Chapter 4: Accrual Accounting Concepts
4.1 Accrual-Basis Accounting and Adjusting Entries
− Accounting divides the economic life of a business into artificial time periods (recall
that this is the periodicity assumption
➢ Accounting periods are generally a month, a quarter, or a year
▪ **An accounting time period that is one year long is call a fiscal year
− Determining the amount of revenues and expenses to report in a given accounting
period can be difficult. Proper reporting require an understanding of the nature of
the company’s business.
➢ Two principles are used as guidelines:
▪ The revenue recognition principle
▪ The expense recognition principle
The Revenue Recognition Principle
• When a company agrees to perform a service or sell a product to a customer, it has
a performance obligation
• Revenue recognition principle = requires that companies recognize revenue in the
accounting period in which the performance obligation is satisfied
o A company satisfies its performance obligation by performing a service or
providing a good to a customer
• Revenue recognition results from a five-step process
The Expense Recognition Principle
• In recognizing expenses, a simple rule is followed: “Let the expenses follow the
revenues”
o Thus, expense recognition is tied to revenue recognition
• The critical issue in expense recognition is determining when the expense makes its
contribution to revenue
• Expense recognition principle = the practice of expense recognition
o --> It requires that companies recognize expenses in the period in which they
make efforts (consume assets or incur liabilities) to generate revenue
• **The term “matching” is sometimes used in expense recognition to indicate the
relationship between the effort expended and the revenue generated
, Decision Tools: the revenue recognition principle and the expense recognition principle
help to ensure that companies report the correct amount of revenues and expenses in a
given period
Accrual versus Cash Basis of Accounting
• Accrual-basis = the transaction that change a company’s financial statements are
recorded in the period in which the events occur, even if cash was not exchanged
o International note: although different accounting standards are often used
by companies in other countries, the accrual basis of accounting is central
to all of these standards
o Using the accrual basis means that companies recognize revenues when
they perform the services (the revenue recognition principle), even if cash
was not received
o Likewise, companies recognize expenses when incurred (the expense
recognition principle), even if cash was not paid
• An alternative to accrual basis is the cash basis
• Cash-basis accounting = accounting basis in which a company records revenue
only when it receives cash and an expense only when it pays cash
4.1 Accrual-Basis Accounting and Adjusting Entries
− Accounting divides the economic life of a business into artificial time periods (recall
that this is the periodicity assumption
➢ Accounting periods are generally a month, a quarter, or a year
▪ **An accounting time period that is one year long is call a fiscal year
− Determining the amount of revenues and expenses to report in a given accounting
period can be difficult. Proper reporting require an understanding of the nature of
the company’s business.
➢ Two principles are used as guidelines:
▪ The revenue recognition principle
▪ The expense recognition principle
The Revenue Recognition Principle
• When a company agrees to perform a service or sell a product to a customer, it has
a performance obligation
• Revenue recognition principle = requires that companies recognize revenue in the
accounting period in which the performance obligation is satisfied
o A company satisfies its performance obligation by performing a service or
providing a good to a customer
• Revenue recognition results from a five-step process
The Expense Recognition Principle
• In recognizing expenses, a simple rule is followed: “Let the expenses follow the
revenues”
o Thus, expense recognition is tied to revenue recognition
• The critical issue in expense recognition is determining when the expense makes its
contribution to revenue
• Expense recognition principle = the practice of expense recognition
o --> It requires that companies recognize expenses in the period in which they
make efforts (consume assets or incur liabilities) to generate revenue
• **The term “matching” is sometimes used in expense recognition to indicate the
relationship between the effort expended and the revenue generated
, Decision Tools: the revenue recognition principle and the expense recognition principle
help to ensure that companies report the correct amount of revenues and expenses in a
given period
Accrual versus Cash Basis of Accounting
• Accrual-basis = the transaction that change a company’s financial statements are
recorded in the period in which the events occur, even if cash was not exchanged
o International note: although different accounting standards are often used
by companies in other countries, the accrual basis of accounting is central
to all of these standards
o Using the accrual basis means that companies recognize revenues when
they perform the services (the revenue recognition principle), even if cash
was not received
o Likewise, companies recognize expenses when incurred (the expense
recognition principle), even if cash was not paid
• An alternative to accrual basis is the cash basis
• Cash-basis accounting = accounting basis in which a company records revenue
only when it receives cash and an expense only when it pays cash
