Introduction Accrual Accounting PDF

Introduction Accrual Accounting
Syllabus for Accounting (FEB11018)
Erasmus School of Economics

Erasmus University Rotterdam
This version: August 18, 2022

Contents
I Basic principles of accounting 5
1 Introduction 6
1.1 Economic value and economic net income . . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.2 Accounting value and accounting net income . . . . . . . . . . . . . . . . . . . . . . . . 8
2 Cash accounting 10
2.1 Example: GreenTees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 True and fair view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
3 Accrual accounting 15
3.1 The balance sheet and the accounting equation . . . . . . . . . . . . . . . . . . . . . . . 16
3.1.1 Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.1.2 Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.1.3 Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.4 The accounting equation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3.1.5 The balance sheet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
3.1.6 Recognition criteria for assets and liabilities . . . . . . . . . . . . . . . . . . . . . 19
3.1.7 Example: GreenTees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Stock vs. flow variables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
3.3 The income statement and revenue recognition . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.1 Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.3.2 Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
3.3.3 Income statement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
3.3.4 Revenue recognition principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.3.5 Expense recognition principle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
1
3.4 The statement of changes in equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
3.5 The statement of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
3.6 Example: GreenTees . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.6.1 September . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
3.6.2 October . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.6.3 November . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.6.4 December . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.7 True and fair view . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
4 Issues and challenges in financial accounting 52

4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
4.2 Recognition and measurement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
4.2.1 Decision usefulness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
4.2.2 Relevance reliability trade-off . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
4.2.3 Historical cost vs. current value . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
4.3 Balance sheet vs. income statement approach . . . . . . . . . . . . . . . . . . . . . . . . 56
II The recording process 61
5 The accounting information system 62

5.1 General ledger . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
5.2 Debit vs. credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
6 The accounting cycle 67

6.1 Analyze transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
6.2 Journalize transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
6.3 Post journal entries to ledger accounts . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
6.4 Trial balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
6.5 Adjusting journal entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89
6.6 Correcting journal entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
6.7 Adjusted trial balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
6.8 Financial statements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95
6.9 Closing journal entries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98
© 2021 Accounting (FEB11018) 2

6.9.1 Closing revenue and expense accounts . . . . . . . . . . . . . . . . . . . . . . . . 98
6.9.2 Closing the capital distributions account . . . . . . . . . . . . . . . . . . . . . . . 99
6.10 Post-closing trial balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
III Accounting for the financing activities of the company 101
7 Equity capital 102

7.1 Sole proprietorship . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 102
7.2 Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
7.2.1 Share issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 104
7.2.2 Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
7.2.3 Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
7.2.4 Statement of changes in equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
7.2.5 Other equity related concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110
8 Debt capital 112

8.1 Long term loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112
8.1.1 Loan issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
8.1.2 Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 113
8.1.3 Loan repayment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
8.2 Short term loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
8.2.1 Zero-interest short term loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

Preface
This syllabus serves as a preamble to the textbook ”Intermediate Accounting - IFRS Edition” for the
course ”Accounting” (FEB11018). The main objective of this syllabus is to provide an introduction to
accrual accounting. It
• explains the basic concepts of accrual accounting,
• illustrates why we do accrual accounting in practice,
• discusses the main issues in accrual accounting,
• explains the recording process in the accounting cycle.
In addition to this, it explains the accounting methods for basic transactions with respect to equity
and debt financing in a company.
In explaining the basics of accrual accounting, this syllabus follows a general perspective rather than
a specific set of accounting standards like International Financial Reporting Standards (IFRS) or US-
GAAP. Although this syllabus aims to be consistent with IFRS as much as possible, it does abstract
from some aspects, details and/or complexities in IFRS to keep the syllabus simple and at an intro-
ductory level.
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Part I
Basic principles of accounting
5
Chapter 1
Introduction
All firms periodically prepare financial reports to inform internal stakeholders like management and/or
external stakeholders like investors and creditors on the current financial position of the firm and its
performance over the past period. For example, when management needs to decide which products
to manufacture and how many, management needs information about the manufacturing cost and
selling price of each product as well as information on production capacity. Internal financial reports
are used to provide this information. As another example, when a firm needs cash to invest in new
manufacturing facilities it can borrow this cash from a bank. When deciding whether to lend this
cash to the firm, the bank needs information on the financial position of the firm to determine its
creditworthiness. The bank needs to assess the risk it takes when lending cash to this firm, i.e., how
likely is it that the firm is able to make all interest payments and pay back the loan? External financial
reports of the current and preceding periods are useful information to assess this risk. When this risk
is higher, the bank may charge a higher interest rate, require collateral or decide to not provide the
loan.
Management accounting primarily deals with internal financial reports that serve to support manage-
ment in all kinds of decisions that they have to make. In contrast, financial accounting deals with
external financial reports that serve to support external stakeholders like investors, banks, suppliers,
and customers in their decision-making processes.
The primary questions that accounting aims to address are:
• How should we measure the financial position and financial performance of a firm?
• And how should this be presented in the financial statements?
Measuring financial position and financial performance is not straightforward though. For example,
consider your own financial position. What determines your current financial position? Is that the
balance in your bank account? Or does it also include your physical belongings? And if so, how do
you measure the current value of your physical belongings? Determining the current value of e.g., your
cell phone or laptop is not straightforward. What you do know is the price at which you bought these
products, but their current value is likely to be lower than that due to wear. Furthermore, do you also
need to include your intangible “belongings” like knowledge and skills in determining your financial
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position? And if so, what is the value of your knowledge and skills.
Financial accounting is thus about measurement. But what does financial accounting aim to measure?
For example, the objective of a speedometer is to measure the speed of a vehicle. Then the usefulness
of a speedometer is determined by how accurately it measures the true speed of the vehicle. The more
precisely it measures the true speed, the more useful the speedometer is to its users. So, what is the
true financial position and true financial performance that financial accounting aims to measure?
1.1 Economic value and economic net income

In business economics, the true financial position of a firm is commonly referred to as the economic
value of the firm:
Definition 1.1 In economic theory, the economic value of the firm is defined as the discounted value
of all future net benefits that the firm is expected to generate.
To see why the focus is on future net benefits, suppose you are a wealthy investor and you want to
buy a firm. The price you would be willing to pay for this firm depends on the future net benefits that
this firm is able to generate because once you become the owner of this firm, these future net benefits
are yours. Hence, the higher these expected net benefits, the higher the economic value of firm and
the higher the price that you are willing to pay for this firm.
The future net benefits are discounted to take into account time: people value receiving a net benefit
today higher than receiving this same net benefit in one year time. Thus, net benefits generated further
into the future contribute less to the economic value of the firm.
Discussion point 1.1 You may wonder why the economic value does not depend on past performance
of the firm or the current possessions of the firm . For example, a company like Heineken possesses
a lot of valuable property and manufacturing facilities. Should these not be included in the economic
value as well? Yes, they should. Actually, they are included in the economic value of the company. To
see this, observe that, roughly speaking, Heineken can generate future cash flows in two ways. First,
it can sell all property and manufacturing facilities and cease operations. This is called the value in
exchange or, in business terms, the liquidation value of the firm. Second, it can generate future cash
flows by using the property and manufacturing facilities to produce and sell beer. We can refer to this
as the value in use. Because the owners of Heineken want to maximize the future cashflows, i.e. the
money that Heineken generates for her owners, the economic value is the maximum of the value in
exchange and the value in use.
The true financial performance of the firm is referred to as the firm’s economic net income. Economic
net income and economic value of the firm relate to each other in the following way: economic value at
the end of a period is equal to the economic value at the start of the period plus economic net income.
In mathematical terms, let Vt denote the economic value of the firm at the end of period t and N It
denote economic net income over period t, then it holds that
Vt = Vt−1 + N It . (1.1)

Alternatively, one can write
N It = Vt − Vt−1 , (1.2)
that is, economic net income over a period is the change in economic value of the firm over this period.
In other words, one can interpret economic net income as the maximum amount of value that the
owners of the firm can take out of the firm during a period without changing the economic value of
the firm, i.e., the economic value of the firm is the same at the end of the period as at the start. This
interpretation of economic net income is particularly relevant in the context of protecting the interests
of debtholders, i.e., to guarantee that a sufficient amount of capital remains within in the firm to repay
the debtholders.
The problem with economic value and economic net income of the firm is that these values are theo-
retical concepts and are not directly observable in practice. In this respect, one can compare economic
value of the firm to the true technical status of a car that determines the likelihood of the car breaking
down during its next trip. It exists but it is not directly observable. Measuring the true technical status
of a car is a complex exercise. For some parts like the tires, wear may be directly observable whereas
for other parts like the internals of the engine, wear may only be observable after disassembling the
car and engine. And for some parts like electronics, wear may be difficult if not impossible to measure.
The same applies to economic value and economic net income. Because economic value and economic
net income are not directly observable, there is a need for financial accounting to develop methods
for measuring economic value and economic net income. And similar to the technical status example,
some aspects of economic value and net income may be easier to measure than others.
1.2 Accounting value and accounting net income

In real life, the economic value of the firm is difficult if not impossible to determine. The future net
benefits of the firm are highly uncertain and different people may have different expectations about
these future net benefits. Some may be more optimistic than others. Consequently, there is no objective
way to determine the economic value of the firm.
Accounting focuses on developing practically feasible method(s) to determine the value of the firm that
approximate the economic value of the firm and economic income of the firm as accurately as possible.
Financial accounting thus produces an accounting value Vta of the firm and financial accounting defines
accounting net income, or in short, net income N Ita = Vta − Vt−1 a
over a period as the change in the
accounting value of the firm over this period. The primary objective of financial accounting is to
develop methods that produce financial statements that present a true and fair view of the firm’s
economic position and performance, so that these financial statements are useful to support users
of these financial statements in making better (investment) decisions. In other words, the primary
objective of financial accounting is to obtain an accounting value Vta that approximates the economic
value Vt as closely as possible, i.e., Vta ≈ Vt and accounting income N Ita that approximates economic
net income N It as closely as possible, i.e., N Ita ≈ N It .
Chapter 2 illustrates one straightforward way of accounting, i.e., cash accounting, where the focus is
on measuring the cash receipts and cash payments of the firm. By means of an example, it analyzes
to what extent this way of accounting presents a true and fair view of the firm’s economic position
and economic performance. Chapter 3 illustrates a more complex way of accounting in business, i.e.,

accrual accounting, that is commonly used in business practice. It explains the basic principles of
accrual accounting and illustrates how accrual accounting provides a better true and fair view of the
firm’s economic position and performance than cash accounting. Chapter 2 and 3 thus explain why we
want to do accrual accounting and not cash accounting.

Chapter 2
Cash accounting
In this chapter we measure the accounting value of the firm by the amount of cash that the firm
possesses and we measure accounting net income as the change in cash position. This method of
accounting is called cash accounting. By means of an example we analyze to what extent this method
of accounting presents a true and fair view of the firm’s economic performance.
2.1 Example: GreenTees

On July 31st 2021, a student has started a webshop GreenTees selling T-shirts with all kinds of prints
made from sustainable fabrics. The company starts with a cash investment of e 6, 000 from the student.
The following events occur during the period August 1 – December 31, 2021:
August 1 GreenTees buys an annual subscription to use webshop software at e 200 per
month. The annual subscription fee of e 2, 400 is paid in cash on August 1.
GreenTees hires a part-time employee for 35 hours per month. The wage is
e 20 per hour. Salary is paid in cash at the end of each month.
GreenTees has a hired an advertizing agency to run an online advertizing
campaign for e 100 per month. The advertizing agency bills GreenTees for
their services at the end of each month and GreenTees pays the bill in cash
in the subsequent month.
August 2-31 GreenTees purchases T-shirts from the supplier in cash at e 20 per shirt.
During August, GreenTees has purchased 350 T-shirts and sold and delivered
300 of these T-shirts to customers in cash on the same day that the shirts
were purchased. The sales price is e 25 per shirt.
September 1 GreenTees pays e 100 to the advertizing agency for their services in August.
GreenTees purchases inventory on credit: 350 shirts at e 20 each. The bill is
paid in October.
September 2-30 GreenTees sells 300 T-shirts in cash and delivers them to the customers (sales
price e 25 per shirt).
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October 1 GreenTees pays e 100 to the advertizing agency for their services in Septem-
ber. GreenTees pays the bill for the purchase on September 1.
GreenTees purchases inventory on credit: 250 shirts at e 20 each. The in-
ventory is paid in November.
October 2-31 GreenTees sells 100 T-shirts in cash and delivers them to the customers (sales
GreenTees sells 200 T-shirts on credit and delivers them to the customers
(sales price e 25 per shirt). Customers pay their bill in November.
November 1 GreenTees pays e 100 to the advertizing agency for their services in October.
GreenTees pays the bill for the purchase on October 1.
GreenTees receives the payment from customers for the credit sales in Octber.
paid in December.
November 10 The owner of GreenTees transfers e 2, 000 in cash to his private account.
November 2-30 GreenTees sells 350 T-shirts in cash (sales price e 25 per shirt).
Because GreenTees only has 300 T-shirts in inventory, 50 T-shirts are in
backorder and will be delivered to customers in December.
December 1 GreenTees pays e 100 to the advertizing agency for their services in Novem-
ber. GreenTees pays the bill for the purchase on December 1.
paid in January.
GreenTees delivers the 50 T-shirts that were in backorder to the customers.
December 2-31 GreenTees sells 200 T-shirts in cash and delivers them to the customers (sales
GreenTees sells 50 T-shirts on credit and delivers them to the customers (sales
price e 25 per shirt). Customers will pay their bill in January.
The monthly financial statements for GreenTees based on these transaction are presented in Table 2.2.
We explain the financial statements for each month in more detail below.
July: The company GreenTees is established on July 31 and the owner of GreenTees invests e 6, 000
cash in the company. There are no other activities by GreenTees in July.
August: GreenTees starts operations. The company’s cash position reduces because the company
made cash payments for a total of e 10, 100 for purchasing T-shirts, the subscription fee of the webshop
software and the employee’s salary. The company’s cash position increases because of e 7, 500 in cash
receipts for the sale of T-shirts. Summarizing, on August 31, the cash position of GreenTees has
decreased by e 2, 600 to e 3, 400.
September: The operating activities of GreenTees are similar to those in August with the exception
of the purchase of inventory. In September, GreenTees purchases inventory on credit: the payment
of the bill of e 7, 000 does not occur in September but in October. Hence, the cash payments of
GreenTees only include the employee’s salary. On September 30, the cash position has increased by
e 6, 700 to e 10, 100.
October: GreenTees pays the bill of e 7, 000 for the inventory purchased in September. The purchase

Jul 31 Aug 31 Sep 30 Oct 31 Nov 30 Dec 31
Accounting value:
Cash 6, 000 3, 400 10, 100 4, 800 10, 750 9, 950
Accounting net income:

Cash receipts 7, 500 7, 500 2, 500 13, 750 5, 000
Cash payments
Purchases 7, 000 0 7, 000 5, 000 5, 000
Subscription fee 2, 400 0 0 0 0
Advertizing 100 100 100 100
Wages 700 700 700 700 700
Capital withdrawal 2, 000
Net income −2, 600 6, 700 −5, 300 5, 950 −800
Table 2.2: Monthly financial statements for GreenTees.
of inventory in October is again on credit so payment for this purchase occurs in November. GreenTees
has also sold 200 T-shirts on credit: GreenTees receives the cash for this sale not in October but in
November. GreenTees only receives cash in October for the 100 T-shirts that are sold in cash. Because
the sale on credit results in low cash receipts in October, the cash position of GreenTees on October
31, has decreased by e 5, 300 to e 4, 800.
November: Cash receipts in November are high because GreenTees has sold 350 T-shirts in cash
and GreenTees receives the cash payment for the credit sales in October. Total cash receipts equal
e 13, 750. There is also a cash outflow of e 2, 000 because the owner of GreenTees withdraws capital
from the company. As a result, the cash position of GreenTees on November 30 has increased by
e 5, 950 to e 10, 750.
December: GreenTees receives the cash for the credit sale in January. Hence, total cash receipts
equal only e 5, 000. Hence, the cash position on December 31 has decreased by e 800 to e 9, 950.
2.2 True and fair view

Do the financial statements in Table 2.2 present a true and fair view of GreenTees ’ economic perfor-
mance? No, they do not for the following reasons:
i. The table below shows the purchasing and sales activities of GreenTees over the period August-
December. As you can see, these activities do not vary that much from month to month. In
particular, observe that GreenTees has delivered 300 T-shirts to her customers in each month.
In other words, in each month GreenTees has served the same number of customers. However,
when you look at the net income number (i.e., change in cash) it varies a lot from month to
month. GreenTees reports negative income in October and December and the difference between
the highest and lowest net income number is as much as e13, 250. Summarizing, the reported net
income number does not seem to properly reflect the numbers of customers served per month.

