Accrual Basis of Accounting Study Notes

Chapter 3 - Accrual Basis of Accounting

Introduction to Chapter 3

  • The chapter focuses on the accrual basis of accounting, which is essential for accurate financial reporting.
  • Major sections covered:
    • Explanation of the accrual basis of accounting.
    • The adjusting process for financial statements.
    • Types of adjusting entries.
    • Preparation of financial statements.
    • The closing process and overview of the accounting cycle.

Learning Objectives

  1. Explain the accrual basis of accounting.
  2. Describe the adjusting process and illustrate the four major types of adjusting entries.
  3. Prepare financial statements.
  4. Describe the closing process and summarize the accounting cycle.

Accrual Basis of Accounting

  • Definition: Accrual-based accounting recognizes assets, liabilities, revenue, and expenses when the transaction occurs, not when cash is exchanged.
  • Contrast with Cash Accounting: Only records transactions upon actual cash flow.
  • Acceptability: Accrual accounting is approved by Generally Accepted Accounting Principles (GAAP).

Components of Accrual Accounting

Recognition Principles
  1. Revenue Recognition Principle: Revenue is recognized when goods or services are provided, not necessarily when cash is received.
  2. Expense Recognition Principle (Matching Principle): Expenses are recognized when incurred to earn revenues in the same period.
    • Example of Costs for Falcon Pizza:
      • Dough, Sauce, Cheese, Toppings, Pizza box, Delivery, Employee wages, Kitchen equipment costs, Insurance, Taxes.
Five Major Steps in the Accounting Cycle
  1. Analyze transactions.
  2. Record transactions.
  3. Adjust accounts (main focus of Chapter 3).
  4. Prepare financial statements.
  5. Close temporary accounts.

Adjusting Process

  • Adjustments are crucial for recognizing revenues and matching expenses with the revenues generated in the correct accounting period.
Types of Adjusting Entries
  1. Deferrals: Cash is received or paid before recognizing revenue or expenses.
    • Example: Prepaid insurance, where cash payment is said prior to recognizing insurance expense.
  2. Accruals: Revenue or expense is recognized before cash is exchanged.
    • Example: Recognizing accrued salaries that have not yet been paid.
Adjusting Transactions Steps
  • Step 1: Analyze transactions.
  • Step 2: Record initial transactions.
  • Step 3: Adjust accounts to reflect accurate revenues and expenses.
  • Step 4: Prepare financial statements post-adjustment.
  • Step 5: Close out temporary accounts.

Cash not part of Adjustments

  • It is important to recognize that cash does not form part of adjusting entries; transactions involving cash occur either before or after the adjusting entries.

Accounting Adjustments Examples

  • Deferred Revenues:
    • Unearned revenue, such as gift cards and subscription services that have yet to be delivered.
  • Deferred Expenses:
    • Prepaid rent, prepaid insurance.
  • Accrued Expenses:
    • Expenses that are incurred but not yet paid, such as salaries payable and interest payable.
  • Accrued Revenues:
    • Revenues that have been earned but not yet billed, such as accounts receivable.

Recording Revenues and Expenses

Revenue Recognition
  • Revenue must be recognized when the company fulfills its obligation to deliver goods or services, not merely when payment is received.
  • Balance Sheet Example (Cash vs. Earned Revenue):
    • Before product/service provided: Cash increases, Unearned Revenue increases.
    • After product/service provided: Unearned Revenue decreases, Retained Earnings increase due to recognized Revenue.
Expense Recognition (Matching) Principle
  • A company must recognize expenses using the cash payments or when expenses are incurred to generate revenue, not when cash is disbursed.
  • Example:
    • Supplies are purchased but expense is only recognized when the supplies are utilized.
Adjusting Entry Examples
  1. Utilities Payable: If utilities incurred but not paid, entries must be adjusted for recognition.
  2. Accrued Salaries: If salaries are owed but not yet paid, they must be recorded.
  3. Deferred Revenue: When payment is received in advance for a service not yet rendered.

Preparing Financial Statements

  • Financial statements are prepared after completing the adjusting entries.
  • The main financial statements include:
    • Income Statement
    • Balance Sheet
    • Statement of Cash Flows
    • Statement of Stockholders' Equity

Closing Process

  • The closing process transfers the balances from temporary accounts to Retained Earnings, effectively resetting their balances for the new accounting period.
  • Steps:
    • Calculate Net Income.
    • Record Dividends paid, which do not affect net income but do affect retained earnings.

Conclusion

  • Accrual accounting is essential for companies to produce accurate financial statements. It ensures that financial positions reflect transactions in the period they occur rather than when the cash is exchanged, thereby delivering a more accurate representation of a company's financial health.