Accrual vs Cash Basis Accounting, Revenue & Expense Recognition Principles, Adjusting Journal Entries, Closing Journal Entries, Evaluating Debt-Paying Ability
Accrual Accounting vs Cash-Basis Accounting
What is Cash-Basis Accounting?
When using cash-basis accounting, we only record business transactions involving the receipt or payment of cash. All other business transactions are ignored.
If a customer purchases a good but does not pay until later, we would not record the sale transactions until the cash payment is received. If a business buys inventory on account, it would not be recorded until the company actually pays cash for the products (despite already receiving the supplies).
If cash basis was used in the examples above, assets, liabilities, revenue & net income would be understated. Because of this, IFRS & ASPE does not permit cash-basis accounting.
What is Accrual Accounting?
When using accrual accounting, the receipt or payment of cash is irrelevant to deciding when to record a transaction. What matters is whether the business has acquired an asset, earned revenue, taken on a liability, or incurred an expense.
Revenue & Expense Recognition Principles
What is the Revenue Recognition Principle?
Revenue consists of amounts earned by a company during its day-to-day business activities, mostly through sales.
The IFRS definition of revenue is “the gross inflow of economic benefits during the period arising during the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants”. ASPE’s definition is similar. In other words, revenue is earned when ordinary business activities result in increases to both assets & shareholders’ equity, other than when shareholders contribute capital to the business.
3 Conditions of a Transaction before its Recognized as Revenue
- The ownership (or control) & benefits of the products have been transferred to the customer.
- The amount of revenue can be reliably measured.
- It’s probable that the business will receive the economic benefits associated with the transaction, which usually come in the form of cash receipts.
What is the Expense Recognition Principle?
Expenses are costs incurred to purchase the products a company needs to run its business on a day-to-day basis.
2 Conditions of a Transaction before its Recognized as an Expense
- There has been a decrease in future economic benefits caused by a decrease in an asset or an increase in a liability.
- The expense can be reliably measured.
Record Adjusting Journal Entries
When a trial balance is prepared, it’s unadjusted. Because IFRS & ASPE requires accrual accounting, we must record adjusting journal entries (which are done at the end of the accounting period, just before the financial statements are prepared).
Main Types of Adjusting Entries
- Deferrals: An adjusting entry must be recorded when a company receives (or pays) cash in advance of providing (or receiving) the product. This type of adjusting entry results in the deferral of the recognition of the related revenue (or expense) until the future period in which the economic benefit is provided.
- Depreciation: An adjusting entry must be recorded to reflect that the future economic benefits of a tangible asset declines with age. This type of adjusting entry results in the depreciation (amortization under ASPE) of the value of the asset over its useful life by expensing the portion of the asset’s economic benefits that has been used up during an accounting period.
- We make an exception for land, which we say does not depreciate because it has unlimited useful life.
- Accruals: An adjusting entry must be recorded when a company delivers (or receives) a product in advance of it being billed or paid for. This type of adjusting entry results in the accrual of the related revenue (or expense) in the period in which the product is provided, regardless that it will not be billed/paid for until a future period.
What are Prepaid Expenses?
A prepaid expense is an expense a company has paid for in advance of the benefit, being listed as an asset when the cash payment is made.
- Prepaid Rent: For example, a company prepays 3 months of rent, which causes ‘Prepaid Rent’ to be debited & ‘Cash’ to be credited. Then, at the end of the first month, you make an adjusting entry where you debit 1/3 of the payment to ‘Rent Expense’ (because you’ve used that asset now) & credit ‘Prepaid Rent’.
- Supplies: Unused supplies on hand at the end of an accounting period, which represents an asset that will be used up in future periods.
Businesses sometimes receive cash before providing the product. This is unearned revenue, which is recorded as a liability.
Note! One company’s unearned revenue is another company’s prepaid expense!
Depreciation of Property, Plant & Equipment
What is the Straight-Line Depreciation Method?
It’s a method that allows us to estimate the amount of depreciation by dividing the cost of the asset by its expected useful life. We decrease Assets by crediting account called Accumulated Depreciation, which is a contra account.
What is a Contra Account?
A contra account has 2 Distinguishing Features:
- It always has a companion account.
- Its normal balance is opposite that of the companion account.
In the case above, the Furniture account is the companion to the Accumulated Depreciation contra account.
What is the Carrying Amount?
The amount obtained by deducting the asset’s accumulated depreciation from its original cost. All long-term tangible assets are reported at their carrying amounts on the balance sheet, with details of their original costs & accumulated depreciation normally disclosed in the financial statement’s notes.
Businesses often incur expenses they have not yet been billed for (utility bills arrive after consumption). For some types of expenses (salaries & loans) no bills will ever be received. At the end of each accounting period, businesses must record adjusting entries called accrued expenses to get these unbilled, unpaid expenses into the books. Typically, they’re typically recorded by debiting an expense account & crediting a liability account.