Purchases 350 350 250 250 400
Sales - cash 300 300 100 350 200

Sales - credit 0 0 200 0 50
Delivered 300 300 300 300 300
Income −2, 600 6, 700 −5, 300 5, 950 −800
ii. The financial statements only keep track of the cash position of GreenTees. It omits other relevant
information:
– The financial statements do not report GreenTees inventory of T-shirts. As the table below
shows, GreenTees has positive inventory levels in August, September, October, and Decem-
ber. In November, GreenTees has ‘negative’ inventory in the sense that 50 T-shirts are in
backorder: these T-shirts have been sold but have not been delivered to the customers yet.

Purchases 350 350 250 250 400
Sales 300 300 300 350 250
Inventory 50 100 50 0 100
Backorder 50
– The financial statements of September do not show that GreenTees still has to pay her
supplier e 7, 000 for the 300 T-shirts that were purchased on credit. The same holds for the
credit purchases that occurred in October – December. Similarly, the financial statements
do not show that GreenTees still has to pay the advertizing agency.
iii. Net income of September is overstated and this may have negative consequences for the creditors
of GreenTees, i.e., the supplier that sold T-shirts on credit to GreenTees. Recall that economic
net income over a period can be interpreted as the maximum amount of value that the owner can
take out of the firm without changing the economic value of the firm (i.e., economic value of the
firm at the end of the period is equal to economic value of the firm at the start of the period).
In other words, if the reported accounting net income of September is a true and fair view of
economic income of September, the owner of GreenTees should be able to withdraw this amount
from the company without changing the economic value of the company. Suppose the owner of
GreenTees withdraws September accounting net income of e 6, 700 in cash from the company to
his private bank account, then the financial statements up to October 1 would be as follows:
This implies that on October 1, the cash position of GreenTees reduces to e 3, 400. Observe
that GreenTees still has to pay the e 7, 000 bill to her supplier. Hence, the cash position of
e 3, 400 of GreenTees is insufficient to pay this bill. One could say that on October 1, GreenTees
is technically bankrupt as she is not able to pay her supplier. Clearly, the withdrawal of cash does
change the economic value of GreenTees, in other words: when using cash accounting, accounting
net income does not represent the amount that the owner of GreenTees can withdraw without
changing the economic value of GreenTees.

Jul 31 Aug 31 Sep 30 Oct 1
Accounting value:
Cash 6, 000 3, 400 10, 100 3, 400
Accounting income:
Cash receipts 7, 500 7, 500
Cash payments
Purchases 7, 000 0
Subscription fee 2, 400 0
Advertizing 100
Wages 700 700
Income −2, 600 6, 700
Capital withdrawal −6, 700
Table 2.3: Financial statements for GreenTees when the owner withdraws the reported September
income of 6, 700 from the firm on October 1.
Summarizing, measuring the accounting value of a firm by her cash position and accounting income
by the change in cash position does not provide a true and fair view.

Chapter 3
Accrual accounting
In practice, the most commonly used method of accounting is accrual accounting rather than cash
accounting.
Definition 3.1 Accrual accounting is an accounting method where transactions are recorded when they
occur rather than when the corresponding cash receipts or cash payments occur.
When using cash accounting, a transaction is only recorded when this transaction results in a cash
receipt or cash payment. If there is no cash flow, a transaction is not recorded. For example, when
GreenTees purchased and received inventory on credit in September, cash accounting did not record
this transaction when GreenTeespurchased and received the inventory; it only recorded the transaction
of GreenTeespaying the bill in October, i.e., when the cash flow occured.
When using accrual accounting, transactions are recorded when they occur. Consider again the pur-
chase and receipt of inventory on credit by GreenTees in September. Accrual accounting also considers
this as a transaction as it affects the financial position of GreenTees. First, the ownership of the in-
ventory changes from the supplier to GreenTees and, second, GreenTeeshas the obligation to pay the
supplier for the inventory. Accrual accounting records both changes in financial position even though
no cash flow has occured.
This chapter introduces the basic concepts and assumptions of accrual accounting and illustrates the
application of accrual accounting in the GreenTees example. In explaining accrual accounting, we
follow the balance sheet approach to be consistent with International Financial Reporting Standards
(IFRS). THe income statement approach and the difference between these two approaches is explained
later in Chapter 4.3. We end this section by showing that the financial statements on the basis of
accrual accounting present a better true and fair view of the firm’s economic performance than cash
accounting.
15
3.1 The balance sheet and the accounting equation
3.1.1 Assets
In financial accounting, a possession of the firm is called an asset.
Definition 3.2 An asset is a resource that is (i) controlled by the entity, (ii) as a result of past events,
and (iii) from which future economic benefits are expected to flow to the entity.
In this definition, a resource means a right that may produce future economic benefits. This right can
be, for example, a right to receive cash or goods, the right to use or sell physical objects, or the right to
use knowledge. Such rights usually arise from contracts between the firm and third parties. Condition
(i) means that the entity (i.e., the firm) has the decision power on how to use the resource. Condition
(ii) implies that a transaction has occured. Finally, condition (iii) implies that the resource results in,
for example, the future receipt of cash, goods and/or services.
Example 3.1 Inventory is an asset because it is controlled by the entity. When purchasing the
inventory in the past, the entity became the legal owner of the inventory and the entity has full control
over what it can do with this inventory. Furthermore, the inventory is expected to yield future benefits
to the entity as the entity plans to sell this inventory for cash to its customers.
Example 3.2 Advertizing does not result in an asset because it does not result in a resource. Adver-
tizing does not result in any right of the firm to receive cash flows. Although advertizing might increase
future sales, the firm does not receive any legal or contractual right as a result of the advertizing.
Example 3.3 Human capital (i.e., employees) of an entity is not an asset because it is not controlled
by the entity. The entity does not have full control over its employees: in most situations, employees
can terminate their labor contract with the entity at any point in time.
Example 3.4 Knowledge that the entity obtains through research activities are usually not considered
to be an asset. The main reason is that it is not clear whether this knowledge will result in future
benefits to the entity. For example, pharmaceutical companies spend a lot of time, effort and cash on
research for new medical treatments. This process usually takes many years and in the early years it
is not clear whether a new medical treatment will be found. All resources spent in this research stage
can therefore not be considered an asset.
Example 3.5 Legal ownership of a resource is not necessary to have control by the entity. For example,
when a firm rents a warehouse, the firm is not the legal owner of the warehouse. However, one can
consider the firm to be the economic owner of the warehouse during the term of the rental contract.
During this time period, the firm has control over how to use the warehouse to store inventory. Hence,
economic ownership could be sufficient to consider a resource to be an asset.
3.1.2 Liabilities
In financial accounting, an obligation of the firm is called a liability.

Definition 3.3 A liability is a present obligation of the entity that (i) arises from past events and
(ii) the settlement of which is expected to result in an outflow from the entity of resources embodying
economic benefits.
An obligation is a duty or responsibility that the firm has towards third parties. Obligations usually
result from contracts between the firm and third parties. Condition (i) implies that a transaction
has occurred. Condition (ii) implies that the firm needs to sacrifice resources to fulfil the duty or
responsibility.
Example 3.6 A bank loan is a liability of the entity. A bank loan results in an obligation of the entity
to repay the loan at the end of the term. At the repayment date, cash is transferred from the entity
to the bank. This amount of cash is a valuable resource of the entity: the entity could have used this
cash, for example, to purchase inventory that could be sold at a profit or to pay its salesmen
Example 3.7 When a publishing company receives annual subscription fees from customers for a
hard-copy or online newspaper, this results in a liability of the entity. Because subscription fees are
usually paid in advance, the publishing company has the obligation to provide the customers with
newspapers for the upcoming year. This obligation results in an outflow of resources as the publishing
company has to pay journalists and editors to produce these newspapers.
3.1.3 Equity
In accounting, the accounting value of the firm Vta (see Chapter 1.2) is the net value of the assets and
liabilities: it is the value of the firm that belongs to the owners of the firm and is referred to as owner’s
equity, or just in short, equity. Equity is the residual interest in the assets after deducting all its
liabilities, i.e., the owners of the entity are the residual claimants of the entity’s assets and liabilities.
3.1.4 The accounting equation
The definition of equity gives rise to the accounting equation:
Total assets = Total liabilities + Equity

Aat = Lat + Vta
The accounting equation is the most important equation in accounting. It makes total assets, total
liabilities and equity interrelated. In particular, the accounting equation implies that a change in the
value of an asset, liability, or equity component must result in the change in value of another asset,
liability or equity component. In other words, a change in value never comes alone.
Observe that the accounting equation also applies to changes, i.e., the change in total assets is equal
to the change in total liabilities and the change in equity, i.e.,
Change in Change in Change in

= +
Total assets Total liabilities Equity
Aat − Aat−1 = Lat − Lat−1 + Vta − Vt−1
a

In many cases, we will apply the accounting equation in terms of changes rather than levels. To reduce
notation, we omit the term “changes in...”; however, which version of the accounting equation we use
will be clear from the text.
Example 3.8 When GreenTees purchases inventory on credit on September 1, GreenTees obtains an
asset, i.e., 350 T-shirts. Observe that inventory meets the definition of an asset: even though GreenTees
has not paid for the T-shirts yet, inventory is an asset because GreenTees is the legal owner of the
T-shirts and thus receives full control over this inventory at the time of purchase and any proceeds
of the sale of these T-shirts flow to GreenTees. The credit purchase also results in an obligation for
GreenTees to pay the bill to the supplier. Hence, the purchase value of the inventory is equal to the
liability to pay the bill so that the accounting equation is satisfied:

Inventory Suppliers payable
e + 7, 000 e + 7, 000
3.1.5 The balance sheet
The balance sheet or statement of financial position presents an overview of the assets, liabilities and
equity of a firm at a certain date. The balance sheet thus presents an overview of the accounting value
Vta of the firm as a specification of the assets Aat and liabilities Lat . The balance sheet can be presented
in a vertical format:
Balance sheet of company X (date)

Total assets Aat
Equity Vta
Total liabilities Lat
Equity and total liabilites Vta + Lat
or in horizontal format (i.e., a so-called T-account):
Balance sheet of company X (date)

Assets Aat Equity Vta
Liabilities Lat
Total assets Aat Equity and total liabilities Vta + Lat
One can interpret the right hand side of the balance sheet as the financial structure of the firm, i.e.,
from which sources did the firm receive its capital. How much capital is provided by the owners (i.e.,
equity) and how much is provided by third parties like banks, suppliers and other creditors. The left
hand side of the balance sheet represents how the capital of the firm has been spent, i.e., what are the
possessions of the firm.
Observe that by definition of the accounting equation, the left hand side of the balance sheet equals
the right hand side, i.e., Aat = Vta + Lat .

At this stage it is also important to mention two additional assumptions underlying accrual accounting:
the economic entity assumption and the monetary unit assumption.
Assumption 3.1 The economic entity assumption states that the financial statements of an economic
entity only reflect the transactions that relate to this economic entity.
Example 3.9 The GreenTees company is an economic entity. The activities of GreenTees can be
distinguished from other companies and from the activities of its owner. When the owner of GreenTees
buys a car on private account, this transaction is not part of GreenTees and this transaction should
therefore not be included in the financial records of GreenTees. If, on the other hand, GreenTees buys a
delivery van then this transaction is part of GreenTees and should be recorded in the financial records.
Example 3.10 An economic entity can be a company, a business unit or even a group of companies.
The crucial aspect in defining an economic entity is that its activities can be distinguished from the
activities of other entities. Entities can be legal entities like corporations but do not have to be legal
entities. A group of companies, i.e., a parent company with her subsidiaries, can also be considered an
economic entity even though it consists of multiple legal entities. Large multinationals usually have
subsidiaries in many countries and these subsidiaries are separate legal entities. Investors, however,
still want financial information on the financial position of the multinational that reflects the activities
of all its subsidiaries.
Assumption 3.2 The monetary unit assumption states that economic transactions are measured in
monetary units.
The monetary unit assumption implies that there is a single basis of measurement, namely, the mon-
etary unit(e.g., euro, US dollar). It implies that the value of all assets and liabilities are measured in
monetary units, which enables us to calculate the value of total assets and total liabilities by adding
the value of the individual assets and liabilities.
3.1.6 Recognition criteria for assets and liabilities
Not all resources that meet the definition of an asset need to be recorded on the balance sheet. An
assets is only recorded on the balance sheet when they meet the recognition criteria: An asset is
recorded on the balance sheet when it meets the definition of an asset and (i) it is probable that future
economic benefits flow the entity and (ii) the value of the asset can be measured in a reliable way.
In condition (i), probable refers to the degree of uncertainty in the future economic benefits. Probable
in this context may be interpreted as “more likely than not”.
Example 3.11 Inventory is considered an asset because it is expected to result in future benefits when
the inventory is sold to customers. Observe that the future benefits are still uncertain as the inventory
has not been sold yet. However, one may presume that it is more likely than not that the inventory
will be sold; for if it would be unlikely that the inventory can be sold to customers, the firm would not
have purchased the inventory in the first place.

In condition (ii), reliable measurement is necessary for otherwise the balance sheet does not present a
true and fair view of the asset or liability.
Example 3.12 Consider again the inventory of Example 3.11. A reliable measurement for the value
of inventory is the purchase price as the purchase is observable and verifiable by a third party. Valuing
inventory at the sales price is less reliable as the sales price may be uncertain. For example, the firm
may need to offer discounts to sell all of its inventory. Furthermore, the firm may be optimistically
biased at which price it is able to sell its inventory. The revenue recognition principle covered in
Chapter 3.3.4 is another reason why inventory should not be valued at sales price.
Example 3.13 When a firm owns a patent of a certain technology, this patent can be considered an
asset for the firm as it gives the firm the exclusive right to use this technology in its products and the
sale of these products results in future benefits. However, when this technology has been developed
by the firm, this asset does not meet the recognition criteria for assets: the value of the patent cannot
be measured reliably as future sales are uncertain and any estimates of future sales are subjective. In
particular, the firm may be optimistically biased and overestimate these future sales.
Similar to assets, not all obligations that meet the definition of a liability need to be recorded on the
balance sheet. The recognition criteria for a liability are as follows: (i) it is probable that the liability
results in an outflow of resources embodying economic benefits and (ii) the value of the liability can
be measured reliably.
Example 3.14 When a firm has been accused of a patent infringement by its competitor, the com-
petitor can sue the firm and demand monetary compensation from the firm. The lawsuit can be
considered a liability by the firm. However, as long as the outcome of the lawsuit is not known, this
liability may not be recognized on the balance sheet when it is not probable that it results in an outflow
of resources, i.e., the firm is not expected to be found guilty of the patent infringement. And even when
it is probable that the firm will be found guilty, the liability may not be recognized on the balance
sheet when the damage payments cannot be estimated reliably.
3.1.7 Example: GreenTees
For the month of July, GreenTees was involved in the following transactions:
July 31 A student has started a webshop GreenTees selling T-shirts with all kinds
of prints made from sustainable fabrics. The company starts with a cash
investment of e 6, 000 from the student.
Table 3.2 presents the balance sheet of GreenTees for July 31. Observe that:
• On July 31, GreenTees is established by an investment of e 6, 000 in cash by the owner. This
implies that the company has e 6, 000 in cash assets. Because the company has no liabilities, the
accounting equation implies that owner’s equity equals e 6, 000. No other activities have been
undertaken in July. The accounting equation for this transaction thus equals:

Balance sheet:
Inventory
Accounts receivable
Cash 6, 000
Total assets 6, 000
Owner’s equity 6, 000
Unearned revenue
Suppliers payable
Fee payable
Equity and
6, 000
Total liabilities
Table 3.2: Financial statements for GreenTees for July 2021.

