prepaid expenses: Initial Entry: Dr. Prepaid Expenses, Cr. Cash. Adjusting Entry: Dr. Expenses, Cr. Prepaid Expenses.
  • Deferred revenues: Initial Entry: Dr. Cash, Cr. Deferred Revenue. Adjusting Entry: Dr. Deferred Revenue, Cr. Revenue.
• Accruals
  • Accrued expenses: Adjusting Entry: Dr. Expense, Cr. Payable.
  • Accrued revenues: Adjusting Entry: Dr. Receivable, Cr. Revenue.

Adjusted Trial Balance

• Prepared after posting all adjusting entries.
• Shows all account balances at period-end, including adjustments.
• Verifies debit balances equal credit balances after adjustments.
• Main source for preparing financial statements.

Financial Statements

• Prepared in the following order:
  1. Statement of income (revenue and expense accounts).
  2. Statement of changes in equity (equity accounts and net income/loss).
  3. Statement of financial position (asset, liability, and equity accounts).

Closing Entries

• Revenue, expense, and dividends declared accounts are temporary accounts that are components of retained earnings.
• Statement of financial position accounts are permanent accounts that carry forward.
• Closing entries:
  • Transfer temporary account balances to Retained Earnings.
  • Produce zero balances in temporary accounts for the next period.

Temporary and Permanent Accounts

• Temporary Accounts
  • All revenue accounts
  • All expense accounts
  • Dividends Declared
• Permanent Accounts
  • All asset accounts
  • All liability accounts
  • Shareholders' equity accounts

The Closing Process

1. Close all revenue accounts: Debit each revenue account for its balance and credit Income Summary for total revenue amount.
2. Close all expense accounts: Debit Income Summary for the total expense amount and credit each expense account for its balance.
3. Close Income Summary: Debit (or credit) Income Summary for the balance in the account and credit (debit) Retained Earnings.
4. Close Dividends Declared account: Debit Retained Earnings and credit Dividends Declared account for the balance.

Post-Closing Trial Balance

• Lists permanent accounts and their balances after closing entries.
• Verifies that debit balances equal credit balances.

Review of the Accounting Cycle

• Chapter 3
  • Analyze transactions.
  • Journalize the transactions.
  • Post to the ledger accounts.
  • Prepare a trial balance.
• Chapter 4
  • Journalize and post adjusting entries.
  • Prepare an adjusted trial balance.
  • Prepare financial statements.
  • Journalize and post closing entries.
  • Prepare a post-closing trial balance.

IFRS and ASPE Review