Accrual accounting is the backbone of financial reporting, recognizing revenues and expenses when earned or incurred, not when cash changes hands. This method provides a more accurate picture of a company's financial health by matching revenues with related expenses in the same accounting period.

Double-entry accounting ensures every transaction is recorded in at least two accounts, maintaining the balance of the accounting equation. This system, along with accrual principles, forms the foundation for creating reliable financial statements that reflect a company's true economic performance and position.

Fundamentals of Accrual Accounting

Impact of transactions on finances

• Business transactions exchange goods, services, or assets between parties
  • Classified as operating (sales, expenses), investing (buying/selling assets), or financing activities (borrowing, issuing stock)
• Transactions affect company's financial position and are recorded in accounting system
• Impact cash flow by increasing or decreasing company's cash balance
  • Inflows: Cash from sales, investments, or financing (loans, stock issuance)
  • Outflows: Cash paid for expenses, investments, or financing (loan repayments, dividends)
• Financial statements prepared based on recorded transactions
  • Income Statement: Revenues earned and expenses incurred during period (month, quarter, year)
  • Balance Sheet: Company's assets, liabilities, and equity at specific point in time (end of month, year)
  • Cash Flow Statement: Inflows and outflows of cash during period (month, quarter, year)

Role of double-entry accounting

• Double-entry accounting records each transaction in at least two accounts
  • Maintains accounting equation balance: Assets = Liabilities + Equity
• Transactions have dual effect on accounting equation
  • Debit: Increases assets and expenses, decreases liabilities, equity, and revenues
  • Credit: Increases liabilities, equity, and revenues, decreases assets and expenses
• Debits and credits must equal for each transaction to maintain equation balance
• Example: Selling goods on credit
  • Debit Accounts Receivable (asset), credit Sales Revenue (revenue)
• Prevents errors and provides clear audit trail

Accrual Accounting Principles

Application of accrual principles

• Accrual accounting (accrual basis) recognizes revenues and expenses when earned or incurred, regardless of cash timing
• Matching Principle: Recognize revenues and related expenses in same accounting period for accurate performance reflection
• Revenue Recognition Principle: Recognize revenue when earned and realized or realizable
  • Earned: Goods or services provided to customer
  • Realized or Realizable: Cash received or expected
• Expense Recognition Principle: Recognize expenses when incurred and matched with related revenues
  • Incurred: Goods or services received or used by company
• Adjusting entries at end of accounting period ensure proper revenue and expense matching
  • Accruals: Record unrecorded earned revenues or incurred expenses
    1. Accrue revenues earned but not yet billed or received (interest revenue)
    2. Accrue expenses incurred but not yet paid or recorded (wages, utilities)
  • Deferrals: Postpone recognition of recorded revenues or expenses
    1. Defer revenues received in advance (subscription fees, rent)
    2. Defer expenses paid in advance (insurance premiums, supplies)

Additional Accounting Principles

• Materiality Principle: Information is material if omitting or misstating it could influence economic decisions of users
• Conservatism Principle: Exercise caution when making accounting estimates in uncertain conditions
• Going Concern Principle: Assume the business will continue to operate in the foreseeable future
• Consistency Principle: Use the same accounting methods and procedures from period to period for comparability