Cash
e + 6, 000 = e + 6, 000

3.2 Stock vs. flow variables
The balance sheet presents the value of so-called stock variables. A stock variable measures the quantity
of this variable at a certain date. So, the variable inventory measures how much inventory the firm
possesses on the balance sheet date. The same holds for accounts receivable and cash. The variable
suppliers payable measures how much money the firm owes suppliers on the balance sheet date and
cash measures how much cash the company possesses on the balance sheet date.
In contrast, a so-called flow variable measures how the quantity of a variable has changed over a
certain period of time. Accounting records both stock and flow variables. Flows can arise between
assets, for example, when cash is used to purchase raw materials, when raw materials are used in
the manufacturing process to result in work-in-progress, and when work-in-progress is completed to
finished goods. Flows can also arise between assets and liabilities, for example, when the firm pays an
instalment on a loan in which case both the value of cash and the value of the loan decreases. As a
final example, observe that net income is also a flow variable as it measures a change in equity over a
certain period of time.
To report changes in financial position, companies need to measure their financial position on a periodic
basis. This is the third assumption of accrual accounting:
Assumption 3.3 The periodicity assumption states that a company reports on a periodic basis.
The period can vary across companies. For internal purposes, large companies may report on a monthly
basis, smaller companies on a quarterly or annual basis. For external purposes, publicly listed com-
panies report on a quarterly or semi-annual basis. In addition to such interim reports, publicly listed
firms also publish annual reports. Privately owned companies usually report on an annual basis. For
tax purposes, reporting is also on an annual basis.
The flow variables that we focus on next are the changes in equity. The value of equity can change as
a result of
• Revenues
• Expenses
• Capital contributions by the owners of the entity (i.e., owners transfer capital from their private
account to the company)
• Capital distributions (or capital withdrawals) to the owners of the entity (i.e., the company
transfers capital from the entity to the owners’ private accounts.
It holds that
Change Capital Capital

= Revenues − Expenses + −
in equity contributions distributions
Observe that revenues and capital contributions result in increases in equity and that expenses and
capital distributions result in decreases in equity. Furthermore, observe that revenues and expenses

differ in nature from capital contributions and capital distributions. Capital contributions and distri-
butions arise from transactions between the company and the owners of the company. In contrast,
revenues and expenses arise from the company’s daily business activities like purchasing and selling
inventory, paying wages, investing in machines and equipment, borrowing from banks and so on. As
users of financial statements want to know how much value the company is able to generate with
her business activities, financial accounting reports revenues and expenses separately from the capital
contributions and capital distributions. The income statement presents the changes in equity due to
revenues and expenses and is discussed in Section 3.3. The statement of changes in equity presents the
changes in equity due to capital contributions or capital distributions and is discussed in Section 3.4.
The decomposition of the change in equity also gives rise to an expanded version of the accounting
equation. Recall that accounting equation can be represented as:

= +
Substituting the decomposition of equity then yields the expanded version the accounting equation:
Changes in Changes in
Capital Capital
Total = Total + Revenues − Expenses + −
contributions distributions
assets liabilities
In the remainder, we again omit the term “changes in...” to reduce notation.
3.3 The income statement and revenue recognition
3.3.1 Revenues
Definition 3.4 In accounting, revenues are (i) receipts of economic benefits during the accounting
period (ii) as a result of ordinary activities of the entity (iii) that result in an increase in equity other
than those relating to contributions from equity participants.
The economic benefits in condition (i) usually refer to cash receipts (i.e., cash sales) or the right to
receive cash receipts (i.e., credit sales). Condition (ii) implies that the economic benefits results from
the ordinary activities of the firm. For example, in the case GreenTees this would the sale of T-shirts.
For example, when a supermarket replaces their refrigerated units, the cash received for the sale of
the old equipment is not considered a revenue as selling equipment is not considered to be part of the
ordinary activities of a supermarket.1 Condition (iii) excludes investments in the firm by the owners of
the firm from being recorded as revenues. In other words, revenues are increases in equity that result
from ordinary activities only. Increases in equity due to investments by the owners are not considered
to be revenues.
Example 3.15 A delivery company generates revenues when it provides delivery services for a cus-
tomer. Because the delivery company receives e 30 cash from the customer for delivering the goods,
1 The supermarket records the sale of the equipment as either a gain or loss on disposal. Sale (or disposal) of equipment
is covered in more detail in the chapter on property, plant and equipment (PPE).

an asset (i.e. cash) of the delivery company has increased in value. As there is no change in obligations
for the delivery company as result of this transaction, the accounting equation implies that equity has
increased in value so that this increase in equity is recorded as revenues:
Total Total
= + Equity
assets liabilities
Capital Capital
Revenues − Expenses + −
e + 30 = e + 30
3.3.2 Expenses
Definition 3.5 In accounting, an expense is (i) an outflow or depletion of resources or the incurrence
of liabilities (ii) as a result of ordinary activities of the entity (iii) that result in a decrease in equity
other than those relating to distributions to equity participants.
The outflow or depletion of resources in Condition (i) implies that some assets of the entity decrease
in value. For example, when a firm sells goods the inventory increases or when a firm pays wages to
employees, cash decreases. Expenses can also arise by means of an increase in liabilities as Example
3.17 below shows. Similar to revenues, expenses only result from the ordinary activities of the firm.
Condition (iii) implies that when the owners of the entity withdraw capital from the entity, this decrease
in equity is treated as a capital distribution and not as an expense.
Example 3.16 A delivery company generates expenses when it provides delivery services for a cus-
tomer because the delivery company has to pay salary e 10 to its employee per delivery. When the
employee is paid in cash when a delivery is made, an asset (i.e. cash) of the entity has decreased in
value. As there is no change in obligations for the delivery company as result of this transaction, the
accounting equation implies that equity has decreased in value.
Total Total
= + Equity
assets liabilities
Capital Capital
e − 10 = − e 10
Example 3.17 Consider the delivery company in Example 3.16. When the employee is paid at the
end of each month for all deliveries made in that month, the cash position of the entity does not change
at the time that the delivery is made. Instead, an obligation arises for the delivery company to pay its
employee at the end of the month for the delivery made. Consequently, total liabilities has increased
in value. The accounting equation then implies that, at the time of the delivery, equity has decreased
in value:

Total Total
= + Equity
assets liabilities
Capital Capital
= e 10 − e 10
3.3.3 Income statement
The income statement presents an overview of the revenues and expenses over a certain period of time.
In financial accounting, the balance of revenues and expenses is accounting income; it is often refered
to as net income or earnings. It represents the change in equity value as a result of the firm’s business
activities. Positive accounting income (profit) results in an increase in equity and thus in an increase
in the value of the company for the owners of the company. Negative accounting income (loss) results
in a decrease in equity and thus in a decrease the value of the company for the owners of the entity.
Similar to the balance sheet, the income statement can be presented in a vertical format or hirozintal
format (T-account):
Income statement of company X (period)

Revenues Rta
Expenses Xta
Net income Ita
Income statement of company X (period)

Expenses Xta Revenues Rta
a
Net income (profit) It Net income (loss) −Ita
Total Total
In the horizontal format, when net income is positive (i.e., a profit), net income is presented on the left
hand side so that the totals of the left hand side and right hand side are equal, i.e., Xta + Ita = Rta . In
contrast, when net income is negative (i.e., a loss), net income is presented on the right hand side so
that the totals of the left hand side and right hand side are equal, i.e., Xta = Rta − Ita . In the horizontal
format, net income is thus always presented by a positive number.
Example 3.18 Assume a firm reports over year 2021 revenues Rta = 2, 000 and expenses Xta = 1, 700.
Then net income equals Ita = 300 and the income statement in horizontal format is as follows:
Income statement of firm (2021)

Expenses 1, 700 Revenues 2, 000
Net income (profit) 300
Total 2, 000 Total 2, 000

Next, assume a firm reports over year 2021 revenues Rta = 2, 000 and expenses Xta = 2, 200. Then net
income equals Ita = −200 (i.e., a loss) and the income statement in horizontal format is as follows:
Income statement of firm (2021)

Expenses 2, 200 Revenues 2, 000
Net income (loss) 200
3.3.4 Revenue recognition principle
Accrual accounting implies that transactions are recorded in the accounting system in the period that
the event occurs. This period need not be the same period in which the cash flows corresponding to
this transaction occur. In contrast, cash accounting records transactions in the accounting system in
the period that the corresponding cash flows occur. Cash accounting thus only keeps track of cash
flows. Just like accrual accounting specifies criteria to recognize assets and liabilities, it also specifies
criteria to recognize revenues and expenses. These criteria are referred to as the revenue recognition
principle and expsense recognition principle.
When an entity sells goods or services to a customer, the entity has a performance obligation to deliver
the goods or services and the customer has the obligation to pay for these goods or services. The
revenue recognition principle states that the entity can record revenue in the period that the entity
has fulfilled its performance obligation.
Example 3.19 When a company sells goods on credit, the company delivers goods to the customer
and the customer will pay for this at later date. In business-to-business transactions, sales on credit
are very common and the term that the customer needs to pay usually varies between 30 − 60 days.
Cash accounting records this sale transaction as a revenue in the period that the customers pays the
invoice. Accrual accounting records this sale transaction in the period that the sale has taken place,
i.e., when the company has fulfilled its part of the sale by transferring ownership of the goods to the
customer. At this point in time, the customer also has a legal obligation to pay for the goods received,
i.e., the company has a legal claim on the customer. In accounting terms, this legal claim is an asset
and is recorded as such.
3.3.5 Expense recognition principle
Expenses arise when there is an outflow of resources from the entity. The expense recognition principle
states that the entity records expenses in the same period as the corresponding revenues are recorded.
If such matching is not feasible, expenses are recorded in the period that the outflow of resources has
occured.
Example 3.20 When a company purchases inventory with cash, there is an outflow of cash and an
inflow of inventory. Cash accounting records this purchase transaction as an expense in the period that
the company pays the supplier. Accrual accounting records this purchase transaction as an expense
in the period that the inventory is sold and delivered (!) to customers. Up to the delivery date, the

inventory is recorded as an asset because it is a resource controlled by the company that results from a
past event (i.e., the purchase transaction) and expected future benefits expected to flow to the company
(i.e., when the inventory is sold).
Example 3.21 Suppose a company rents office space for its management and rent is paid in advance
semi-annually on January 1st and July 1st of each year. Cash accounting records a rent expense in the
period that the rent is paid, i.e., it records a rent expense in January and July and it records no rent
expense in any of the other months. For accrual accounting, observe that it is not feasible to match
the rent expense with revenues: one cannot establish how much of the management activities in, e.g.,
March, result in how much revenues in April and May (and beyond). In this case, accrual accounting
records a rent expense in the period that the resource is used. When the company pays the rent on
January 1st for the upcoming 6 months, the company receives an asset: the company has the right to
use the office space for 6 months. On January 31st, the value of this asset has reduced because the
company now only has the right to use the office space for 5 months. In other words, during January,
the company has ”used up” part of its asset and this part is recorded as a rent expense in January.
We illustrate the income statement and the revenue/expense recognition principles for the August
transactions of GreenTees. Recall that the transactions for August are the following:
month. The annaul subscription fee of e 2, 400 is paid in cash on August 1.
GreenTees hires a part-time employee for 35 hours per month. The wage is
e 20 per hour. Salary is paid in cash at the end of each month.
GreenTees has a hired an advertizing agency to run an online advertizing
campaign for e 100 per month. The advertizing agency bills GreenTees for
their services at the end of each month and GreenTees pays the bill in cash
in the subsequent month.
August 2-31 GreenTees purchases T-shirts from the supplier in cash at e 20 per shirt.
During August, GreenTees has purchased 350 T-shirts and sold and delivered
300 of these T-shirts to customers in cash on the same day that the shirts
were purchased. The sales price is e 25 per shirt.
Table 3.4 presents the financial statements of GreenTees for August. Observe that:
• On August 1, GreenTees pays e 2, 400 in cash for an annual subscription to use webshop software.
GreenTees thus makes a prepayment on the right to use the webshop software for the upcoming
year. This prepayment can be considered to be an asset: it results from a past event, GreenTees
has full control over the decision to make use of the software and it should generate future benefits
in the form of sales. The accounting equation for this transaction thus equals:

Balance sheet:
Inventory 1, 000
Prepaid fee 2, 200
Accounts receivable
Cash 6, 000 3, 400
Total assets 6, 000 6, 600
Owner’s equity 6, 000 6, 500
Unearned revenue
Suppliers payable
Expense payable 100
Equity and
6, 000 6, 600
Total liabilities
Income statement:
Revenues 7, 500
Expenses
Cost of goods sold 6, 000
Subscription fee 200
Advertizing expense 100
Wages 700
Net income 500
Table 3.4: Financial statements for GreenTees up to August 31, 2021.
Total Total
= + Equity
assets liabilities
Prepaid Capital Capital
Cash Revenues − Expenses + −
fee contr. distr.
−e 2, 400 + e 2, 400 = 0
• During August, GreenTees pays e 700 for the employee’s salary. These resources are used to
generate revenues in August. Hence, the expense recognition principle states that these costs
are reported as expenses in August. This also follows from the accounting equation as both
transactions result in a reduction of cash assets. As no liability arises, these transactions should
be recorded as expenses:
Total Total
= + Equity
assets liabilities
Capital Capital
−e 700 = − e 700
• The purchase of T-shirts from suppliers results in an asset for GreenTees called (obviously)
inventory. Observe that inventory meets the conditions of an asset: GreenTees has full control

over what it can do with the T-shirts, ownership of the T-shirts resulted from the purchase
transaction, and GreenTees hopes to sell the T-shirts at a higher price to customers. Furthermore,
observe that the purchase of inventory does not result in an expense. As follows from the
accounting equation, purchase of inventory is just the subtitution of cash assets for another asset
(i.e., inventory):
Total Total
= + Equity
assets liabilities
Capital Capital
Cash Inventory Revenues − Expenses + −
contr. distr.
e − 7, 000 e + 7, 000= 0
• The sale of a T-shirt is reported as a revenue when the T-shirt is delivered to the customer. This
is the application of the revenue recognition principle. Because 300 T-shirts have been delivered,
e 7, 500 is reported in revenues. This also follows from the accounting equation: cash assets
have increased by e 7, 500 and there is no liability as GreenTees has fullfilled her part of the sale
transactions. Hence:
Total Total
= + Equity
assets liabilities
Capital Capital
e 7, 500 = e 7, 500
• The purchase price of a T-shirt is reported as an expense when the T-shirt is sold and delivered to
a customer. This is the application of the expense recognition principle: the expense is matched
to the revenues. Because only 300 T-shirts have been sold and delivered, an expense of e 6, 000
is reported. This expense is reported as cost of goods sold. That an expense needs to be reported
also follows from the accounting equation as the asset inventory reduces with e 6, 000 and this
transaction does not result in any liability:
Total Total
= + Equity
assets liabilities
Capital Capital
Inventory Revenues − Expenses + −
e − 6, 000 = − e 6, 000
• During August, GreenTees has made use of the services of the advertizing agency. This has
resulted in an obligation to pay e 100 in September. Observe that the services of the advertizing
agency do not result in an asset (see Example 3.2). Because these advertizing services have been
used in August, the expense recognition principle states that these costs are reported as expenses
in August. This also follows from the accounting equation:
Total Total
= + Equity
assets liabilities
Accounts Capital Capital
payable contr. distr.
= +e 100 − e 100

