Accrual Accounting and the Accounting Cycle: Chapter 3 Study Guide

Accrual Accounting and Income

Accrual vs. Cash-Basis Accounting

Accrual accounting records revenues and expenses when they are earned or incurred, regardless of when cash is exchanged. Cash-basis accounting records revenues and expenses only when cash is received or paid. Accrual accounting is required under GAAP and provides a more accurate picture of a company's financial performance.

• Accrual Basis: Revenues recognized when earned; expenses recognized when incurred.

• Cash Basis: Revenues and expenses recognized only when cash changes hands.

• Research: Accrual basis results in "smooth" earnings and better predicts future cash flows.

• GAAP: Public companies must use accrual basis; private companies may use either, but banks often require accrual statements.

Revenue Recognition Principle

The revenue recognition principle determines when and how much revenue to record. Revenue is recognized when it is earned, i.e., when goods are transferred or services are performed, not necessarily when cash is received.

• Revenue: Increase in net assets from operations.

• Gain: Increase in net assets from peripheral transactions.

• Net Assets: $\text{Net Assets} = \text{Assets} - \text{Liabilities}$

• Timing: Recognize revenue when earned.

• Measurement: Recognize cash received or realizable cash equivalent.

Timing of Revenue	Journal Entries
Before Cash Received (Accrual)	1. Increase Receivable & Revenue 2. Increase Cash & Decrease Receivable
Same Time as Cash Received	1. Increase Cash & Revenue
After Cash Received (Deferral)	1. Increase Cash & Liability 2. Decrease Liability & Increase Revenue

Expense Recognition (Matching Principle)

The matching principle requires that expenses be recognized in the same period as the related revenues. Expenses are decreases in net assets from operations, while losses are decreases from peripheral transactions.

• Direct Matching: Match expenses with revenues in the same period (e.g., Cost of Goods Sold).

• Indirect Matching: Match expenses with a period (e.g., depreciation, salaries, utilities).

• Measurement: Cash paid or cash equivalent of future payments.

Timing of Expense	Journal Entries
Before Cash Paid (Accrual)	1. Increase Expense & Liability 2. Decrease Liability & Cash
Same Time as Cash Paid	Increase Expense & Decrease Cash
After Cash Paid (Deferral)	1. Increase Prepaid Asset & Decrease Cash 2. Increase Expense & Decrease Prepaid Asset

The Accounting Cycle

12 Steps of the Accounting Cycle

The accounting cycle is a systematic process for recording and reporting financial transactions. It ensures that financial statements are prepared accurately and consistently.

1. Analyze transactions

2. Record journal entries

3. Post to ledger

4. Prepare unadjusted trial balance

5. End of period (artificial time period)

6. Record adjusting journal entries (AJE)

7. Post to ledger

8. Prepare adjusted trial balance

9. Prepare financial statements

10. Record closing journal entries (CJE)

11. Post to ledger

12. Prepare post-closing trial balance

End of Period and Adjusting Entries

Adjusting entries are made at the end of the period to update accounts for accruals and deferrals, ensuring compliance with the revenue and matching principles.

• Going Concern Assumption: Firm will continue indefinitely.

• Periodicity Assumption: Life of firm divided into artificial periods.

• Rules: No cash in adjusting entry; always affects at least one real and one nominal account.

Types of Adjusting Entries

• Accruals: Revenue/expense recognized before cash changes hands.

• Deferrals: Cash changes hands before revenue/expense is recognized.

Type	End of Period Entry	AJE
Accrued Revenue	Receivable	Revenue
Accrued Expense	Expense	Payable
Deferred Revenue	Unearned Revenue	Revenue
Deferred Expense	Expense	Prepaid Expense

Estimated Items: Depreciation and Bad Debts

Some adjusting entries involve estimates, such as depreciation and bad debts. Depreciation allocates the cost of a fixed asset over its useful life.

• Straight-Line Depreciation Formula:

$\text{Depreciation Expense} = \frac{\text{Historical Cost} - \text{Estimated Salvage Value}}{\text{Estimated Useful Life}}$

• Example: Truck cost $19,000, salvage value $2,000, useful life 4 years. Annual depreciation:$\frac{19,000 - 2,000}{4} = 4,250$ per year.

• Partial year: Multiply by fraction of year used.

Financial Statement Preparation

Adjusted Trial Balance

The adjusted trial balance lists all accounts and their balances after adjusting entries. It ensures that debits equal credits and is used to prepare financial statements.

