Lecture 2 - Accrual Accounting

Accrual Accounting

It would be nice if we could just take the balances from the Trial Balance and transfer them to the financial statements. Unfortunately, it's not so simple. There are some prepaid/unpaid expenses and

We need to make adjustments for these issues before we close out the books for the accounting period.

Assumption: Investors are primarily concerned with income. Therefore the income statement is much more important and exact than the balance sheet. Ex: the balance sheet assumes the value of an asset (real estate) at purchase price, even though it may have increased in value since the purchase. However, the income statement is very precise and must only contain income that actually pertains to the reporting period.

Going Concern Assumption: The business will continue to exist into the indefinite future.

Conventions of periodic reporting and revenue recognition: report revenues in the year in which they are "earned".

Revenues for goods are generally recognized at the date of sale. Service revenues are usually recognized when the service is performed and they are billable. (There are more details and exceptions for specific goods and services.)

Expenses are recognized in the same period as the revenues to which they relate are recognized. Again, there are details and exceptions for some expenses, such as R&D which is expensed as incurred.

So now the expanded accounting cycle is:
...
Trial Balance
Adjustments
Adjusted Trial Balance
...

Adjusting Entries

Adjusting entries adjust transactions between the balance sheet (assets, liabilities) and the income statement (revenues, expenses). There are 4 possible combinations.

Revenue Earned but Not Recorded (Revenue, Asset)
Ex: Accrued interest that hasn't been paid yet. Debit the Interest Receivable account (asset) and credit the Interest Revenue account (revenue).

Expenses Incurred but Not Recorded (Expense, Liability)
Ex: Utility expenses are incurred this period but the bill may not be received until next period.
Debit the Utilities Expense (expense) account and credit the Utilities Payable account (liability).

Expenses Recorded but Not Incurred (Expense, Asset)
Ex: Prepaid rent or insurance.
Original prepayment is recorded as a debit to prepaid rent account (expense) and credit to cash.
Adjustment is made by debiting rent expense account and crediting prepaid expense

Depreciation of a special case. It's usually impossible to match the expense of the machine to the revenue that it generates. Rather, we depreciate it over time. This is analogous to a prepaid expense.

The original purchase of the asset is recorded by debiting the depreciable asset account and crediting cash.
Then the depreciation adjustment is made by debiting the depreciation expense account and crediting the accumulated depreciation account. The accumulated depreciation is a special "contra" asset account. It is unusual among asset accounts in that it has a credit balance.

Revenues Recorded but Not Earned (Revenue, Liability)
Ex: Revenues received for prepaid magazine subscriptions.
The original transaction is recorded as a debit to cash (asset) and a credit to unearned revenue (liability).
The adjustment is a debit to unearned revenue (liability) and a credit to a revenue account (revenue).