Essential Principles of Accrual Accounting and Financial Statements

Core Concepts of Accrual Accounting

Accrual accounting dictates that we record revenue when we have actually delivered the product or service—not when the customer pays.

Fundamental Accounting Equations

• Balance Sheet: Assets = Liabilities + Equity
• Income Statement: Revenue - Expenses = Net Income

The income statement does not include dividends. A consolidated balance sheet represents the total of the parent company and all its subsidiaries.

Financial vs. Tax Reporting

Firms must maintain at least two sets of books:

• Financial Reporting (GAAP): For investors and external users.
• Tax Reporting (Tax Code): For determining taxable income.

Key Accounting Entries

Accounts Receivable (Asset)

Accounts receivable increase and retained earnings increase (revenue) when a customer has not yet paid.

Deferred Revenue (Liability)

This represents an advance payment where the customer pays but the service has not been received. Deferred revenue increases, and revenue is fully recognized upon delivery.

Accrued Liabilities (Liability)

The company incurs an expense but has not paid yet. Accounts payable increases, and retained earnings decrease (expense).

Prepaid Expenses (Asset)

Cash is paid upfront and expensed over time. Prepaid expenses increase, and retained earnings decrease (expense).

Retained Earnings and Revenue Recognition

Retained earnings represent the earned capital of the reporting entity; it is the cumulative net earnings a company keeps after paying dividends to shareholders.

If the customer pays early, it is not revenue yet. COGS is recorded in the same period as the revenue it helps generate. Other costs (SG&A, R&D, interest) are recorded when the cost is incurred, not when cash goes out.

Retained Earnings Calculation

Beginning Retained Earnings ± Net Income (Loss) – Dividends = Ending Retained Earnings.

Operating Expenses Defined

• COGS: Cost of goods sold (also known as cost of sales or cost of revenues).
• SG&A: Selling, general, and administrative expenses—include sales and marketing costs, and overheads such as corporate compensation, HR, and legal fees.

Profitability Metrics

• Gross Margin: Gross Profit / Sales
• Operating Margin: Operating Profit / Sales
• Profit Margin: Net Profit / Sales

Capital Expenditures vs. Operating Expenses

Some expenditures are capitalized as assets on the balance sheet. These are treated as capital investments (CAPEX) rather than operating expenses (OPEX). CAPEX delays expense recognition, whereas OPEX hits the income statement immediately.

Intangible Assets and Goodwill

Intangibles include goodwill, trademarks, and patents. Goodwill = Purchase Price – Fair Value of Identifiable Net Assets (Assets – Liabilities). This usually occurs when companies overpay for acquisitions.