Accrual Accounting and Income

Accrual Accounting vs. Cash-Basis Accounting

Accrual accounting and cash-basis accounting are two fundamental methods for recording financial transactions. Understanding their differences is essential for accurate financial reporting.

• Accrual Accounting: Records both cash and noncash transactions. Noncash transactions include sales on account, purchases of inventory on account, accrual of expenses incurred but not yet paid, depreciation expense, usage of prepaid rent, insurance, and supplies, and earning of revenue when cash is collected in advance.

• Cash-Basis Accounting: Only records transactions when cash is received or paid. Examples include collecting cash from customers, paying salaries, rent, and other expenses, borrowing money, paying off loans, and issuing stock.

• Time-Period Concept: Ensures accounting information is reported at regular intervals, typically one year. Companies may use a calendar year or a fiscal year ending on a different date. Financial statements are also prepared for interim periods.

Revenue and Expense Recognition Principles

The revenue and expense recognition principles guide when and how much revenue and expense to record, ensuring accurate measurement of net income.

• Revenue Principle: Revenue is recognized when goods are delivered or services performed for an amount expected to be received. The amount recorded is the cash or its equivalent transferred.

• Expense Recognition Principle: Expenses are identified and measured in the same period as related revenues. This means subtracting expenses from related revenues to compute net income or net loss.

Adjusting the Accounts

Adjusting entries are necessary to ensure that all revenues and expenses are recorded in the correct period. These entries update account balances before financial statements are prepared.

• Deferrals: Adjustments for payment of an item or receipt of cash in advance (e.g., prepaid expenses).

• Depreciation: Allocates the cost of a plant asset to expense over its useful life.

• Accruals: The opposite of deferrals; record expenses or revenues that have been incurred or earned but not yet paid or received.

Prepaid Expenses

• Expenses paid in advance are assets, providing future benefit.

• Example: Prepaid rent of $3,000 for three months. At month-end, $1,000 is transferred from Prepaid Rent to Rent Expense.

• Example: Supplies purchased for $700; $400 remain at month-end, so $300 is recognized as Supplies Expense.

Depreciation of Plant Assets

• Plant assets are long-lived tangible assets (land, buildings, equipment).

• Depreciation spreads the cost of the asset over its useful life, except for land.

• Straight-Line Depreciation Formula:

• Example: Equipment cost $24,000, useful life 5 years. Annual depreciation = $4,800; monthly depreciation = $400.

• Accumulated Depreciation: Contra asset account showing the sum of all depreciation expense; normal credit balance.

Accrued Expenses

• Liabilities from expenses incurred but not yet paid.

• Example: Salary expense of $1,800/month, paid half on the 15th and half at month-end. If month-end payment is delayed, an adjusting entry is made for the unpaid portion.

Accrued Revenues

• Revenues earned but not yet collected.

• Example: Commission of $600 for booking clients; $300 earned in June, $300 in July.

Unearned Service Revenue

• Liability created when cash is received before revenue is earned.

• Example: Alladin Travel receives $400 in advance; earns part of it by booking clients during the month.

Summary of the Adjusting Process

Adjusting entries serve two purposes: measuring income and updating the balance sheet. Every adjusting entry affects both a revenue or expense account and an asset or liability account.

Income Tax Accrual

• Adjusting entry to accrue income tax expense and related income tax payable at period-end.

The Adjusted Trial Balance

The adjusted trial balance summarizes all accounts and their final balances after adjusting entries have been posted, serving as the basis for preparing financial statements.

Constructing Financial Statements

Financial statements are prepared from the adjusted trial balance:

• Income Statement: Lists revenue and expense accounts.

• Statement of Retained Earnings: Shows changes in retained earnings.

• Balance Sheet: Reports assets, liabilities, and stockholders’ equity.

Closing the Books

Closing entries reset temporary accounts (revenues, expenses, dividends) to zero, preparing accounts for the next period. Permanent accounts (assets, liabilities, stockholders’ equity) are not closed.

• Steps to close the books:

  • Debit each revenue for its credit balance; credit Retained Earnings for total revenues.

  • Credit each expense for its debit balance; debit Retained Earnings for total expenses.

  • Credit Dividends for its debit balance; debit Retained Earnings for the same amount.

Classifying Assets and Liabilities

Assets and liabilities are classified as current or long-term based on liquidity, which measures how quickly an item can be converted to cash.

• Current Assets: Most liquid; converted to cash, sold, or consumed within one year or operating cycle. Examples: Cash, Short-term Investments, Accounts Receivable, Prepaid Expenses.

• Long-Term Assets: Not current; include plant assets such as Land, Buildings, Furniture, Equipment.

• Current Liabilities: Debts payable within one year or operating cycle. Examples: Accounts Payable, Notes Payable (due within one year), Salary Payable, Unearned Revenue, Interest Payable, Income Tax Payable.

• Long-Term Liabilities: Debts not payable within one year. Many Note Payables are long-term.

Analyzing and Evaluating Debt-Paying Ability

Two key ratios are used to assess a company’s ability to pay its debts:

• Current Ratio: Measures operating liquidity. Companies prefer a high current ratio.

• Debt Ratio: Measures the proportion of assets financed with debt. A low debt ratio is safer.

• Working Capital (Net Working Capital):

Additional info: Data visualization and chart types are mentioned as learning objectives but not covered in detail in the provided notes. For academic completeness, common chart types in accounting include bar charts (for comparing account balances) and pie charts (for showing proportions of expenses or revenues).