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Int. Acc. FA LECT 1: Introduction and recap part 3 (ACCRUAL BASIS OF…
Int. Acc. FA LECT 1: Introduction and recap part 3
ACCRUALS
When to recognize revenues and expenses?
Moreover, some “transactions” happen on an ongoing basis
Use of inventories, advertising, labor etc.
Make adjustments at the end of the year (e.g. physical
stocktaking) (
end-of-period adjustments
)
When to recognize revenues and expenses?
Recognize revenue and expenses in the periods in which the economic events occur, not (per se) the periods in which cash is received or paid (accrual accounting)
CASH INFLOW ≠ REVENUE CASH OUTFLOW ≠ EXPENSE
(Cash accounting: Recognize revenue and expenses in the period in which cash is received or paid.)
ACCRUAL BASIS OF ACCOUNTING
Consumption of assets = value decrease in assets
- “Assets flow out of the firm as expenses”
Matching principle:
Expenses follow revenues
Expenses are recognized when corresponding revenue is generated, not when cash flows out of the firm
To generate revenues, assets are consumed
ACCRUAL BASIS OF ACCOUNTING
Advantages:
Better measurement of performance (expenses more closely match reported revenue)
Less scope for timing manipulations.
Disadvantages:
Requires more estimates and assumptions (i.e., more costly).
Subject to manipulation by the choice of recognition rules.
Transactions are recorded when they occur regardless of when cash is exchanged
Transactions are recognized if there is a economic substance, independent of cash flows
Economically, changes in wealth may occur without involving cash
Two kinds of transactions in which the exchange of cash does not coincide with the economic substance of the transaction: SEE SLIDE 47-48/72
ACCRUALS
ACCRUALS EXPENSE
Company consumes resources but pays later -> consumption but no cash
ACCRUALS REVENUE
Company delivers product to customer and customer pays later -> value creation but no cash
DEFERRALS
DEFERRAL REVENUE
Company receives cash from customer but delivers later -> no value creation or consumption, just cash
DEFERRAL EXPENSE
Company pays for resources but consumes later -> no consumption, just cash