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Principles of Finance

4.2 Economic Basis for Accrual Accounting

Principles of Finance4.2 Economic Basis for Accrual Accounting

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

By the end of this section, you will be able to:

  • Assess the impact of business transactions on cash flow.
  • Define double-entry accounting and explain how it supports the accounting equation.

How and when we record our transactions can have a significant impact on financial statements, especially the income statement (net income). In this section you will explore the impact business transactions have on financial statements under each method. In doing so, you’ll be introduced to double-entry accounting and see how it functions to support the accounting equation.

Timing of Business Activity versus Cash Flow

The first financial statement prepared is the income statement, a statement that shows the organization’s financial performance for a given period of time. We already saw that Chris, who is a sole proprietor, started a summer landscaping business on August 1, 2020. She categorized her business as a service entity and used the cash-basis method of accounting to record the initial operations for her business. Although Chris was using her family’s tractor to get her work done, she was responsible for paying for fuel and any maintenance costs. So, on August 31, Chris realized she had only $250 in her checking account.

This balance was lower than expected because she had spent only slightly less ($1,150 for brakes, fuel, and insurance) than she earned ($1,400)—leaving a net income of $250. While she would like the checking balance to grow each month, she realized that most of the August expenses were infrequent (brakes and insurance) and the insurance, in particular, was an unusually large expense. She knew that the checking account balance would likely grow more in September because she would earn money from some new customers; she also anticipated having fewer expenses.

This simple landscaping example can be used to discuss the elements of the income statement, which are revenues, expenses, gains, and losses for a particular period of time (see Figure 4.2). Together, these determine whether the organization has net income (where revenues and gains are greater than expenses and losses) or net loss (where expenses and losses are greater than revenues and gains). Revenues, expenses, gains, and losses are further defined in the Income Statement provided.

Chris’ Landscaping, Income Statement, For the Month Ended August 31, 2020. Revenue $1,400, Total revenue $1,400. Expenses: Tractor brake repair 100, Tractor fuel 50, Buiness insurance 1,000; Total Expenses 1,150; Net income $250.
Figure 4.2 Income Statement for Chris’s Landscaping

The income statement can also be visualized by the formula:

Revenue-Expenses=NetIncomeorNetLossRevenue-Expenses=NetIncomeorNetLoss

Let’s change this example slightly and assume the $1,000 payment to the insurance company will be paid in September rather than in August. In this case, the ending balance in Chris’s checking account would be $1,250, a result of earning $1,400 and only spending $100 for the brakes on the tractor and $50 for fuel. This stream of cash flows is an example of cash-basis accounting because it reflects when payments are received and made, not necessarily the time period that they affect. At the end of this section, you will address accrual accounting, which does reflect the time period that payments affect.

The Accounting Equation

It may be helpful to think of the accounting equation from a “sources and claims” perspective. Under this approach, the assets (items owned by the organization) were obtained by incurring liabilities or were provided by owners. Stated differently, every asset has a claim against it—by creditors and/or owners.

Assets=Liabilities+OwnersEquityAssets=Liabilities+OwnersEquity

You may recall from mathematics courses that an equation must always be in balance. Therefore, we must ensure that the two sides of the accounting equation are always equal. We will explore the components of the accounting equation in more detail shortly. First, we need to examine several underlying concepts that form the foundation for the accounting equation: the double-entry accounting system, debits and credits, and the “normal” balance for each account that is part of a formal accounting system.

Think It Through

The Accounting Equation

On a sheet of paper, use three columns to create your own accounting equation. In the first column, list all the things you own (assets). List only the asset itself; don’t worry about any associated liabilities (expenses) in that column. In the second column, list any amounts owed (the liabilities). When you are done, total up all the assets. Then total up all the liabilities.

Now, use the accounting equation to calculate the net amount of the asset (equity). To do so, subtract the total assets from the total liabilities. This figure makes the accounting equation balance and represents equity, or an estimate of your net worth.

Here is something else to consider: Is it possible to have negative equity? It sure is . . . ask any college student who has taken out loans. At first glance there is no asset directly associated with the amount of the loan. But is that, in fact, the case? You might ask yourself why you should make an investment in a college education—what is the benefit (asset) to going to college? The answer lies in the difference in lifetime earnings with a college degree versus without a college degree. This is influenced by many things, including the supply and demand of jobs and employees. It is also influenced by the earnings for the type of college degree pursued.

