Accrual accounting recognizes revenue when it is earned and expenses when they are incurred, regardless of when cash is exchanged. This follows the matching concept:
Revenue ⇒ when earned
Expenses ⇒ when incurred
Cash basis accounting recognizes revenue when cash is received and expenses when cash is paid.
Revenue ⇒ when cash received
Expenses ⇒ when cash paid
Going forward in this course, we will use accrual basis accounting.
Accrual Accounting (GAAP)
GAAP requires accrual-basis accounting: record events/transactions when they occur, even if no cash changes hands at that moment.
Focus is on the timing of events, not the timing of cash flows.
Recording an event is called RECOGNITION.
Collecting or paying the related cash is called REALIZATION.
These can occur at the same time, but often they do not.
Relationship: Revenue is recognized at the point of earning; cash collection may occur later.
Accruals & Deferrals
An “event” is always either a Revenue event or an Expense event, and is based on when cash moves.
Accruals reflect revenues earned or expenses incurred before cash is exchanged (cash not yet moved).
Deferrals reflect cash exchanged before revenue is earned or expenses are incurred (cash moved early; recognition delayed).
The Accounting Cycle: Overview (LO 2-4)
Step 1: Record transactions as they occur (Journal Entries).
Step 2: Adjust accounts at period end (Adjusting Entries).
Step 3: Prepare financial statements.
Step 4: Close temporary accounts (Closing Entries).
These steps form the full accounting cycle.
Accounts Receivable vs. Accounts Payable
If I purchase something “on account,” I pay later but have something today.
If I sell something “on account,” I receive cash later but have made a sale today.
Receivable mirrors Payable: RECEIVABLE ↔ PAYABLE in the accounting records.
Other receivables exist but are less common; many payables appear throughout the semester:
Note Payable = money owed to a creditor (usually a bank)
Salaries Payable = money owed to employees
Taxes Payable = money owed to the government
etc.
All PAYABLES are liabilities.
LO 2-1: Receivables and Financial Statements (accruals)
Receivables represent the amount of cash the company expects to collect in the future.
Type: Asset.
Also referred to as accrued revenue when earned but not yet collected.
Impact on financial statements:
Balance Sheet: Increase in Assets (Accounts Receivable)
Income Statement: Revenue recognized when earned (even if cash not yet collected)
Statement of Cash Flows: Cash collections recorded when cash is received, not when revenue is earned
LO 2-2: Payables and Financial Statements (accruals)
Payables represent the amount of cash the company is expected to pay in the future.
Type: Liability.
Impact on financial statements:
Income Statement: Expenses recognized when incurred (even if cash not yet paid)
Balance Sheet: Increase in Liabilities (Accounts Payable) and corresponding asset usage or expense recognition
Statement of Cash Flows: Cash outflows occur when cash is paid
Accrued Expenses
Expense definition: a decrease in assets or an increase in liabilities arising from efforts to produce revenue.
Practical meaning: all costs to run the business (wages, utilities, insurance, rent, etc.) must be recorded as expenses in the period incurred, regardless of whether cash is paid in that period.
Event-Based Illustrations (Events 1–7)
Event 1: Cato Consultants started January 1 Year 1 by issuing common stock for $5,000 cash.
Journal impact: Debit Cash $5,000; Credit Common Stock $5,000.
Effect: Increases assets; increases equity.
Event 2: During Year 1, provided $84,000 of consulting services but collected no cash yet.
Concept: Income (revenue) recognized once service obligation has been fulfilled.
Event 7: Signed contracts for $42,000 of consulting services to be performed in Year 2 (revenue recognized for work actually completed, not contract value).
Effect: Revenue is not recognized yet; no impact on Year 1 financial statements for this contract.
LO 2-5 to LO 2-7: Deferrals and Related Concepts
Deferrals occur when cash is exchanged before revenue/expense is recognized.
Example category: Prepaids (Prepaid Items) and Unearned Revenues (Deferred Revenue).
Prepaid Items (LO 2-6)
Definition: Prepaid items are assets representing expenditures paid in advance for future benefit. An expenditure is not the same as an expense.
Key distinction:
Expenditure = cash outlay
Expense = use of an asset
If you receive something of value in return later, the initial cash outlay is likely a prepaid asset, not an expense yet.
The asset is used over time; end-of-period adjustment would recognize Rent Expense for the portion used and reduce Prepaid Rent accordingly.
Relationship Between Costs, Assets and Expenses
Prepaid items are assets on the balance sheet.
They represent deferred expenses: cash moves before the related expense is incurred.
As you use prepaid assets, you reduce the asset balance and record the corresponding expense.
Important nuance: An expenditure is not always an expense.
Deferred Revenue (Unearned Revenue) (LO 2-7)
Definition: Cash received before revenue is earned creates a liability called Unearned Revenue.
Upon earning the revenue, you reduce Unearned Revenue and increase Service Revenue.
Why it happens: cash is received upfront; the service/good has not yet been delivered at receipt time.