• At the end of August, GreenTees has used the webshop software for one month. This means
that GreenTees only has the right to use the webshop software for another 11 months. The value
of this right is 11 × 200 = e 2, 200. Hence, the asset prepaid fee has decreased in value with
e 200. The accounting equation then implies that this corresponds to an expense of e 200.
Alternatively, one can argue that the use of the webshop software costs 2, 400/12 = e 200 per
month. The expense recognition principle then states that each month e 200 should be recorded
as an expense as this resource is used to generate sales in this month. The accounting equation
then implies that the asset prepaid fee should decrease:
Total Total
= + Equity
assets liabilities
fee contr. distr.
−e 200 = − e 200
• Reported net income for August equals e 500. As the income statement shows, revenues equal
e 7, 500 and total expenses equal e 7, 000.
• The cash position of GreenTees has decreased by e 2, 600. The reason for this is that GreenTees
received e 7, 500 in cash from sales but paid e 7, 000 for inventory, e 2, 400 for the annual
subscription fee, and e 700 in wages.
• Observe that the change in cash position is e−2, 600 and net income is e+500. The difference
between net income and the change in cash position thus equals e − 3, 100 and the explanation
for this difference is threefold:
Effect on cash Effect on income Difference

Subscription fee e − 2, 400 e − 200 e − 2, 200
advertizing e0 e − 100 e + 100
Inventory e − 1, 000 e0 e − 1, 000
Total difference e − 3, 100
First, the payment of e 2, 400 for the annual subscription fee only resulted in an expense of
e 200 in August. Hence, the change in cash position is e 2, 200 lower than income. Second,
the advertizing results in an expense of e 100 but no cash payment, i.e., the change in cash
position is e 100 higher than income. Third, GreenTees has paid e 1, 000 for the inventory of
100 T-shirts, which have not resulted in an expense, i.e., the change in cash position is e 1, 000
lower than income.
• Observe that reported net income is equal to the change in equity. During August, the total
assets of GreenTees increased by e 600: inventory increased during August by e 1, 000 (i.e.,
purchase of inventory at e 7, 000 minus the delivered T-shirts with a purchase value of e 6, 000),
prepaid fee increased by e 2, 200 and cash decreased by e − 2, 600. Total liabilities of GreenTees
increased by e 100 for the advertizing services that still have to be paid. Hence, consistent with
the accounting equation, the change in equity equals:

= +
e 600 = e 100 + e 500
The above records have implicitly used a fourth assumption in accrual accounting, namely, the going
concern assumption.
Assumption 3.4 The going concern assumption states that the company will continue her operations
long into the future.
Example 3.22 Recording the asset prepaid fee at e 2, 200 is an application of the going concern
assumption. It assumes that GreenTees will continue her operations in the future so that it will make
use of the webshop software for the period September-July. If GreenTees would have to stop operations
in December due to lack of sales, e 2, 200 would not be a true and fair valuation of the asset prepaid
fee: GreenTees has paid the subscription fee for the period January-July but GreenTees will not be
using the webshop software during that period to generate revenues. However, as one cannot look into
future whether GreenTees will be successful, one makes the going concern assumption and assumes the
company will continue operations into the future.
Example 3.23 The going concern assumption has implications for the valuation of assets and liabil-
ities. When a delivery company is likely to go bankrupt then the delivery vans need to be valued at
their current sales value. This value is usually low as the company’s assets need to be turned into cash
quickly and so the company’s assets will usually be sold at a discount in a liquidation sale.

3.4 The statement of changes in equity
The statement of changes in equity shows how owner’s equity has changed during a period. The
statement of changes in equity is based on the following equation:
Change Capital Capital

= Revenues − Expenses + −
in equity contributions distributions
The statement of changes in equity decomposes the changes in equity into changes due to accounting
income, capital contributions, and capital distributions. The usual presentation format is as follows:
Statement of changes in equity

(period)
Owner’s equity (beginning of period) ...
+ Net income ...
+ Capital contributions ...
− Capital distributions ...
Owner’s equity (end of period) ...
The statement of changes in equity differs from the income statement in that it also shows the trans-
actions with the owners of the company, i.e., did the owners invest additional equity capital in the
company or did they extract equity capital from the company. Observe that the transactions between
the company and her owners do affect the value of owner’s equity but they do not affect accounting
income.
The statement of changes in equity for July and August is included in the financial statements of
GreenTees in Table 3.5. In July, when GreenTees is established, the only change in equity is the capital
contribution by the owner. In August, there are no capital contributions or capital distributions and
the only change in equity is driven by the accounting income of e + 500.

Balance sheet:
Inventory 1, 000
Prepaid fee 2, 200
Accounts receivable
Cash 6, 000 3, 400
Unearned revenue
Suppliers payable
Expense payable 100
Equity and
6, 000 6, 600
Total liabilities
Income statement:
Revenues 7, 500
Expenses
Wages 700
Net income 500
Statement of changes in equity:

Owner’s equity (begin) 0 6, 000
Net income 0 +500
Capital contributions +6, 000 0
Capital distributions 0 0
Owner’s equity (end) 6, 000 6, 500
Table 3.5: Financial statements for GreenTees for July and August.

3.5 The statement of cash flows
The essential part of accrual accounting is that revenues and expenses are not equivalent to cash receipts
and cash payments. The revenue recognition principle states that revenue is recognized when the
company has fullfilled her performance obligation. For a sales transaction, the performance obligation
of the company is to deliver a good or service. Hence, a revenue is recognized when the good or service
has been delivered. When the customer is actually paying for this good or service is not relevant.
The focus on revenues and expenses does not imply that cash flows are completely irrelevant informa-
tion. Accrual accounting uses revenues and expenses so as to better present the company’s economic
performance. Cash flow information is still important because the company needs cash to fund her
operational activities, i.e., the company needs cash to pay the bills. For external stakeholders it is
therefore also useful to receive information on the company’s ability to generate cash. A supplier needs
such cash flow information to decide whether to sell inventory on credit to the company; or to decide
on the credit terms of the sale of inventory to the company. Similarly, a bank needs such cash flow
information to check the company’s ability to pay back the loan.
The statement of cash flows presents an overview of the change in the company’s cash position. The
statement of cash flows distinguishes between three types of cash flows:
• Cash flows from operations: these are cash receipts and cash payments that result from the
company’s operational activities, i.e., the sale of goods and/or services.
• Cash flow from investing activities: these are cash receipts and cash payments that result from
the company’s investing activities. Investing activities comprise transactions in assets that are
used in operational activities for multiple periods. For example, the purchase of manufacturing
equipment, buildings, furniture, vehicles or land result in cash payments for investing activities.
When the company disposes of these assets, i.e., the company sells manufacturing equipment,
buildings, furniture, vehicles or land, then this results in cash receipts for investing activities.
• Cash flow from financing activities: these are cash receipts and cash payments that results from
the company’s financing activities. Financing activities comprise transactions with the equity
and debt capital providers of the company. Cash receipts arise when the owners invest additional
capital in the company or when the company buys a loan from a bank. Cash payments arise
when the owners withdraw capital from the company or when the company pays back a loan.
For the external stakeholders, it is important to know how much cash the company can generate with
her operational activities. When the cash flow from operations is negative period after period, the
company will eventually run out of cash. In that case, to continue operations, the company would have
to obtain additional capital either from the owners or from third parties like banks or creditors.
For now, we present the format of the cash flow statement as follows:

Statement of cash flows
(period)
Cash flow from operations ...
Cash flow from investing activities ...
Cash flow from financing activities ...
Total change in cash ...
Cash (begin of period) ...
Total change in cash ...
Cash (end of period) ...
Observe that the amount of cash (begin of period) is equal to the amount of cash reported on the
balance sheet at the start of the period. Similarly, the amount of cash (end of period) is equal to the
amount of cash reported on the balance sheet at the end of the period. Observe that the total change
in cash is the same as the accounting income reported on the basis of cash accounting (see Section 2).
With accrual accounting, however, it should be stressed that the change in cash does not represent
accounting income (nor economic income).
In practice, the statement of cash flows also includes more detailed information on the cash flow from
operations: it also specifies different types of cash receipts and cash payments. This information is
beyond the scope of this course.
The statement of cash flows for July and August is included in the financial statements of GreenTees
in Table 3.6. In July, when GreenTees is established, the only cash flow is the investment by the owner
of e 6, 000 cash. This cash flow is reported as a cash flow from financing activities. In August, the
cash position decreases by e − 2, 600. As these cash flows are related to the purchase of inventory
and the annual subscription, this is reported as cash flows from operations. Observe that there are no
investing or financing activities in August so that the corresponding cash flows equal zero.

Balance sheet:
Inventory 1, 000
Prepaid fee 2, 200
Accounts receivable
Cash 6, 000 3, 400
Unearned revenue
Suppliers payable
Expense payable 100
Equity and
6, 000 6, 600
Total liabilities
Income statement:
Revenues 7, 500
Expenses
Wages 700
Net income 500

Owner’s equity (begin) 0 6, 000
Net income 0 +500
Capital contributions +6, 000 0
Capital distributions 0 0
Owner’s equity (end) 6, 000 6, 500
Statement of cash flows:

Operating cash flow 0 −2, 600
Investing cash flow 0 0
Financing cash flow +6, 000 0
Total change in cash +6, 000 −2, 600
Cash (begin) 0 6, 000
Total change in cash +6, 000 −2, 600
Cash (end) 6, 000 3, 400
Table 3.6: Financial statements for GreenTees for July and August.

3.6 Example: GreenTees
This section presents accrual accounting for the remaining periods in the GreenTees example. For each
month, the complete financial statements are presented and explained.
3.6.1 September
The transactions for September are the following:
September 1 GreenTees pays e 100 to the advertizing agency for their services in August.
paid in October.
September 2-30 GreenTees sells 300 T-shirts in cash and delivers them to the customers (sales
GreenTees has hired an advertizing agency to run an online advertizing cam-
paign in September. The bill of e 100 will be paid in October.
Table 3.8 presents the financial statements of GreenTees for September. Observe that:
• The cash payment of the bill of the advertizing agency reduces the cash position of GreenTees
by e 100 and reduces the obligation expense payable by the same amount as this obligation no
longer exists. The accounting equation for this transaction is:
Total Total
= + Equity
assets liabilities
payable contributions distributions
−e 100 = −e 100
• The purchase of inventory on credit results in a liability of the company. This liability equals
e 7, 000 and is reported on the balance sheet. The purchase of inventory also results in an asset
as the possessions of the company have increased. The accounting equation for this transaction
is:
Total Total
= + Equity
assets liabilities
Suppliers Capital Capital
e 7, 000 = e 7, 000
• Revenues and expenses for September are the same as in August as GreenTees has again sold and
delivered 300 T-shirts to customers and the sale and purchase price for these T-shirts have not
changed either. That the T-shirts have been purchased on credit from the supplier is not relevant
for income. Consistent with the expense recognition principle, T-shirts are recorded as expenses
when T-shirts are sold and delivered to the customer: when the T-shirts are delivered, GreenTees
no longer has these T-shirts in her inventory and so the value of inventory has decreased. The
accounting equation then implies that this decrease results in an expense.

• The cash position of GreenTees has increased by e 6, 700. The reason for this is that GreenTees
has purchased inventory on credit. Hence, besides the cash receipts of e 7, 500, GreenTees only
made cash payments of e 100 and e 700 in September.
• Observe that the change in cash position is e 6, 200 higher than income. The main reason for this
that an expense has been recorded for the 300 T-shirts sold in September even though GreenTees
has not paid the supplier for these 300 T-shirts. The effect of the differences for advertizing in
August and September cancel each other out because in both months the advertizing services
has a value of e 100. Observe though that advertizing in August results in a cash payment
in September but not an expense, i.e., it does give rise to a difference in the change in cash
position and income. For advertizing in September the opposite holds: it results in an expense
in September but not a cash payment.

Subscription fee e0 e − 200 e 200
Inventory e0 e − 6, 000 e 6, 000
Advertizing (August) e − 100 e0 e − 100
Advertizing (September) e0 e − 100 e + 100
Total difference e + 6, 200
• Finally, the change in equity is equal to reported income because there were no transactions
between GreenTees and her owners. This also shows in the statement of changes in equity.
Observe that even tough total assets has increased in September by e7, 500 (i.e., inventory
increased by e1, 000 and cash by e 6, 500), the liabilities of GreenTees has increased by e 7, 000
as well. Consistent with the accounting equation, equity has increased by e 500:

= +
e 7, 500 = e 7, 000 + e 500

Balance sheet:
Inventory 1, 000 2, 000
Prepaid fee 2, 200 2, 000
Accounts receivable
Cash 6, 000 3, 400 10, 100
Total assets 6, 000 6, 600 14, 100
Owner’s equity 6, 000 6, 500 7, 000
Unearned revenue
Suppliers payable 7, 000
Expense payable 100 100
Equity and
6, 000 6, 600 14, 100
Total liabilities
Income statement:
Revenues 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000
Subscription fee 200 200
Advertizing expense 100 100
Wages 700 700
Net income 500 500

Owner’s equity (begin) 0 6, 000 6, 500
Net income 0 +500 +500
Capital contributions +6, 000 0 0
Capital distributions 0 0 0
Owner’s equity (end) 6, 000 6, 500 7, 000

Operating cash flow 0 −2, 600 +6, 700
Investing cash flow 0 0 0
Financing cash flow +6, 000 0 0
Total change in cash +6, 000 −2, 600 +6, 700
Cash (begin) 0 6, 000 3, 400
Total change in cash +6, 000 −2, 600 +6, 700
Cash (end) 6, 000 3, 400 10, 100
Table 3.8: Financial statements for GreenTees up to September 30, 2021.