Let’s continue our exploration of the accounting equation, focusing on the equity component in particular. Recall that we defined equity as the net worth of an organization. It is helpful to also think of net worth as the accounting value of the organization. Recall, too, that revenues (inflows as a result of providing goods and services) increase the accounting value of the organization. So every dollar of revenue an organization generates increases the overall value of the organization.

Likewise, expenses (outflows as a result of generating revenue) decrease the value of the organization. So each dollar of expenses an organization incurs decreases the overall value of the organization. The same approach can be taken with the other elements of the financial statements:

  • Gains increase the value (equity) of the organization.
  • Losses decrease the value (equity) of the organization.
  • Investments by owners increase the value (equity) of the organization.
  • Distributions to owners decrease the value (equity) of the organization.
  • Changes in assets and liabilities can either increase or decrease the value (equity) of the organization depending on the net result of the transaction.

Let’s look at Chris’s Landscaping business again and do the same quick exercise you did with your personal finances. If we were to total all of Chris’s assets, we would find just one: $250 in cash. She’s using the family’s tractor, but she doesn’t own the tractor, so it is not her asset. Her liabilities are currently $0, as she paid cash for all the expenses she incurred already. If we total her assets, we get $250. Liabilities total $0. Using the accounting equation, we find her equity to currently be $250, or

Assets ($250)  Liabilities ($0)=Equity ($250)Assets ($250)  Liabilities ($0)=Equity ($250)

Double-Entry Accounting

Accounting is based on a double-entry accounting system, which requires the following:

  • Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
  • Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
  • The sum of the debits must equal the sum of the credits for each transaction.

In order for companies to record the myriad of transactions they have each year, there is a need for a simple but detailed system. Journals are useful tools to meet this need.

Debits and Credits

Each account can be represented visually by splitting the account into left and right sides as shown. The graphic representation of a general ledger account is known as a T-account. It is called this because it looks like a “T,” as you can see with the T-account shown in Figure 4.3.

A general ledger account or T-account shows debit records financial information on the left side of each account and credit records financial information on the right side of an account. A vertical line divides these sections. The account title goes above the debit and credit information; it is underlined. The underline and dividing line forms a T.
Figure 4.3 T-Account

A debit records financial information on the left side of each account. A credit records financial information on the right side of an account. One side of each account will increase, and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account. You will often see the terms debit and credit represented in shorthand, written as DR or dr and CR or cr, respectively. Depending on the account type, the sides that increase and decrease may vary. We can illustrate each account type and its corresponding debit and credit effects in the form of an expanded equation (see Figure 4.4).

An expanded accounting equation. The general equation is: assets = liabilities + common stocks minus dividends + revenues minus expenses. Common stocks, dividends, revenues, and expenses are collectively known as equity.
Figure 4.4 Expanded Accounting Equation

As we can see from this expanded accounting equation, Assets accounts increase on the debit side and decrease on the credit side. This is also true of Dividends and Expenses accounts. Liabilities increase on the credit side and decrease on the debit side. This is also true of Common Stock and Revenues accounts. This becomes easier to understand as you become familiar with the normal balance of an account.

The balance sheet is a reflection of the accounting equation (see Figure 4.5). It has two sections, assets in one section and liabilities and equity in the other section. It’s key to note that both assets and liabilities are broken down on the balance sheet into current and noncurrent classifications in order to provide more detail and transparency. Current assets are those that are consumed within a year. Assets that will be in use longer than a year are considered noncurrent. Current liabilities are those that will be due within a year. Noncurrent liabilities are those that are due more than a year into the future.

Graphical Representation of the Accounting Equation. The balance sheet shows assets and liabilities, categorized as current and noncurrent. Various activities that affect the equity of the business are highlighted. Activities that have a negative impact include distribution to owners, expenses, and losses. Activities that have a positive impact include investments by owners, revenues, and gains. Comprehensive income can have a negative or positive effect on the owner’s equity.
Figure 4.5 Graphical Representation of the Accounting Equation Both assets and liabilities are categorized as current and noncurrent. Also highlighted are the various activities that affect the equity (or net worth) of the business.

Notice each account subcategory (Current Assets and Noncurrent Assets, for example) has an “increase” side and a “decrease” side. As you may recall, these are called T-accounts, and they are used to analyze transactions.

The basic components of even the simplest accounting system are accounts and a general ledger. An account is a record showing increases and decreases to assets, liabilities, and equity—the basic components found in the accounting equation. Each of these categories, in turn, includes many individual accounts, all of which a company maintains in its general ledger. A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

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