Order of Financial Statements

• Income Statement (or Statement of Comprehensive Income)

• Retained Earnings Statement (or Statement of Changes in Equity)

• Balance Sheet

• Statement of Cash Flows

Sample Financial Statements

Below are sample formats for the main financial statements:

Income Statement	Retained Earnings Statement	Balance Sheet
Revenues - Cost of Goods Sold = Gross Profit - Operating Expenses = Net Income	Beginning Retained Earnings + Net Income - Dividends Declared = Ending Retained Earnings	Assets = Liabilities + Equity Assets: Current Assets, Long-term Investments, PPE, Intangibles Liabilities: Current Liabilities, Long-term Liabilities Equity: Common Stock, Retained Earnings

Classified Balance Sheet

A classified balance sheet separates assets and liabilities into current and long-term categories.

• Current Assets: Cash, short-term investments, accounts receivable, inventory, prepaid expenses.

• Long-term Investments: Investments in stocks/bonds, real estate, life insurance.

• Property, Plant & Equipment: Land, buildings, equipment, furniture, vehicles, accumulated depreciation.

• Intangible Assets: Patents, copyrights, trademarks, goodwill.

• Current Liabilities: Accounts payable, wages payable, unearned revenues, notes payable.

• Long-term Liabilities: Notes payable, bonds payable.

• Stockholders' Equity: Common stock, APIC, retained earnings.

Closing the Books

Closing Journal Entries (CJE)

Closing entries reset all nominal (temporary) accounts to zero at the end of the period, transferring their balances to retained earnings.

• Nominal Accounts: Revenues, gains, expenses, losses, dividends declared.

• Purpose: Prepare accounts for the next period; ensure only real accounts carry forward.

• Process:

  1. Close all revenue/gain accounts to Retained Earnings.

  2. Close all expense/loss accounts to Retained Earnings (except Dividends).

  3. Close Dividends Declared to Retained Earnings.

Post-Closing Trial Balance

The post-closing trial balance contains only real accounts (assets, liabilities, equity) to ensure debits equal credits after closing entries.

Examples and Applications

Journal Entry Examples

• Sale for Cash: Debit Cash, Credit Sales Revenue; Debit Cost of Goods Sold, Credit Inventory.

• Sale on Account: Debit Accounts Receivable, Credit Sales Revenue; Debit Cost of Goods Sold, Credit Inventory.

• Paying Utilities: Debit Utilities Expense, Credit Cash.

• Renting Truck on Account: Debit Rent Expense, Credit Accounts Payable.

• Receiving Cash from Customers: Debit Cash, Credit Accounts Receivable.

• Paying Wages: Debit Wages Expense, Credit Cash.

• Mixed Sale (Cash and Account): Debit Cash and Accounts Receivable, Credit Sales Revenue; Debit Cost of Goods Sold, Credit Inventory.

Accrual vs. Cash Basis Calculations

• Accrual Net Income: $\text{Net Income} = \text{Total Revenues} - \text{COGS} - \text{Other Expenses}$

• Cash from Operations: $\text{Cash from Operations} = \text{Cash Sales} + \text{Cash Received} - \text{Cash Paid for Inventory} - \text{Cash Paid for Expenses}$

Adjusting Entries and Trial Balance

• Supplies Adjustment: Debit Supplies Expense, Credit Supplies for amount used.

• Salaries Adjustment: Debit Salaries Expense, Credit Salaries Payable for accrued salaries.

• Prepaid Rent Adjustment: Debit Rent Expense, Credit Prepaid Rent for rent used.

• Unearned Revenue Adjustment: Debit Unearned Revenue, Credit Revenue for amount earned.

• Interest Payable Adjustment: Debit Interest Expense, Credit Interest Payable for accrued interest.

Depreciation Example

• Acquisition: Debit Equipment, Credit Cash.

• Depreciation: Debit Depreciation Expense, Credit Accumulated Depreciation.

• Balance Sheet Presentation: Equipment less Accumulated Depreciation equals Book Value.

Summary Table: Accruals vs. Deferrals

Type	When Recognized	Example
Accrued Revenue	Before cash received	Interest earned but not yet received
Accrued Expense	Before cash paid	Salaries earned but not yet paid
Deferred Revenue	After cash received	Unearned rent received in advance
Deferred Expense	After cash paid	Prepaid insurance

Additional info: All examples and tables are expanded for clarity and completeness. Formulas are provided in LaTeX for exam preparation. The notes cover all key aspects of accrual accounting, adjusting entries, and the accounting cycle as required for financial accounting students.