Accrual Accounting and the Closing Process
Chapter 3. Accrual Accounting and the Closing Process
If we only recorded transactions when cash was received or paid, could we truly create an accurate report of a firm’s performance? Today, we enter the world of Accrual Basis Accounting, the principle that turns accounting into a true ‘art’ of measurement.
1. Cash Basis vs. Accrual Basis
While a personal checkbook might use the Cash Basis, corporate accounting primarily follows the Accrual Basis. This is a deliberate effort to reflect the economic reality of events.
| Category | Cash Basis | Accrual Basis |
|---|---|---|
| Revenue Recognition | When cash is received | When the revenue-generating activity is complete (Realization) |
| Expense Recognition | When cash is paid | When resources are sacrificed to generate revenue (Matching) |
| Advantages | Easy to track cash flows | Accurate measurement of periodic profit/loss |
| Disadvantages | Impossible to match revenue and expense | Subjective judgment (estimations) may be involved |
Matching Principle: This principle requires that revenues and the expenses incurred to generate those revenues be recognized (‘matched’) in the same accounting period.
2. Adjusting Entries
To perfectly implement accrual accounting, a process of adjusting the books to match the actual situation is necessary at the end of the accounting period.
| Item | Accrual | Deferral |
|---|---|---|
| Expense | Accrued Expense (e.g., Unpaid Interest) | Prepaid Expense (e.g., Prepaid Insurance) |
| Revenue | Accrued Revenue (e.g., Interest Receivable) | Unearned Revenue (e.g., Prepaid Rent) |
3. The Accounting Cycle (Closing)
Closing is the process of finalizing the fiscal year and creating the final report card for external stakeholders.
Initial check for errors in recording
Adjusting books based on accrual accounting
Final verification of debit/credit balance
Generating final reports like B/S and I/S
Depreciation is also a form of adjusting entry in a broad sense. it is the process of systematically allocating the cost of fixed assets over their useful lives to achieve revenue-expense matching.
Well done! Now that we’ve covered the basics, next time we will move into Intermediate Accounting and examine Specific Asset Valuation Methods.
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