3.6.2 October
The transactions for October are the following:
October 1 GreenTees pays e 100 to the advertizing agency for their services in Septem-
ber.
GreenTees pays the bill for the purchase on September 1.
GreenTees purchases inventory on credit: 250 shirts at e 20 each. The in-
ventory is paid in November.
October 2-31 GreenTees sells 100 T-shirts in cash and delivers them to the customers (sales
GreenTees sells 200 T-shirts on credit and delivers them to the customers
(sales price e 25 per shirt). Customers pay their bill in November.
paign in October. The bill of e 100 will be paid in November.
Table 3.10 presents the financial statements of GreenTees for October. Observe that:
• The payment of e 7, 000 to the supplier for the credit purchase of inventory in September results
in a decrease in cash assets of e 7, 000 and the liability to pay the supplier reduces by e 7, 000
to e 0:
Total Total
= + Equity
assets liabilities
e − 7, 000 = e − 7, 000
• The purchase of 250 T-shirts on credit is similar to the purchase of inventory on credit in Septem-
ber. In this case, the credit purchase increases inventory by e 5, 000 and increases the liability
suppliers payable by e 5, 000. Hence, the balance sheet of GreenTees on October 30 shows a
liability suppliers payable with a value of e5, 000.
• The cash sale of 100 T-shirts is similar to the cash sales of GreenTees in August and September.
What is different now is that GreenTees has also sold 200 T-shirts on credit, i.e., the T-shirts have
been sold and delivered to the customers but the customers have not paid yet for the T-shirts.
Because GreenTees has fullfilled her part of the sales transactions, i.e., the T-shirts have been
delivered to the customer, the revenue recognition principle states that the revenues have to be
recorded in October. Because the credit sale does not result in a liability for GreenTees , the ac-
counting equation implies that this credit sale gives rise to an asset, namely, GreenTees possesses
the legal right to receive cash from her customers. This asset is called accounts receivable, or in
short, receivables:
Total Total
= + Equity
assets liabilities
Capital Capital
Accounts receivable Revenues − Expenses + −
e + 5, 000 = e + 5, 000

Observe that the asset accounts receivable meets the conditions of an asset: GreenTees has full
control over this claim; GreenTees can decide to waive or reduce the required payment from the
customer. The asset is the result of the past credit sale transaction and the asset results in future
benefits when the customers pay their bills, i.e., GreenTees receives cash.
• The delivery of the 200 T-shirts that were sold on credit also result in expenses, consistent with
the expense recognition principle. Because the 200 T-shirts have been delivered, GreenTees’
inventory decreases:
Total Total
= + Equity
assets liabilities
Capital Capital
e − 4, 000 = − e 4, 000
• The income statement is the same as in previous months as GreenTees has again sold and delivered
300 T-shirts to customers.
• The cash position of GreenTees has decreased by e 5, 300. The main reason for this is the credit
sale which considerably reduces the cash receipts in October. Cash receipts only equal e 2, 500
whereas cash payments equal e 7, 000 (suppliers payable!), e 100, and e 700.
• The change in cash position is e 5, 800 lower than income. The explanation for this is twofold:
first, the credit sale results in e 5, 000 in revenues that are not cash receipts, i.e., the change in
cash position is e 5, 000 lower than income. Second, the e 7, 000 payment to the supplier does
not correspond with the recorded expense of e 6, 000 for the 300 T-shirts that have been sold
and deliverd, i.e., the change in cash position is e 1, 000 lower than income.

Subscription fee e0 e − 200 e + 200
Suppliers payable/cost of goods sold e − 7, 000 e − 6, 000 e − 1, 000
Credit sale e0 e + 5, 000 e − 5, 000
Advertizing (September) e − 100 e0 e − 100
Advertizing (October) e0 e − 100 e + 100
• The statement of changes in equity shows that the change in equity is equal to reported income.
Again, there were no transactions with the owner of GreenTees. Observe that total assets has
decreased in October by e1, 500 and the liabilities of GreenTees have decreased by e 2, 000.
Consistent with the accounting equation, equity has increased by e 500:

= +
e − 1, 500 = e − 2, 000 + e 500

Balance sheet:
Inventory 1, 000 2, 000 1, 000
Prepaid fee 2, 200 2, 000 1, 800
Accounts receivable 5, 000
Cash 6, 000 3, 400 10, 100 4, 800
Total assets 6, 000 6, 600 14, 100 12, 600
Owner’s equity 6, 000 6, 500 7, 000 7, 500
Unearned revenue
Suppliers payable 7, 000 5, 000
Expense payable 100 100 100
Equity and
6, 000 6, 600 14, 100 12, 600
Total liabilities
Income statement:
Revenues 7, 500 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000 6, 000
Subscription fee 200 200 200
Advertizing expense 100 100 100
Wages 700 700 700
Net income 500 500 500

Owner’s equity (begin) 0 6, 000 6, 500 7, 000
Net income 0 +500 +500 +500
Capital contributions +6, 000 0 0 0
Capital distributions 0 0 0 0
Owner’s equity (end) 6, 000 6, 500 7, 000 7, 500

Operating cash flow 0 −2, 600 +6, 700 −5, 300
Investing cash flow 0 0 0 0
Financing cash flow +6, 000 0 0 0
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300
Cash (begin) 0 6, 000 3, 400 10, 100
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300
Cash (end) 6, 000 3, 400 10, 100 4, 800
Table 3.10: Financial statements for GreenTees up to October 31, 2021.

3.6.3 November
For the month of November, GreenTees has the following transactions:
November 1 GreenTees pays e 100 to the advertizing agency for their services in October.
GreenTees pays the bill for the purchase on October 1.
GreenTees receives the payment from customers for the credit sales in Octber.
paid in December.
November 10 The owner of GreenTees transfers e 2, 000 in cash to his private account.
November 2-30 GreenTees sells 350 T-shirts in cash (sales price e 25 per shirt).
Because GreenTees only has 300 T-shirts in inventory, 50 T-shirts are in
backorder and will be delivered to customers in December.
paign in November. The bill of e 100 will be paid in December.
Table 3.12 presents the financial statements of GreenTees for November. Observe that:
• The payment of the supplier and the purchase of new inventory on credit are similar to October.
• When the customers pay their bill for the credit sales in October, GreenTees receives e 5, 000 in
cash and the value of accounts receivable decreases by e 5, 000 to e 0 as GreenTees no longer
has claim on the customers that they should pay their bill. The accounting equation for this
transaction is:
Total Total
= + Equity
assets liabilities
receivable contr. distr.
e 5, 000 e − 5, 000=
• When the owner of GreenTees withdraws e 2, 000 in cash from the company, this implies that
cash decreases by e 2, 000. As this is a transaction between GreenTees and her owner, it is not
an expense but a capital dsitribution:
Total Total
= + Equity
assets liabilities
Capital Capital
−e 2, 000 = − e 2, 000
• GreenTees sells and delivers 300 T-shirts to customers. This sale is in cash and is thus similar
to cash sales that occured in previous months. Hence, it results in e 7, 500 in cash and revenues
and it result in e 6, 000 in expenses and a reduction of e 6, 000 in inventory.

• GreenTees has sold 50 T-shirts for which customers have paid e 1, 250 in cash. GreenTees,
however, has run out of inventory and is not able to deliver these T-shirts to the customers in
November. GreenTees needs to backorder these T-shirts and will deliver these T-shirts to the
customers in December. Consistent with the revenue recognition principle, GreenTees can not
record the e 1, 250 as revenues in November as GreenTees has not fullfilled her part of the sales
transaction yet. The accounting equation then implies that the cash receipt of e 1, 250 also
results in a liability to GreenTees, i.e., the obligation to deliver 50 T-shirts. This obligation is an
example of unearned revenue and the value of this obligation is the sales value of the T-shirts at
e 1, 250:
Total Total
= + Equity
assets liabilities
Unearned Capital Capital
revenue contributions distributions
e 1, 250 = e 1, 250
• The cash position of GreenTees has increased by e 5, 950. The main drivers for this are the
e 5, 000 cash receipts for the October credit sale and the e 1, 250 prepayments of customers on
the 50 T-shirts that are in backorder. Total cash receipts then amount to e 7, 500+ e 5, 000+
e 1, 250 =e 13, 750 and total cash payments are e 5, 000 (suppliers payable!), e 100, e 700, and
the capital distribution of e2, 000. Observe that the latter cash flow is part of cash flow from
financing activities. Consequently, the cash flow from operations is e 7, 950.
• The change in cash position is e 5, 450 higher than income. The explanation for this is as follows:

Credit sale (October) e + 5, 000 e0 e + 5, 000
Unearned revenue e 1, 250 e0 e + 1, 250
Suppliers payabale/cost of goods sold e − 5, 000 e − 6, 000 e + 1, 000
Advertizing (October) e − 100 e0 e − 100
Advertizing (November) e0 e − 100 e + 100
Capital dsitribution e − 2, 000 e0 e − 2, 000
Total difference e + 5, 450
The October credit sale results in cash receipts of e 5, 000 that are not recorded as revenues in
November, i.e., the change in cash position is e 5, 000 higher than income. Next, the 50 T-shirts
in backorder resulted in a cash receipt of e 1, 250 payment that is not recorded as a revenue in
November, i.e., cash receipts are e 1, 250 higher than income. The payment of e 5, 000 to the
supplier does not correspond with the recorded expense of e 6, 000 for the 300 T-shirts that have
been sold and deliverd, i.e., the change in cash position is e 1, 000 higher than income. Finally,
the capital distribution results in a cash outflow ofe 2, 000 that is not an expense.

• The statement of changes in equity shows that the change in equity is not equal to reported
income. The capital distribution decreases owner’s equity by e 2, 000, resulting in a net decrease
of e 1, 500. Total assets has decreased in November by e250, the liabilities of GreenTees have
increased by e 1, 250. Consistent with the accounting equation, equity has decreased by e 1, 500:

= +
−e 250 = e 1, 250 − e 1, 500

Balance sheet:
Inventory 1, 000 2, 000 1, 000 0
Prepaid fee 2, 200 2, 000 1, 800 1, 600
Accounts receivable 5, 000 0
Cash 6, 000 3, 400 10, 100 4, 800 10, 750
Total assets 6, 000 6, 600 14, 100 12, 600 12, 350
Owner’s equity 6, 000 6, 500 7, 000 7, 500 6, 000
Unearned revenue 1, 250
Suppliers payable 7, 000 5, 000 5, 000
Expense payable 100 100 100 100
Equity and
6, 000 6, 600 14, 100 12, 600 12, 350
Total liabilities
Income statement:
Revenues 7, 500 7, 500 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000 6, 000 6, 000
Subscription fee 200 200 200 200
Advertizing expense 100 100 100 100
Wages 700 700 700 700
Net income 500 500 500 500

Owner’s equity (begin) 0 6, 000 6, 500 7, 000 7, 500
Net income 0 +500 +500 +500 +500
Capital contributions +6, 000 0 0 0
Capital distributions 0 0 0 0 −2, 000
Owner’s equity (end) 6, 000 6, 500 7, 000 7, 500 6, 000

Operating cash flow 0 −2, 600 +6, 700 −5, 300 +7, 950
Investing cash flow 0 0 0 0
Financing cash flow +6, 000 0 0 −2, 000 −2, 000
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300 +5, 950
Cash (begin) 0 6, 000 3, 400 10, 100 4, 800
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300 +5, 950
Cash (end) 6, 000 3, 400 10, 100 4, 800 10, 750
Table 3.12: Financial statements for GreenTees up to November 30, 2021.

3.6.4 December
In December, GreenTees has the following transactions:
December 1 GreenTees pays e 100 to the advertizing agency for their services in October.
GreenTees pays the bill for the purchase on December 1.
paid in January.
GreenTees delivers the 50 T-shirts that were in backorder to the customers.
December 2-31 GreenTees sells 200 T-shirts in cash and delivers them to the customers (sales
GreenTees sells 50 T-shirts on credit and delivers them to the customers (sales
price e 25 per shirt). Customers will pay their bill in January.
paign in December. The bill of e 100 will be paid in January.
Table 3.14 presents the financial statements of GreenTees for December. Observe that:
• The payment of the supplier and the purchase of new inventory on credit are similar to previous
months.
• When GreenTees delivers the 50 T-shirts that were in backorder, GreenTees has fullfilled her
part of the sales transaction. Hence, the liability unearned revenue decreases by e 1, 250 to e 0.
The revenue recognition principle states that GreenTees can record a revenue of e 1, 250, i.e.,
the sales value of the 50 T-shirts. The accounting equation for this transaction is:
Total Total
= + Equity
assets liabilities
revenue contributions distributions
= e − 1, 250 + e 1, 250
• The delivery of the 50 T-shirts is similar to previous deliveries, i.e., inventory decreases by e 1, 000
and an expense is recorded for e 1, 000.
• The cash and credit sales in December are treated similar to previous cash and credit sales.
Combining both sales and the corresponding delivery of T-shirts in one yields the following
accounting equation:
Total Total
= + Equity
assets liabilities
receivables contr. distr.
e 5, 000+ e 1, 250 e − 5, 000= e 6, 250 − e 5, 000

• The cash position of GreenTees has decreased by e 800. GreenTees has received e 5, 000 for the
cash sale and has paid e 5, 000 to the supplier, e 700 in wages, and e 100 to the advertizing
agency. No other cash flows occured in December. In particular, because there are no investing
or financing transactions, the cash flow from operations equals e − 800.
• The change in cash position is e 1, 300 lower than income. The explanation for this is as follows:

Unearned revenue e0 e + 1, 250 e − 1, 250
Credit sale e0 e + 1, 250 e − 1, 250
Suppliers payable/cost of goods sold e − 5, 000 e − 6, 000 e + 1, 000
Advertizing (November) e − 100 e0 e − 100
Advertizing (December) e0 e − 100 e + 100
The backorder of 50 T-shirts resulted in revenues of e 1, 250 but the corresponding cash receipt
already occured in November, i.e., the change in cash position is e 1, 250 lower than income. The
credit sale of 50 T-shirts in December resulted in revenues of e 1, 250 but the corresponding cash
receipt will occur in January next year, i.e., the change in cash position is e 1, 250 lower than
income. Finally, the payment of e 5, 000 to the supplier does not correspond with the recorded
expense of e 6, 000 for the 300 T-shirts that have been sold and deliverd, i.e., the change in cash
position is e 1, 000 higher than income.
• The statement of changes in equity again shows that the change in equity is equal to reported in-
come as there were no transactions between GreenTees and her owner. Total assets has increased
in December by e2, 250, the liabilities of GreenTees have increased by e 1, 750. Consistent with
the accounting equation, equity has increased by e 500:

= +
e 2, 250 = e 1, 750 + e 500

Balance sheet:
Inventory 1, 000 2, 000 1, 000 0 2, 000
Prepaid fee 2, 200 2, 000 1, 800 1, 600 1, 400
Accounts receivable 5, 000 0 1, 250
Cash 6, 000 3, 400 10, 100 4, 800 10, 750 9, 950
Total assets 6, 000 6, 600 14, 100 12, 600 12, 350 14, 600
Owner’s equity 6, 000 6, 500 7, 000 7, 500 6, 000 6, 500
Suppliers payable 7, 000 5, 000 5, 000 8, 000
Expense payable 100 100 100 100 100
Equity and
6, 000 6, 600 14, 100 12, 600 12, 350 14, 600
Total liabilities
Income statement:
Revenues 7, 500 7, 500 7, 500 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000 6, 000 6, 000 6, 000
Subscription fee 200 200 200 200 200
Advertizing expense 100 100 100 100 100
Wages 700 700 700 700 700
Net income 500 500 500 500 500

Owner’s equity (begin) 0 6, 000 6, 500 7, 000 7, 500 6, 000
Net income 0 +500 +500 +500 +500 +500
Capital contributions +6, 000 0 0 0 0 0
Capital distributions 0 0 0 0 2, 000 0
Owner’s equity (end) 6, 000 6, 500 7, 000 7, 500 6, 000 6, 500

Operating cash flow 0 −2, 600 +6, 700 −5, 300 +7, 950 −8, 00
Investing cash flow 0 0 0 0 0 0
Financing cash flow +6, 000 0 0 0 −2, 000 0
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300 +5, 950 −800
Cash (begin) 0 6, 000 3, 400 10, 100 4, 800 10, 750
Total change in cash +6, 000 −2, 600 +6, 700 −5, 300 +5, 950 −800
Cash (end) 6, 000 3, 400 10, 100 4, 800 10, 750 9, 950
Table 3.14: Financial statements for GreenTees up to December 31, 2021.

3.7 True and fair view
Observe that the financial statements on the basis of accrual accounting present a more true and fair
view than cash accounting. By comparing tables 2.2 and 3.14, one can see that the shortcomings of
cash accounting mentioned in Subsection 2.2 are resolved by accrual accounting:
i. Reported income numbers better present the economic activities of GreenTees. GreenTees has
sold and delivered 300 T-shirts each month and this also shows in the identical income numbers
of e 500. Recall that with cash accounting the financial performance varied considerable across
the months.
ii. The financial statements show the inventory of GreenTees and any obligations that GreenTees
has at a certain point in time. It thus provides a more complete picture than cash accounting.
iii. The interests of the creditors are better protected. When the owner of GreenTees withdraws the
reported income of September of e 500 from the company on October 1, the financial statements
are as presented in Table 3.15. Observe that the total assets of GreenTees on October 1 are more
than sufficient to meet the obligation to pay the supplier e 7, 000. GreenTees does not become
technically bankrupt as in the cash accounting case (cf. Table 2.3).

Jul 31 Aug 31 Sep 30 Oct 1
Balance sheet:
Inventory 1, 000 2, 000 2, 000
Prepaid fee 2, 200 2, 000 2, 000
Accounts receivable
Cash 6, 000 3, 400 10, 100 9, 600
Total assets 6, 000 6, 600 14, 100 13, 600
Owner’s equity 6, 000 6, 500 7, 000 6, 500
Unearned revenue
Equity and
6, 000 6, 600 14, 100 13, 600
Total liabilities
Income statement:
Revenues 7, 500 7, 500
Expenses
Subscription fee 200 200
Advertizing expense 100 100
Wages 700 700
Net income 500 500

Owner’s equity (begin) 0 6, 000 6, 500 7, 000
Net income 0 +500 +500
Capital contributions +6, 000 0 0
Capital distributions 0 0 0 −500
Owner’s equity (end) 6, 000 6, 500 7, 000 6, 500
Table 3.15: Financial statements for GreenTees when the owner withdraws September net income of
500 from the firm on October 1.

Chapter 4
Issues and challenges in financial

accounting
4.1 Introduction
Accrual accounting records transactions when they occur. When a transaction occurs, accounting
needs to answer the following question: does this transaction change the value of any assets, liabilities
and/or equity of the firm? However, to be able to answer this question, one first needs to know how to
measure the value of assets, liabilities and equity. For some type of transactions, such measurement is
rather straightforward. Examples of this are the transactions in the GreenTees example: cash/credit
purchase of inventory, cash sales. However, not all transactions are that simple or straightforward.
Some examples:
• In many countries customers have the right to return goods bought from a webshop. How does
this influence the time when the webshop can recognize the revenue? Can it recognize the revenue
when the good has been delivered? Or should it recognize the revenue when the return period
has expired?
• Retailers usually sell their goods with a warranty period. During this warranty period, the retailer
is responsible for any defects with the goods. How should the retailer account for this? Should it
record revenues for the sale when the warranty period has expired? Or should the costs related
to the warranty policy be treated separately from the sales transaction?
• How should a firm account for a customer loyalty plan, e.g., airline companies offering airmiles
to their customer?
• Companies frequently lease (manufacturing) equipment instead of buying the equipment. As the
company does not become the legal owner of the equipment in a lease, should leased equipment
be recorded as an asset? if not, how does it affect the relevance and reliability of the financial
statements.
52
• Companies with excess cash usually invest this cash in financial instruments like stocks and
bonds. When the company has bought stocks and the market price of these stocks increase, does
this result in a profit for the company? or should the profit on such investment be determined
and reported at the time that the company sells the stock again?
• Companies buy other companies. When a company acquires another company, how should this
be recorded in the financial statements.
• Similarly, large multinational companies usually consist of a parent company with many subsi-
daries. How can the financial statements of the group company properly present the activities of
the parent company and its subsidiaries?
• Companies whose equity shares are listed on a stock exchange usually compensate their manage-
ment with cash, stock, and stock options. How should stock and stock option compensation be
recorded in the financial statements? What is the cost of the company for paying management
with stock?
These are just a couple of examples of (complex) transactions that firms engage in.
For each type of transaction, accounting methods need to be designed that prescribe how such trans-
actions are recorded in the financial statements. Such an accounting method is called an accounting
standard. Each country has its own accounting standard setting body that determines the collection
of accounting standards that firms in that country need to comply with. This collection of accounting
standards is usually referred to as the Generally Accepted Accounting Standards (GAAP) for that
country. In addition to the country specific GAAPs, there also exist International Financial Reporting
Standards (IFRS) that are designed by the International Accounting Standards Board (IASB). IFRS is
not country specific. The European Union and many other countries require companies whose equity
shares are listed on a stock exchange to report on the basis of IFRS. Private companies usually have
to report on the basis of their country GAAP.
This course focuses on the basic transactions that firms engage in like purchasing and selling inventory,
borrowing and investing in property, plant and equipment. The more complex transactions are beyond
the scope of this course. In discussing the various accounting methods, this course mostly follows
the accounting standards of IFRS. The remainder of this chapter discusses the primary issues and
trade-offs that accounting standard setting bodies encounter when designing accounting standards.
4.2 Recognition and measurement

In designing an accounting standard for a certain type of transaction, the two main issues are recog-
nition and measurement. First, standard setters need to decide whether this type of transaction
• results in an asset and/or liability that needs to be recognized on the balance sheet;
• results in revenues and/or expenses that need to be recognized on the income statement.
Second, if an asset or liability needs to be recognized on the balance sheet, standards setters need to
decide on:

• At which value is the asset and/or liability recognized on the balance sheet on the transaction
date?
• How is the value of the asset and/or liability measured after the transaction date?
If revenues and/or expenses need to be recognized on the income statement, standard setters need
to decide on how to measure the value of these revenues and/or expenses. In resolving the issues of
recognition and measurement, the following aspects play an important role:
• Decision Usefulness
• Relevance-reliability trade-off
• Historical cost vs. current value
We discuss each of these aspects in more detail below.
4.2.1 Decision usefulness
A primary objective of financial reporting is to provide stakeholders with information that is useful
for their decision making processes. For example, assume that the company GreenTees wants to
expand her operational activities. To increase the scale of her operations, GreenTees needs to have
additional capital to purchase more inventory, obtain more storage space, hire more personnel and so
on. If GreenTees also wants to start a brick-and-mortar shop, she needs to obtain a retail store, invest
in equipment, sales personnel and so on. To obtain this capital, GreenTees may turn to a bank to
obtain a loan. To make a proper lending decision, the bank needs to assess the creditworthiness of the
GreenTees, i.e., what is the ability of GreenTees to make the interest payments on the loan and to pay
back the principal amount. One piece of information that the bank can use for this are the financial
statements of GreenTees.
When GreenTees would use cash accounting, GreenTees would provide the financial information of
Table 2.2 to the bank. We repeat this table below:

Accounting value:
Cash 6, 000 5, 500 12, 000 6, 500 14, 250 13, 450
Accounting income:
Cash receipts 7, 500 7, 500 2, 500 13, 750 5, 000
Cash payments
Purchases 7, 000 0 7, 000 5, 000 5, 000
Subscription fee 200 200 200 200 0
Wages 800 800 800 800 800
Income −500 6, 500 −5, 500 7, 750 −800
Based on this information, the bank may conclude that GreenTees operations are rather risky: income
varies considerably from month to month and there are also months that GreenTees makes a loss; and

the loss over October is also quite considerable. The same holds for GreenTees cash receipts; these also
vary considerably across months. The bank may assess lending to GreenTees as high risk and decide
to not provide the loan at all; or if the bank does provide the loan, it may do so at a very high interest
rate and additional conditions like demanding collateral or the right to recall the loan at any time.
When GreenTees would use accrual accounting, GreenTees would provide the financial information of
Table 3.14. It shows a stable income e 500 per months and stable revenues of e 7, 500 per month.
Based on this information, the bank may assess the credit risk of GreenTees as low and decide the lend
capital at relatively low interest rates.
For proper decision-making the bank needs financial information that presents a true and fair view
of GreenTees economic performance as such information will enable the bank to correctly assess the
credit risk of GreenTees. In other words, the bank wants information that is relevant or decision useful.
Information is more relevant when it better presents a true and fair view of economic performance.
In the previous sections it is shown that accrual accounting does a much better job at this than cash
accounting.
4.2.2 Relevance reliability trade-off
The relevance reliability trade-off is an important trade-off in accounting. It influences which assets
and liabilities are recorded on the balance sheet and at which value. The trade-off exists because,
generally speaking, a more relevant valuation method is less reliable. This may imply that when a
relevant valuation method is not reliable, it may be preferred to report this asset and/or liability at a
less relevant but more reliable value on the balance sheet; or if such value does not exist, to not report
it all.
Example 4.1 Recall from Section 1.1 that the economic value of the firm is defined as the discounted
value of all future cash flows. Hence, it would be most relevant to report the expected future cash flows
of the firm in the financial statements. However, the future is uncertain and any estimate of expected
future cash flows will be subjective. Different people may come up with different estimates and it is
difficult, if not impossible, to determine which estimates are correct and which are not. Furthermore,
the firm itself is likely optimistic about its expected future cash flows and thus makes higher estimates
of future cash flows than others would. Because there is usually no reliable measure for the expected
future cash flows of a company, they are usually not reported in the financial statements.
Example 4.2 Consider a firm that buys a patent on a certain technology from another firm. This
patent can be considered an asset of the buying firm (cf. Definition 3.2): the patent is controlled by
the firm, results from past events and will result in future economic benefits. How should one value the
patent? One alternative is to value the patent based on the expected future cash flows. This valuation
method is most relevant as it coincides with the economic value of the patent. However, for the same
reasons as mentioned in Example 4.1, this valuation method is not very reliable. A second alternative
is to value the patent at the purchase price. Observe that the purchase price is a more reliable valuation
method as it is verifiable by third parties. Furthermore, one may assume that the firm that buys the
patent expects that the expected future cash flows of the patent will be higher than the purchase price
for otherwise it would never have bought the patent at that price. But this, in turn, implies that the
purchase price is less relevant as it does not completely reflect the expected future benefits.

4.2.3 Historical cost vs. current value
The relevance reliability trade-off also arises in the valuation of assets and liabilities. Valuing an asset
at historical cost is more reliable as the price at which an asset has been acquired is verifiable by a third
party. However, when time passes one can question whether the historical cost still properly reflects
the value of the asset. In that case, using the current value of the asset may provide more relevant
information. The trade-off is how reliable one can measure the current value.
Example 4.3 When GreenTees sells T-shirts on credit for e 2, 000, GreenTees debits the asset ac-
counts receivable by e 2, 000. At the time of the sale, e 2, 000 is the amount of cash that GreenTees
expects to receive from her customers. This is the historical cost valuation and this valuation is reli-
able as it can be verified by an external auditor. When time progresses, some customers may miss the
payment deadline after which GreenTeeswill send these customers a reminder. Most of these customers
will eventually pay their bill, but several customers may not. Hence, when at the end of a month,
GreenTees reports the original amount of e 2, 000 in accounts receivables, this is not the most relevant
valuation. Users of financial statements would like to know how much GreenTees actually expects to
receive from their customers, i.e., users would like GreenTees to take into account the possibility that
some customers will not pay their bill. Observe that the current value of receivables takes default into
account: if 20% of the customers is not expected to pay, the current value of the receivables is e 1, 600
instead of e 2, 000. Observe that estimating how many customers will default on their payment may be
subjective and reduce the reliability. However, in practice, objective and reliable estimates can usually
be made based on customers’ payment records of preceding periods.
Example 4.4 When, at the end of the month, GreenTees reports inventory of e 1, 000 based on
the historical purchase price, this valuation is reliable. However, it may be less relevant, especially
for fashionable items like the T-shirts that GreenTeessells. Inventory can loose value when the items
become out of fashion. For example, it could be that GreenTeesinventory primarily consists of T-shirts
with unfashionable colors that customers do not want to buy. Hence, the current value of GreenTees’
inventory is more relevant information to the users of financial statements. The users would like to
know at what price GreenTeesis able to sell her inventory. Again, determining the current value of the
inventory may be subjective: GreenTeesneeds to estimate at what price customers are willing to buy
these T-shirts. This subjectivity may reduce reliability.
Observe that current value is a general concept and implies that the valuation on the measurement
date incorporates up-to-date information. Current value can be implemented in accounting in different
ways; commonly used terminology in this respect includes fair value, value in use, net realisable value,
and recoverable amount. At this stage, however, there is no need to know the differences between these
valuation methods.
4.3 Balance sheet vs. income statement approach

Recall the extended version of the accounting equation:

Total Total
= + Equity
assets liabilities
Capital Capital
The accounting equation establishes a strict relation between the valuation of assets and liabilities on
the one hand and the valuation of revenues and expenses on the other hand. In particular, the way one
values assets and liabilities determines the value of revenues and expenses and the other way around.
We illustrate this strict relation by means of an example.
Example 4.5 Recall from the GreenTees example that on December 31, GreenTees has 100 T-shirts
in inventory at a purchase price of e 20 per T-shirt. Assume that in January, GreenTees purchases
another 100 T-shirts at e 23 per T-shirt. At this date, the inventory consists of 200 T-shirts at a value
of e 4, 300. Next, assume that GreenTees sells 100 T-shirts in cash at e 25 per T-shirt. How should
GreenTees value ending inventory and cost of good sold? Observe that GreenTees has 100 T-shirts in
the ending inventory. At what price should these T-shirts be valued: at the old purchase price of e 20
or the current purchase price of e 23?
Using the old purchase price of e 20, values the ending inventory at e 2, 000. This valuation implies
that inventory decreases from e 4, 300 to e 2, 000 so that cost of goods sold must equal e 2, 300, i.e.,
cost of goods sold are valued at the new purchase price of e 23 so that the reported profit on this sale
equals e 200.
Using the new purchase price of e 23, values the ending inventory at e 2, 300. This valuation implies
that inventory decreases from e 4, 300 to e 2, 300 so that cost of goods sold must equal e 2, 000, i.e.,
cost of goods sold are valued at the old purchase price of e 20. Consequently, the reported profit on
this sale equals e 500.
Observe that it is not possible to value ending inventory and cost of goods sold both at the new
purchase price as this violates the accounting equation. Valuing ending inventory at the new purchase
price implies that inventory decreases by e 2, 000 whereas valuing cost of goods sold at the new purchase
price yields cost of goods sold of e 2, 300:
Total Total
= + Equity
assets liabilities
Capital Capital
−e 2, 000 ̸= − e 2, 300
The strict relation between the valuation of assets and liabilities and revenues and expenses implies
that in designing accounting standards, one either focuses on the valuation of assets and liabilities,
from which the valuation of revenues and expenses then follows automatically; or one focuses on the
valuation of revenues and expenses, from which the valuation of assets and liabilities then follows
automatically. The first is called the balanced sheet approach of financial accounting; this is also the
approach we have been following thus far and it is also the approach followed by IFRS. The second
is called the income statement approach of financial accounting: it focuses on allocating revenues and
expenses to the most appropriate periods.

Example 4.6 Consider the advertizing services that GreenTees has bought in August for e 100.
Furthermore, assume that the advertizing services entail ads published in August to promote a sales
discount in September. The balance sheet approach analyzes this transaction on the basis of whether
it results in an asset to GreenTees. Advertizing does not meet the definition of an asset because it
does not result in a resource (i.e., a right to future benefits). Consequently, no asset is recognized and
thus, e 100 is reported as advertizing expenses in August.
The income statement approach analyzes this transaction on the basis of in which periods the adver-
tizing generates additional sales. The cost of the advertizing is then allocated over these periods and
reported as advertizing expenses in these periods. In this particular case, one can argue that the adver-
tizing service only generates additional sales in September so that advertizing expenditures of e 100 in
August will be reported as advertizing expenses in September. Consequently, the accounting equation
implies that GreenTees reports an asset of e 100 in August called deferred advertizing expenses.
Example 4.7 Assume that on January 31, GreenTees buys computer equipment to process purchases,
sales and so on more efficiently. The cost of the computer equipment is e 3, 600 and the computer
equipment is expected to be used for the next 3 years. Under the balance sheet approach, the accounting
for the computer equipment focuses on the asset value of the computer equipment at the end of each
reporting period. The decrease in the asset value over a reporting period is then reported as an expense.
These expenses are referred to as depreciation expenses.
Under the income statement approach, the accounting for the computer equipment focuses on allocating
the purchase price of e 3, 600 over the periods that the computer equipment is used. Ideally, the expense
recorded in each period reflects the extent to which the computer equipment contributed to the firm’s
revenues in that period. The expense is again referred to as a depreciation expense. Furthermore, the
expense determines by how much the asset value of the computer equipment decreases.
Summarizing, the balance sheet approach focuses on the decrease in the value of the asset and records
the decrease as a depreciation expense whereas the income statement approach focuses on what the
appropriate depreciation expense should be and the depreciation expense determines by how much the
value of the asset decreases.
One can interpret the balance sheet approach and income statement approach as two different philoso-
phies to design accounting standards. However, it does not automatically imply that the balance sheet
approach and income statement approach lead to significantly different accounting methods.
The income statement approach also implies a different interpretation for many assets and liabilities.
Because the income statement approach focuses on allocating revenues and expenses to the appropriate
periods, revenues need not be recorded in the same period as the corresponding cash flow is received.
Similarly, expenses need not be recorded in the same period as the corresponding cash payment is made.
These timing differences result in assets or liabilities being reported on the balance sheet. These assets
are either accrued revenues or deferred expenses and these liabilities are either deferred revenues or
accrued expenses.
• Accrued revenue: a revenue is recorded in a period before the period that the corresponding cash
inflow arises. The revenue is recorded when the company has fulfilled her performance obligation;
at this point in time the company has a legal claim to receive cash from the customer. This claim

is reported as an asset for the company (cf. accounting equation). When the customer pays the
cash, the value of the asset reduces.
Example 4.8 Consider the financial statements of GreenTeeson 3.10. During October, GreenTees has
sold 200 T shirts on credit. Under the income statement approach, the corresponding asset accounts
receivable of e 5, 000 on October 31 is an example of an accrued revenue: GreenTees has recorded
a revenue in October as GreenTeeshas fulfilled the performance obligation in October. However, the
corresponding cash receipt will take place in a later period when the customers pay their bill.
Example 4.9 Another example of an accrued revenue can arise in health care organizations. When
the health care organization has treated a patient, it may take some time when the patient’s health
insurer pays the bill. In this case, the health care organization recognizes the revenue when the patient
has been treated and it recognizes an asset that represents the amount of cash that the health care
organization is entitled to receive from the patient’s health insurer.
• Deferred expense: a cash outflow arises in a period before the period that the corresponding
expense is recorded. A deferred expense gives rise to an asset for the company. When the
company pays cash, it either receives inventory or it receives the right to use goods or services.
This is recorded as an asset. An expense is recorded when the asset is ”used up”, e.g., when
inventory is sold or when a time period has passed. At that point in time, the asset value also
decreases.
Example 4.10 Consider the financial statements of GreenTeeson 3.4. Under the income statement
approach, the asset prepaid fee of e 2, 200 on August 31 is an example of a deferred expense: the cash
payment for this asset has been made by GreenTees in August but the recording of the expenses has
been deferred to the future: an expense of e 200 will be recorded in each of the upcoming 11 months.
Observe that the web software is used in each month to generate sales in that month so that according
to the income statement approach, e 200 should be reported as an expense in each month.
The asset inventory of e 1, 000 on August 31 is also an example of a deferred expense: the cash
payment for this inventory has been made by GreenTees in August. However, this cash payment has
not resulted in an expense in August. The recording of the expense has been deferred to the future:
an expense will be recorded in the period that this inventory will be sold and delivered to customers.
The expense is matched with the period that the sale of inventory generates revenues.
• Deferred revenue: a cash inflow arises in a period before the period that the corresponding
revenue can be recorded. A deferred revenue gives rise to a liability of the company. When
the company receives the cash, the company has a performance obligation: it needs to provide
goods or services for the cash that it received from the customer. This performance obligation is
recorded as a liability. When the company fulfills the performance obligation, the company can
record a revenue and the liability reduces in value.
Example 4.11 Consider the financial statements of GreenTeeson 3.12. The backorder of 50 T-shirts
resulted in a liability unearned revenue of e 1, 250 on November 30. Under the income statement
approach, this liability is an example of a deferred revenue: GreenTees has received cash in November

but the corresponding revenue will be recorded in a later period when the T-shirts have been delivered
to the customers. In other words, revenues have been deferred to a future period.
Example 4.12 Another common example of deferred revenue are newspaper or magazine subscrip-
tions. When the customer pays the annual subscription fee on a newspaper, the publisher cannot
recognize this cash receipt as a revenue as the publisher still has a performance obligation to fulfill,
namely, the publisher has to deliver newspapers to this customer for the next 12 months. Only once
the performance obligation has been fulfilled, can the publisher recognize revenue. In this case, the
1
publisher can recognize at the end of each month 12 -th of the annual subscription fee as revenue
(presuming that the publisher delivered all the newspapers during this month to the customer).
• Accrued expense: an expense is recorded in a period before the period that the corresponding
cash outflow arises. An accrued expense gives rise to a liability of the company. When the
company recognizes an accrued expense, the company has used a resource or service for which
it still needs to pay cash. When the company makes the cash payment, the liability reduces in
value.
Example 4.13 Consider the financial statements of GreenTeeson 3.4. The purchase of the adevertiz-
ing services results in a liability expense payable of e 100 on August 31. Under the income statement
approach, this liability is an example of an accrued expense: an expense has been recorded whereas the
cash payment occurs in a future month. In other words, the cash payment has been deferred to a future
period. In this case, the advertizing expense of e 100 is recorded in August and the corresponding
cash payment arises in September.
Example 4.14 Another common example where accrued expenses arise is in bank loans. Consider a
bank loan op e10, 000 with annual interest rate of 6%. When the interest is paid annually at the end
of each year, the borrower needs to pay e600 in interest to the bank at the end of the year. However,
the interest on the loan increases as time passes. After 1 month, the borrower has the obligation to pay
the bank 121
× 6% × 10, 000 = e50in interest. Hence, at the end of the first month, the borrower needs
to recognize an interest expense of e 50 even though the borrower only needs to pay this amount at
the end of the year. This is consistent with the expense recognition principle that states that expenses
need to be recorded in the period that the outflow of resources has occured.

Part II
The recording process
61
Chapter 5
The accounting information system
The GreenTees example of Chapter 3 involved only a limited number of transactions to illustrate
the basic concepts of accrual accounting and to illustrate how these transactions affect the balance
sheet and income statement. In practice, firms engage in many transactions. Large retailers may
have thousands of sales transactions per day and need to purchase and keep inventory of hundreds or
thousands of different items. This requires a systematic administrative system and process to record
all these transactions. This chapter introduces the primary concepts of the administrative system, i.e.,
the accounting information system. The next chapter presents the process.
5.1 General ledger

Financial transactions can cause changes in the assets, liabilities and owner’s equity. In the examples
in Chapter 3, we processed all transactions directly into the balance sheet and income statement. In
practice, it is not efficient to produce a new balance sheet and income statement each time a financial
transaction occurs. Instead, we make use of a general ledger. The general ledger consists of accounts
for all different types of assets and liabilities, owner’s equity, and all types of revenues and expenses.
The general form of a ledger account (also called T-account) is as follows:
debit account name credit

date description amount date description amount
... ... ... ... ... ...
... ... ... ... ... ...
The debit and credit sides of the ledger account are explained in the next subsection. For now, observe
that the general ledger consists of many ledger accounts. For each separate line item on the balance
sheet there is a separate ledger account. Recall that the balance sheet line items measure stock
variables, i.e., they measure the quantity of the variable. The balance sheet accounts are therefore
called ‘permanent’ or ‘real’ accounts. For each line item on the income statement there is also a
separate ledger account. The income statement line items measure flow variables, i.e., how much the
62
quantity of a variable changes. The income statements accounts are therefore called ‘temporary’ or
‘nominal’ accounts because they start with zero values at the beginning of each reporting period.
For the GreenTees example, the general ledger consists of the following permanent accounts:
Owner’s
debit Inventory credit debit equity credit
Prepaid Unearned
debit fee credit debit revenue credit
Account Suppliers
debit receivables credit debit payable credit
debit Cash credit Expense

debit payable credit
and it consists of the following temporary accounts:
Cost of Subscription
debit goods sold credit debit fee expense credit
Wages Advertizing
debit expense credit debit expense credit
debit Revenues credit
Observe that new accounts can be added to the general account whenever necessary. For example,
when GreenTees buys the loan on January 1, it needs to include separate accounts in the general ledger
for the loan and the corresponding interest expense.

Assets Liabilities Owner’s equity Revenues Expenses
Increase Debit Credit Credit Credit Debit
Decrease Credit Debit Debit Debit Credit
Table 5.1: The meaning of debit and credit.
5.2 Debit vs. credit

Debit and credit are terminology that is typical for financial accounting and bookkeeping. Debit and
credit are used to indicate an increase or decrease in value. However, whether debit means ‘increase’
or ‘decrease’ depends on the type of account that one refers to. The meaning of debit and credit is
presented in Table 5.1.
To better understand the meaning of debit and credit, consider the balance sheet and income statement
of GreenTees for December in horizontal format:
Balance sheet GreenTees

debit (December 31) credit
Inventory 2,000 Owner’s equity 6,500
Prepaid fee 1,400 Unearned revenue -
Accounts receivable 1,250 Suppliers payable 8,000
Cash 9,950 Expense payable 100
Total assets 14,600 Equity and total liabilities 14,600
Income statement GreenTees

debit (December) credit
Cost of goods sold 6,000 Revenues 7,500
Subcription fee expense 200
Wages expense 800
Net income (profit) 500
Total 7,500 Total 7,500
The balance sheet in horizontal format is presented as a ledger account: the left hand side of the
balance sheet is the debit side and contains all assets and the right hand side of the balance sheet
is the credit side and contains owner’s equity and all liabilities. Increasing (decreasing) the value of
an asset then corresponds to debiting (crediting) the asset account because an asset is on the debit
side of the balance sheet. Similarly, increasing (decreasing) the value of a liability corresponds to
crediting (debiting) the liability account because a liability is on the credit side of the balance sheet.
The same holds for the owner’s equity account: increases in equity are credited and decreases in equity
are debited.
The same argument applies to the income statement accounts. The income statement in horizontal
format is presented as a ledger account: the left hand side of the income statement is the debit side and
contains all expenses and the right hand side of the income statement is the credit side and contains all
revenues. Increasing (decreasing) the value of an expense then corresponds to debiting (crediting) the

expense account because an expense is on the debit side of the income statement. Similarly, increasing
(decreasing) the value of a revenue corresponds to crediting (debiting) the revenue account because a
revenue is on the credit side of the income statement. Observe that this interpretation is consistent
with the treatment of owner’s equity: a revenue is credited because a revenue increases owners’ equity
and an increase in owner’s equity is credited. Similarly, an expense is debited because an expense
decreases owner’s equity and a decrease in owner’s equity is debited.
Summarizing, the meaning of debit and credit can be easily inferred by checking whether the account
shows up on the debit or credit side of the balance sheet or income statement.
Finally, observe that the values reported on the balance sheet or income statement correspond to the
net value on the corresponding ledger account. For example,on the balance sheet of GreenTees on
December 31, the net value of inventory is a debit value of e 2, 000. This implies that on December 31,
the ledger account inventory has a debit value of e 2, 000. So, the balance sheet and income statement
of December 31 correspond to the following general ledger balance values:
Owner’s
debit Inventory credit debit equity credit
Dec 31 2, 000 Dec 31 6, 500
Prepaid Unearned
debit fee credit debit revenue credit
Dec 31 1, 400
Accounts Suppliers
debit receivable credit debit payable credit
Dec 31 1, 250 Dec 31 8, 000
Expense
debit Cash credit debit payable credit
Dec 31 9, 950 Dec 31 100
Cost of Subscription
debit goods sold credit debit fee expense credit
Dec 31 6, 000 Dec 31 200
Wages Advertizing
debit expense credit debit expense credit
Dec 31 700 Dec 31 100
debit Revenues credit

Dec 31 7, 500
The reason for using debit and credits is that it enables a control mechanism to check for any errors.
As will become clear in the following chapter, in a journal entry (cf. Chapter 6.2) the total of amounts

debited must be equal to the total of amounts credited. Similarly, in the (adjusted) trial balance (cf.
Chapter 6.4 and 6.7), the total amounts debited must be equal to the total amounts debited. If these
equalities do not hold, you know an error has been made which should be corrected.

Chapter 6
The accounting cycle
The accounting cycle is the administrative process that is repeated for each reporting period and
consists of the following 10 steps:
1. Analyze transactions
2. Journalize transactions
3. Post journal entries to accounts
4. Trial balance
5. Adjusting journal entries
6. Correcting journal entries
7. Adjusted trial balance
8. Financial statements
9. Closing journal entries
10. Post-closing trial balance
Steps 1 − 3 occur during the reporting period; steps 4 − 10 occur at the end of the reporting period.
Example: GreenTees
This chapter illustrates the 10 steps of the accounting cycle by means of the GreenTees example for
the month of January. Recall that the balance sheet on December 31 is as follows:
67
Balance sheet of GreenTees
(December 31)
Inventory 2,000
Prepaid fee 1,400
Accounts receivable 1,250
Cash 9,950
Total assets 14,600
Equity 6,500
Unearned revenue -
Suppliers payable 8,000
Expense payable 100
Equity and total liabilities 14,600
Furthermore, recall that on August 1, GreenTees bought an annual subscription for the use of webshop
software for e 2, 400 per year, to be payable in cash on May 1. For the month of January, GreenTees
has the following transactions:
January 1 GreenTees buys a loan from a bank. The term of the loan is 3 years, the
amount borrowed is e 10, 000 and the annual interest rate is 12%. The
annual interest is paid at the end of each year. GreenTees pays back the loan
in full at the end of the 3 year term.
January 3 GreenTees rents storage space for e 100 per month. The annual rent of
e 1, 200 is paid in advance on January 3 and covers the period January 1 -
December 31.
January 5 GreenTees pays the supplier e 8, 000 for the T-shirts delivered in December.
January 6 GreenTees purchases 600 T-shirts on credit and 300 T-shirts in cash at a
purchase price of e 20 per T-shirt. The supplier will be paid for the 300
T-shirts in February.
January 11 GreenTees receives e 1, 250 from customers for the credit sales of December.
January 14 GreenTees pays the advertizing agency e 100 for services delivered in De-
cember. GreenTees does not run any advertizing campaign in January.
January 25 GreenTees pays her employee e 700 in wages. However, this transaction
is recorded incorrectly by GreenTees bookkeeper: the bookkeeper records a
payment of e 900.
January 27 A customer orders 100 T-shirts with a personalized print fore 30 per T-shirt.
Because the 100 T-shirts have to be custom made, GreenTees will deliver
these T-shirts in February. The customer makes a prepayment on this order
of e 2, 100 in cash. The remainder of e 900 will paid upon delivery.
January 29 The owner of GreenTees withdraws e 1, 600 cash to a private account.