Businesses sometimes earn revenues they have not yet billed their customers for, e.g. providing a service prior to invoicing. Other revenues may never be invoiced, such as loan interest.
We record similar accrual entries for other kinds of accrued revenues - an accrued revenue account is debited and a revenue account is credited.
Summary of Adjusting Process
What is the Adjusted Trial Balance?
An adjusted trial balance lists all the ledger accounts & their adjusted balances, which are what we need to report on the financial statements.
Example Financial Statements
Statement of Cash Flows is not included because it’s not prepared from the adjusted trial balance!
Formats for the Financial Statements
Balance Sheet Formats
- Classified Balance Sheet: separates current assets from non-current assets and current liabilities from non-current liabilities, and it also subtotals the current assets and current liabilities. An unclassified balance sheet does not separate current and non-current assets or liabilities. Regardless of which format is used, current assets are always listed in order of decreasing liquidity. IFRS & ASPE require the use of classified balance sheets.
- Report Format: Lists assets at the top, followed by liabilities & then shareholders’ equity.
- Account Format: Uses a T-account as a framework with assets (debits) listed on the left side & liabilities and shareholders’ equity (credits) on the right. The example in the previous page of Moreau Ltd. is in this format.
Income Statement Formats
- Single-Step Income Statement: Lists all the revenues together under a heading such as Revenues or Income. The expenses are together under a heading such as Expenses or Expenses & Losses. This format only contains one step: subtracting Total Expense from Total Revenues to arrive at Net Income.
- Multi-Step Income Statement: Contains a number of subtotals to highlight important relationships among revenues & expenses, such as separating gross profit, operating expenses & loss before income taxes before arriving at the net income (loss).
Record Closing Journal Entries
What are Closing Entries?
Closing Entries are journal entries that transfer the balances in all revenue, expense & dividend accounts in the Retained Earnings account. After these entries, all income statement & dividend accounts have 0 balance, leaving them ready to track revenues, expenses & dividends for the next year.
Because revenue, expense & dividend accounts are closed at the end of each year, we call them temporary accounts. In contrast, all the asset, liability & shareholders’ equity accounts we report on the balance sheet are permanent accounts. The balance in these accounts at the end of one fiscal year becomes the beginning balance of the next fiscal year.
The 4-Step Process to Record & Post Closing Journal Entries
- Debit each revenue account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues. Now the sum of the revenues has been added to Retained Earnings.
- Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses. The sum of the expenses has now been deducted from Retained Earnings.
- Credit the Dividends account for the amount of its debit balance. Debit Retained Earnings for the same amount. The dividends have now been deducted from Retained Earnings.
- Post all the closing journal entries to the ledger to close the accounts for the year.
If the ending balance in the Retained Earnings account does not match the balance reported in these financial statements, then you know you have made an error in the closing process.
Analyze & Evaluate a Company’s Debt-Paying Ability
What is Net Working Capital?
A figure that indicates a company’s liquidity. In this context, liquidity refers to the ease with which a company will be able to use its current assets to pay off its current liability. The higher the company’s liquidity, the easier it will be able to pay off its current liabilities.
Net Working Capital = Total Current Assets – Total Current Liabilities
A company is considered to be liquid when its current assets sufficiently exceeds its current liabilities!
What is the Current Ratio?
The higher the current ratio, the more liquid the company is. As a rule of thumb, a company’s current ratio should be at least 1.5. The threshold, however, does vary by industry & can be as low as 1 or as high as 2. A current ratio less than 1 is considered low by any standard.
What is the Debt Ratio?
This ratio indicates the proportion of a company’s assets that is financed with debt, which help evaluate the company’s ability to pay both current & non-current debts (total liabilities). Low debt ratio is better because it indicates a company has not used an excessive amount of debt to finance. Most companies have a debt ratio of 0.6 to 0.7.
How Do Transactions Affect the Ratios?
Lending agreements often require that a company’s current ratio not fall below a certain level, or that its debt ratio not rise above a specified threshold. When a company fails to meet one of these conditions, it is said to default on its lending agreements. The penalty for default can be severe & can require immediate repayment of the loan.
Increases in current assets (such as cash) affect both ratios. It makes the current ratio bigger & debt ratio smaller. Issuance of shares slightly improves both ratios, as current assets increase while liabilities remain unchanged. Purchasing a non-current asset decreases the current ratio but does affect the debt ratio. Collecting accounts receivable has no affect on either ratios.
Strategies to Avoid Default
- Increase sales to enhance both net income & current assets.
- Decrease expenses to improve net income & reduce liability.
- Sell additional shares to increase cash & shareholders’ equity.