Accrual Accounting and Income: Study Notes

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Accrual Accounting and Income

Accrual vs. Cash-Basis Accounting

Accounting systems record business transactions and measure financial performance. The two main methods are accrual accounting and cash-basis accounting.

Accrual Accounting: Records transactions when they occur, regardless of when cash is exchanged. Required by U.S. GAAP. Revenue is recognized when earned; expenses are recognized when incurred. Used by all but the smallest businesses. Provides a complete financial picture.
Cash-Basis Accounting: Records only cash receipts and payments. Not accepted by GAAP. Ignores important non-cash information, resulting in incomplete statements. Used only by very small businesses. Simpler but limited.
Time-Period Concept: Accounting information is reported at regular intervals, typically annually, but also quarterly or monthly.

Revenue & Expense Recognition Principles

Accrual accounting relies on principles that determine when revenues and expenses are recorded.

Revenue Principle: Revenue is recorded when it is earned (goods delivered or services performed), and the amount is measurable. The company must give up an economic resource to earn revenue.
Expense Recognition (Matching Principle): Expenses are costs required to generate revenue. Once the benefit is used or consumed, it becomes an expense. Expenses are matched to the same period as the revenues they helped generate.
Net Income Formula:

Matching Principle: Recognize expenses in the same period as the revenues they helped generate. This is the foundation of accrual accounting and drives all adjusting entries.

Adjusting Entries — Overview

Adjusting entries are made at the end of the accounting period to ensure that revenues and expenses are recorded in the correct period. They always affect one income statement account and one balance sheet account, and never affect cash.

Deferrals: Cash is paid or received before the revenue or expense is recognized.
Prepaid Expenses: Cash paid first; recorded as an asset and converted to expense as benefit is used.
Depreciation: Spread the cost of a long-term asset over its useful life using a contra account (Accumulated Depreciation).
Accruals: Revenue or expense is recognized before cash is exchanged.
Unearned Revenue: Cash received first; recorded as a liability and converted to revenue as earned.
Accrued Expenses: Expense recognized before cash is paid; creates a liability.
Accrued Revenues: Revenue recognized before cash is received; creates an asset.

Deferrals & Depreciation

Prepaid Expenses (Deferred Expenses): Example: Rent paid in advance. Initial entry: Dr Prepaid Rent / Cr Cash. Adjusting entry: Dr Rent Expense / Cr Prepaid Rent. Asset is reduced; expense is recognized.
Depreciation (Special Deferred Expense): Straight-line method: Example: years = or . Journal entry: Dr Depreciation Expense / Cr Accumulated Depreciation. Book value:
Contra Account: Accumulated Depreciation allows analysts to see both the original cost and how much has been used.

Accruals & Unearned Revenue

Unearned Revenue (Deferred Revenue): Cash received first; recorded as a liability. Adjusting entry converts liability to revenue. Example: Alladin collects $400, earns $200 by period end; adjust half.
Accrued Expenses: Expense recognized before cash is paid. Adjusting entry: Dr Salary Expense / Cr Salary Payable. Cash paid later settles the liability.
Accrued Revenues: Revenue recognized before cash is received. Adjusting entry: Dr Accounts Receivable / Cr Commission Revenue. Cash collected later settles the asset.
Key: Every adjusting entry touches Revenue or Expense and Asset or Liability. Cash is never affected by adjusting entries.

Adjusting Entry Summary Table

Type	Cash Timing	Initial Entry	Adjusting Entry	Account Affected
Prepaid Expense	Cash paid first	Asset ↑	Expense ↑, Asset ↓	Expense, Asset
Depreciation	Cash paid first	Asset ↑	Expense ↑, Contra Asset ↑	Expense, Contra Asset
Unearned Revenue	Cash received first	Liability ↑	Revenue ↑, Liability ↓	Revenue, Liability
Accrued Expense	Cash paid later	None	Expense ↑, Liability ↑	Expense, Liability
Accrued Revenue	Cash received later	None	Asset ↑, Revenue ↑	Asset, Revenue

Financial Statements & Closing the Books

Financial statements are prepared from the adjusted trial balance in a specific order. Closing the books ensures that temporary accounts are reset for the next period.

Order of Statements:
1. Income Statement: Reports revenues and expenses for a period.
2. Statement of Retained Earnings: Shows changes in retained earnings for a period.
3. Balance Sheet: Reports assets, liabilities, and equity as of a date.
Income Statement Formats: Single-step (simple, less detail) vs. Multi-step (preferred, separates operating from non-operating items).
Closing the Books:
1. Close Revenues: Debit each revenue, credit Retained Earnings.
2. Close Expenses: Credit each expense, debit Retained Earnings.
3. Close Dividends: Credit Dividends, debit Retained Earnings.
Temporary Accounts: Revenues, Expenses, Dividends (closed each period).
Permanent Accounts: Assets, Liabilities, Stockholders' Equity (never closed).

Analyzing Debt-Paying Ability

Financial ratios help assess a company's ability to pay its debts and manage liquidity.

Net Working Capital: Measures operating liquidity; should be positive.
Current Ratio: Measures short-term liquidity; higher is better (1.0–2.0+ is typical).
Debt Ratio: Measures proportion of assets financed by debt; lower is safer.

Data Visualization & Key Formulas Reference

Data visualization tools help interpret financial data. Key formulas are essential for financial analysis.

Bar/Column Chart: Compares categorical data across groups (e.g., revenue by quarter).
Line Chart: Shows data trends over time (e.g., stock price).
Graph vs. Chart: Graphs show mathematical relationships; charts display various data types.

Key Formulas

Net Income:
Book Value:
Straight-Line Depreciation:
Net Working Capital:
Current Ratio:
Debt Ratio: