Financial Accounting: Accrual Accounting Notes
Chapter 3: Accrual Accounting
Learning Objectives
Understand cash-basis vs. accrual-basis accounting.
Learn about the time-period assumption, revenue recognition principle, and expense recognition principle.
Identify transactions requiring end-of-period adjustments.
Prepare adjusting entries for accruals and deferrals.
Create financial statements from adjusted trial balance.
Explain closing entries and the accounting cycle steps.
Utilize a worksheet for financial statement preparation.
Completing the Accounting Cycle (Learning Objective 3.1)
Numerous adjustments are made at the end of accounting periods due to ongoing business activities.
Accrual accounting ensures incomplete transactions are recognized in financial statements.
Requires estimates about timing of revenue/expense recognition.
Accrual vs. Cash Basis Accounting
Cash-basis accounting: Records revenue when cash is received; recognizes expenses when cash is paid.
Accrual-basis accounting: Records revenue when earned (not necessarily received); expenses matched to revenue period (not necessarily paid).
Required by GAAP.
Offers a better reflection of income linked to overall company activities.
Proceeds from the sale of goods/services recognize revenues as delivered.
Key Elements of Accrual Accounting (Learning Objective 3.2)
Time-Period Assumption: Divides the life of a company into artificial time periods for income measurement.
Revenue Recognition Principle: Revenue is recorded in the period earned, with reasonable assurance of cash collection.
Expense Recognition Principle: Expenses are recorded in the same period as the revenues they generate.
Adjusting Entries (Learning Objective 3.3)
Adjusting entries: Journal entries made at the end of periods to update accounts affected by partially completed transactions.
Necessary for accurate representation of revenues, expenses, assets, and liabilities.
Types of Adjustments
Accruals:
Accrued revenues: Revenues earned but cash not yet received.
Accrued expenses: Expenses incurred but cash not yet paid.
Deferrals:
Deferred revenues: Cash received before products/services delivered; recorded as liabilities until earned.
Deferred expenses: Costs paid but not incurred; recognized as expenses when used.
Steps for Making Adjusting Journal Entries
Identify income statement and balance sheet accounts needing adjustment.
Determine the amount to adjust based on earned revenue or incurred expenses.
Record the adjusting journal entry.
Recording Accrued and Deferred Entries
Example of accrued revenues: Rent earned by providing space with payment received later; adjusting required for income.
Example of accrued expenses: Salaries earned by employees without immediate payment; required adjustment needed to recognize expenses.
Depreciation Accounting
Depreciation: Allocates the cost of tangible assets over their useful lives.
Adjusting entries needed to record depreciation expenses that impact net income and asset values.
The Closing Process (Learning Objective 3.6)
Temporary accounts (revenues, expenses) reset to zero to begin the new accounting period; balances transferred to Retained Earnings.
Steps in the closing process:
Close revenues to Retained Earnings.
Close expenses to Retained Earnings.
Close dividends declared to Retained Earnings.
Summary of the Accounting Cycle (Learning Objective 3.7)
Important steps include preparing adjusted trial balances and financial statements in a specific order.
Worksheet: Facilitates organization of financial statement preparations and accounting cycle endings.
Cash-basis vs. Accrual-basis Summary
Cash-basis: Revenues/expenses are recorded with cash flow timing.
Accrual-basis: Revenues/expenses recorded when earned/incurred, providing a more accurate financial picture.