April 25, 2016

Accrual Accounting and Financial Statements - Review Notes

Review of chapter of Horngren (Introduction to Financial Accounting)

The first objective in this article  is to understand the types of adjustments typically made to the accounts, and why those adjustments need to be made.

Accrual Accounting

A simple definition of accrual accounting is:  "record all revenues in the period we earn them; record all expenses in the period we incur them."  It can also be explained as recording a business transaction as it happens without waiting for the cash payment or receipt.  For revenues, the basic approach is to determine when the revenue was earned. If  a service is performed, the revenue is accounted as earned during the period.

Expenses work in a similar way.  If an advertisement is run in the newspaper in a  month, the accounting transaction is entered in the journal, even though cash payment is done by the firm after two months,. The incurrence of the expense is recognized, rather than the timing of the cash payment.

Facts about Adjustments

Every adjustment affects one income statement account and one balance sheet account.  The income statement account will be a revenue or an expense.

Adjustments are only done at the end of an accounting period.  We will assume that the entire accounting cycle takes place in one month's time.  Therefore, the adjustments would be recorded at the end of each month.

The accountant has to  use good judgment in deciding if an adjustment is necessary.

Accrual accounting requires that adjustments be made to properly reflect periodic revenues and expenses.

There are two principles of accounting that are satisfied by the adjusting process. First, we want to make sure we record all revenues that were earned this period. This is called the revenue recognition principle. The revenue recognition principle says that "we must record all revenues in the period they were earned, regardless of whether the cash has been received."

Second, we want to match all expenses that we incurred this period to the revenues earned this period. This is called the matching principle. Some expenses such as rent expense involve paying cash for the expense. However, using up supplies is also an expense, one in which an asset other than cash is being consumed. Similarly, using up insurance and equipment are considered expenses in the adjusting process.

As the revenues and expenses come together on the income statement, these two principles are the foundation for computing net income according to accrual accounting rules.

Adjusting entries, unearned/accrued, revenue/expense
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Adjusting the accounts - Review notes


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Financial, Cost and Management Accounting - Review Notes List

Updated 25 Apr 2016, 12 March 2016, 8 Dec 2011

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