Encoder caution: Unearned Revenue is not revenue and should not be included in the Income Statement until earned.
Mirror image concept: Prepaid Assets on one side correspond to Unearned Revenue on the other side; reflects the entity concept.
Deferrals: Unearned Revenue Example (Event 4 and Adjustment)
Event 4: Cato receives $18,000 cash in advance from Westberry Company for consulting services to be performed over a one-year period beginning June 1 Year 2.
Year-End Adjustment for Unearned Revenue (Adjustment 3): Recognize the portion earned during the accounting period.
If services began June 1 and 7 months were performed by year-end, the earned portion = $18,000 × 7/12 = $10,500.
Journal impact: Debit Unearned Revenue $10,500; Credit Service Revenue $10,500.
Remember: Unearned Revenue is NOT Revenue (yet) and should not be included as Revenue on the Income Statement until earned.
Mirror Image & Entity Concept
For every T-account, the mirror side exists: Prepaid Assets on our books correspond to Unearned Revenue on the other side of the transaction in the other party’s records.
This aligns with the Entity Concept (the business is a separate entity from its owners).
The Accounting Cycle Takeaways (Chapter 2 Takeaways)
Through accruals and deferrals, we record events WHEN they HAPPEN, which may not be WHEN cash changes hands.
On-account transactions imply no immediate cash involvement:
Purchasing on account ⇒ Increase Accounts Payable.
Selling on account ⇒ Increase Accounts Receivable.
Collecting cash from customers (Accounts Receivable) is not a sales event; revenue was recognized earlier when the sale occurred.
Accounts Receivable exists because revenue was recorded at the time of the sales event.
When cash is received, reflect the receipt by increasing Cash and decreasing Accounts Receivable.
The Accounting Cycle: Steps and Visual Summary
Step 1: Record transactions as they occur (Journal Entries).
Step 2: Adjust accounts (Adjusting Entries).
Step 3: Prepare financial statements.
Step 4: Close temporary accounts (Closing Entries).
Visual reminder of the cycle: 01 Record transactions → 02 Adjust accounts → 03 Prepare statements → 04 Close temporary accounts.
Adjusting Entries & the Matching Concept
Objective: Accrual accounting improves the matching of expenses with revenues.
Cash flows may not align with revenue recognition or expense incurrence; adjusting entries fix this.
Adjusting entries update revenues and expenses for the period.
Period costs are expenses that are recognized in the period they pertain to.
Important rule: An adjusting entry will NEVER involve cash as one of the accounts.
Common Adjusting Entries (Examples)
Recognize Rent or Insurance used during the period.
Recognize Supplies used.
Recognize other expenses incurred but not yet paid (utilities, salaries).
Recognize revenue earned that wasn’t tied to a specific event.
Dates and Timing Considerations
Don’t lose easy points: If an event happens on the 1st of the month, there’s still a full month left to recognize timing effects.
Preparing Financial Statements with Accruals
Step 3: Prepare financial statements that include accruals.
The Accounting Cycle (Exhibit 2.4) emphasizes the sequence: Record → Adjust → Prepare statements → Close.
The Income Statement and the Matching Concept
The Income Statement is based on the matching concept: revenues matched with the costs (expenses) incurred to generate them.
Rules for accrual accounting in the Income Statement:
Revenue recognized when earned.
Expenses recognized when incurred, not necessarily when cash is paid.
Example for Year 1 (Cato):
Revenue: Consulting revenue for all services performed in Year 1 (84,000). Even if cash isn’t received by year-end.
Expenses include all costs incurred to produce revenue, whether paid or not by year-end (e.g., Salaries: 16,000 total in Year 1 from 10,000 paid and 6,000 accrued).
Balance Sheet: Assets, Liabilities, and Stockholders’ Equity (A = L + OE)
The Balance Sheet discloses assets, liabilities, and stockholders’ equity at a point in time.
Example: Cato Consultants balance sheet at Year 1 end shows:
Total assets: 77{,}000
Liabilities: 6{,}000
Stockholders’ Equity: 71{,}000
Accounting equation representation: A = L + OE
Statement of Changes in Stockholders’ Equity & the Income Statement
Statement of Changes in Stockholders’ Equity shows how equity changes during the period due to issuing stock, net income, and dividends.
Net income flows from the Income Statement to the Statement of Changes in Stockholders’ Equity.
Statement of Cash Flows and Cash Flow Timing
In Year 1, beginning cash = 0; ending cash = 53,000.
The Statement of Cash Flows explains the change in cash:
Cash collections from customers: +60,000
Cash payments for expenses: -12,000
Cash received from issuing common stock: +5,000
Net change: +53,000; Ending cash: 53,000.
Note: Cash receipts are not always revenue, due to accrual accounting.
The Closing Process (Temporary vs Permanent Accounts)
Purpose: Transfer net income (or loss) and dividends to Retained Earnings and reset temporary accounts to zero for the next period.