January 31 GreenTees buys computer equipment for e 3, 600 and pays in cash. The
computer equipment has an expected useful life of 3 years and is depreciated
in a straight line. Monthly depreciation expenses amount to e 100 and are
recorded for the first time in February.
Janaury 02 − 31 GreenTees sells and delivers 600 T-shirts in cash at a sales price of e 25 per
T-shirt.
GreenTees sells and delivers 250 T-shirts on credit at a sales price of e 27
per T-shirt. Customers will pay the bill in February.
6.1 Analyze transactions

Financial accounting and bookkeeping in particular is based on financial transactions, not on opinions
and desires. A financial transaction is any event that affects the financial position of the company and
that can be measured reliably. To measure a financial transaction, you must decide when the trans-
action occurred (the recognition issue), at what value to measure the transaction (the measurement
issue) and how the different components of the transaction should be categorized (the classification
issue).
The recognition issue refers to the difficulty of deciding when a financial transaction should be recorded.
The resolution of this issue is important because the date on which a transaction is recorded affects
amounts in the financial statements. The recognition criteria for assets, liabilities, revenues and ex-
penses are leading in this respect. The measurement issue focuses on assigning a monetary value to the
assets, liabilities, revenues and/or expenses that result from a financial transaction. The classification
issue has to do with assigning all the transactions in which the firm engages to appropriate categories,
or accounts. Classification of debts can affect a firm’s ability to borrow money and classification of
purchases can affect its income.
To analyze transactions, you can follow the following steps:
1. Basic analysis: what has happened?
2. Which accounts are affected and by how much?
3. What is the effect on the accounting equation?
Example: GreenTees
Let us illustrate these steps for one of the January transactions of GreenTees:

GreenTees has received e 10, 000 in cash from the bank and has the obligation to repay the loan
in 3 years time.

The account cash increases by e 10, 000. GreenTees needs to create a new account in the general
ledger called bank loan. This account represents a liability and the value of this account increases
by e 10, 000.
Total Total
= + Equity
assets liabilities
Bank Capital Capital
loan contr. distr.
e 10, 000 = e 10, 000
Discussion point 6.1 Why are the future interest payments not included in this analysis? The
reason is straightforward: on January 1 GreenTees does not have any obligation to make the interest
payments. The bank can only claim interest once time has passed. For example, on January 31 when
1
one month has passed, the interest on the loan has accrued to 12 × 12% × 10, 000 =e 100. However,
when GreenTees decides to repay to loan on January 2, there is no interest payment.
6.2 Journalize transactions

Each transaction needs to be translated in bookkeeping terms so that it can be processed and recorded
in the general ledger. This translation is called the journal entry. A journal entry has the following
structure:
Date Name of account that changes Debit Credit

... ... ... ...
... ... ... ...
... ... ... ...
The first column lists the date of the transaction. The second column lists all the accounts that are
affected by this transaction. The third column includes the value by which the account should be
debited and the fourth column includes the value by which the account should be credited. Observe
that an account is either debited or credited but not both. It is common to structure a journal such
that you first list the accounts that are debited and then the accounts that are credited.
The use of debit and credits to indicate increases or decreases in the value of accounts gives rise to a
control check: for each journal entry, the total value of all debited amounts should always be equal
to the total value all credited amounts. If this is not the case, then the journal entry is not a correct
representation of the transaction.
The complete set of journal entries (in chronological order) is called the general journal.

Example: GreenTees
Consider the bank loan transaction of Janaury 1. The transaction analysis in Section 6.1 showed that
the bank loan resulted in an increase of the account cash by e 10, 000. Because cash is an asset and is
listed on the debit side of the balance sheet, an increase in cash implies that the account cash needs to
be debited (see Table 5.1). Because the bank loan is a liability and is listed on the credit side of the
balance sheet, an increase in the value of the bank loan implies that the account bank loan needs to
be credited (see Table 5.1). The journal entry of this transaction is thus as follows:

Jan 01 Cash 10, 000
Bank loan 10, 000
6.3 Post journal entries to ledger accounts

The next step in the accounting cycle is to post the journal entries to the accounts, i.e., debit or credit
the accounts by the amounts as prescribed in the journal entry.
Example: GreenTees
For the bank loan transaction of Janaury 1, the accounts cash and bank loan need to be adjusted.
Observe that the account bank loan does not exist yet in the general ledger as GreenTees did not
have any bank loans on December 31. Hence, this account is created and has a starting value of zero
(credit). Processing the journal entry of the bank loan has the following effect on the accounts:
debit Cash credit debit Bank loan credit

Dec 31 9, 950 Jan 01 10, 000
Jan 01 10, 000
The cash account has been debited for e 10, 000 so that the total net value in the cash account is
e 19, 950 debit. Similarly, the bank loan account is credited for e 10, 000 so that the total net value
in the bank loan account is e 10, 000 credit.
We will now present the three steps of transaction analysis, journalizing, and posting for the other
Janaury transaction of GreenTees.

Transaction analysis:
December 31.

GreenTees has paid e 1, 200 in cash for the annual rent of storage space. At the same time,
GreenTees has received the right to use storage space for the period January 1 - December 31.
This right is an asset for GreenTees. Observe that this transaction does not affect the value of
total assets of GreenTees. It only affects the composition of assets: some cash has been exchanged
for the right to use storage space.

The cash account has deceased with e 1, 200. GreenTees has to create a new account called
prepaid rent. This account represents an asset and has increased in value by e 1, 200.
Total Total
= + Equity
assets liabilities
rent contr. distr.
−e 1, 200 +e 1, 200 = 0
Journal entry:

Jan 03 Prepaid rent 1, 200
Cash 1, 200
Observe that the account prepaid rent has been added to the general ledger. Because prepaid rent is
an asset and its value increases, the account prepaid rent has to be debited. Similarly, cash is an asset
and decreases in value. Hence, the cash account has to be credited (cf. Table 5.1).
Posting to ledger accounts:
debit Cash credit debit Prepaid rent credit

Dec 31 9, 950 Jan 03 1, 200 Jan 03 1, 200
Jan 01 10, 000

January 5 GreenTees pays the supplier e 8, 000 for the T-shirts delivered in December.

GreenTees has paid e 8, 000 in cash to pay the bill of the supplier that was still outstanding.
Hence, GreenTees has fullfilled an obligation.

The cash account has decreased with e 8, 000 and the liability suppliers payable has decreased
with e 8, 000.
Total Total
= + Equity
assets liabilities
−e 8, 000 = −e 8, 000
Journal entry:

Jan 05 Suppliers payable 8, 000
Cash 8, 000
Because suppliers payable is a liability and its value decreases, the account suppliers payable has to be
debited. Similarly, cash is an asset and decreases in value. Hence, the cash account has to be credited
(cf. Table 5.1).
Suppliers
Dec 31 9, 950 Jan 03 1, 200 Jan 05 8, 000 Dec 31 8, 000
Jan 01 10, 000 Jan 05 8, 000

January 6 GreenTees purchases 600 T-shirts on credit and 300 T-shirts in cash at a
purchase price of e 20 per T-shirt. The supplier will be paid for the 600
T-shirts in February.

GreenTees has purchased 900 T-shirts from the supplier. GreenTees has paid for 300 T-shirts in
cash and has the obligation to pay the remaining 600 T-shirts in February.

The asset account inventory has increased in value by e 18, 000 and the cash account has de-
creased by e 6, 000. The liability account suppliers payable has increased in value by e 12, 000.
Total Total
= + Equity
assets liabilities
−e 6, 000 +e 18, 000 = +e 12, 000
Journal entry:

Jan 06 Inventory 18, 000
Cash 6, 000
Because inventory is an asset its value increases, the account inventory has to be debited. Cash is
an asset and decreases in value. Hence, the cash account has to be credited. Suppliers payable is a
liability and increases in value so that the account suppliers payable has to be debited. (cf. Table 5.1).
debit Cash credit debit Inventory credit

Dec 31 9, 950 Jan 03 1, 200 Dec 31 2, 000
Jan 01 10, 000 Jan 05 8, 000 Jan 06 18, 000
Jan 06 6, 000
Suppliers
debit payable credit
Jan 05 8, 000 Dec 31 8, 000
Jan 06 12, 000

January 11 GreenTees receives e 1, 250 from customers for the credit sales of December.

GreenTees has received e 1, 250 in cash and GreenTees no longer has a claim on customers to
pay their bill.

The asset account cash has increased by e 1, 250 and the asset accounts receivable has decreased
by e 1, 250.
Total Total
= + Equity
assets liabilities
e 1, 250 −e 1, 250 = 0
Journal entry:

Jan 11 Cash 1, 250
Because cash is an asset its value increases, the cash account has to be debited. Conversely, accounts
receivable is an asset and decreases in value. Hence, the accounts receivable account has to be credited
(cf. Table 5.1).
Accounts
debit Cash credit debit receivable credit
Dec 31 9, 950 Jan 03 1, 200 Dec 31 1, 250 Jan 11 1, 250
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000

January 14 GreenTees pays the advertizing agency e 100 for services delivered in De-
cember. GreenTees does not run any advertizing campaign in January.

GreenTees has paid e 100 in cash and GreenTees no longer has the obligation to pay the adver-
tizing agency.

The asset account cash has decreased by e 100 and the liability expense payable has decreased
by e 100.
Total Total
= + Equity
assets liabilities
Expenses Capital Capital
−e 100 = −e 100
Journal entry:

Jan 14 Expense payable 100
Cash 100
Because expense payable is a liability and its value decreases, the expense payable has to be debited.
Cash is an asset and its value decreases so that the cash account has to be credited (cf. Table 5.1).
Expense
Dec 31 9, 950 Jan 03 1, 200 Jan 14 100 Dec 31 100
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 14 100

is recorded incorrectly by GreenTees bookkeeper: the bookkeeper records a
payment of e 900.

GreenTees has paid cash for the labor services provided by the employee.

The asset account cash has decreased by e 700 and the expense account wages expense has
increased by e 700.
Total Total
= + Equity
assets liabilities
Capital Capital
contr. distr.
−e 700 = − e 700
Journal entry: The correct journal entry for this transaction would be as follows:

Jan 25 Wages expense 700
Cash 700
Because wages expense is an expense account and its value increases, the accounts wages expense has
to be debited. Cash is an asset and its value decreases so that the cash account has to be credited (cf.
Table 5.1).
However, observe that in this case it is mentioned that the accountant makes an error and records the
following incorrect journal entry:

Cash 900
Wages
debit Cash credit debit expense credit
Dec 31 9, 950 Jan 03 1, 200 Jan 25 900
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 14 100
Jan 25 900

January 27 A customer orders 100 T-shirts with a personalized print for e 30 per T-shirt.
Because the 100 T-shirts have to be custom made, GreenTees will deliver
these T-shirts in February. The customer makes a prepayment on this order
of e 2, 100 in cash. The remainder of e 900 will paid upon delivery.

This transaction can be split in two parts. First, GreenTees has received e 2, 100 in cash and
GreenTees has the obligation to manufacture and deliver 70 T-shirts to the customer. Second,
GreenTees has agreed with the customer to deliver 30 T-shirts in February for which the customer
pays e 900 upon delivery.

The asset account cash has increased with e 2, 100 and the liability unearned revenue has in-
creased with e 2, 100. Observe that GreenTees cannot recognize e 2, 100 as revenues because
GreenTees has not fullfilled her part of the sales transaction.
The second part of the transaction is not recorded. GreenTees did not receive any cash nor can
she record revenue because she has not delivered to 30 T-shirts yet.
Total Total
= + Equity
assets liabilities
revenue contr. distr.
e 2, 100 = e 2, 100
Journal entry:

Jan 27 Cash 2, 100
Because cash is an asset and its value increases, the cash account has to be debited. The account
unearned revenue is a liability and its value increases. Hence, the account unearned revenue has to be
credited (cf. Table 5.1).
Unearned
debit Cash credit debit revenue credit
Dec 31 9, 950 Jan 03 1, 200 Dec 31 0
Jan 01 10, 000 Jan 05 8, 000 Jan 27 2, 100
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 25 900

January 29 The owner of GreenTees withdraws e 1, 600 cash to a private account.

The owner of GreenTees has taken e 1, 600 of cash out of the company.

The cash account decrease by e 1, 600. The account capital distributions increases by e 1, 600.
Total Total
= + Equity
assets liabilities
Capital Capital
contr. distr.
−e 1, 600 = − e 1, 600
Journal entry:

Jan 29 Capital distributions 1, 600
Cash 1, 600
Observe that the account capital distributions has been added to the general ledger of GreenTees.
Because capital distributions decrease owner’s equity, an increase in capital distributions should be
debited (cf. Table 5.1).
Capital
debit Cash credit debit distributions credit
Dec 31 9, 950 Jan 03 1, 200 Jan 29 1, 600
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 25 700
Jan 29 1, 600

January 31 GreenTees buys computer equipment for e 3, 600 and pays in cash. The
computer equipment has an expected useful life of 3 years and is depreciated
in a straight line. Monthly depreciation expenses amount to e 100 and are
recorded for the first time in February.

GreenTees has become the owner of computer equipment at a price of e 3, 600. The computer
equipment is an asset for GreenTees; GreenTees has full control over the computer equipment
and it should result in future benefits as the computer is need to run her operations.

The cash account decreases by e 3, 600. GreenTees obtains a new asset which is recorded in the
account equipment. The value of this account increases by e 3, 600.1
Total Total
= + Equity
assets liabilities
Capital Capital
Cash Equipment Revenues − Expenses + −
contr. distr.
−e 3, 600 +e 3, 600 = 0
Journal entry:

Jan 31 Equipment 3, 600
Cash 3, 600
Observe that the account equipment has been added to the general ledger of GreenTees. Because
equipment is an asset and its value increases, the account equipment has to be debited. The cash
account is an asset that decreases in value so that the cash account has to be credited (cf. Table 5.1).
debit Cash credit debit Equipment credit

Dec 31 9, 950 Jan 03 1, 200 Jan 31 3, 600
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 25 700
Jan 29 1, 600
Jan 31 3, 600
1 Observe that under the income statement approach one interprets the account equipment as a deferred expense. The
cash payment has been made today but expenses are recorded in future periods when the computer equipment is being
used. Expenses are matched to the periods that the asset is in use.

January 02 − 31 GreenTees sells and delivers 600 T-shirts in cash at a sales price of e 25 per
T-shirt.

Actually, two transactions have occured: first, the sale of 600 T-shirts for which GreenTees has
received e 15, 000 in cash. Second, the delivery of 600 T-shirts with a purchase value of e 12, 000.
The latter reduces GreenTees’ inventory of T-shirts. Because the T-shirts are sold at a higher
price than the purchase price, GreenTees makes a profit on this sale.

For the sale: cash account increases by e 15, 000 and revenues increases by e 15, 000 because
the T-shirts have been delivered to the customers. For the delivery: inventory decreases in value
by e 12, 000. This use of resources thus results in an expense cost of goods sold of e 12, 000.

Sales transaction:
Total Total
= + Equity
assets liabilities
Capital Capital
contr. distr.
e 15, 000 = e 15, 000
Delivery transaction:
Total Total
= + Equity
assets liabilities
Capital Capital
contr. distr.
−e 12, 000 = − e 12, 000
Journal entry:
Sales transaction:

Jan 2 − 31 Cash 15, 000
Revenues 15, 000
Because cash is an asset and increases in value, the cash account has to be debited. Revenues increase
which implies that the account revenues is credited. Observe that an increase in revenues increases
owner’s equity and increases in owner’s equity have to be credited (cf. Table 5.1).

Jan 2 − 31 Cost of goods sold 12, 000
Inventory 12, 000
Inventory is an asset and decreases in value. Hence, the inventory account has to be credited. Cost of
goods sold is an expense and an increase in expenses has to be debited. Observe that an increase in
expenses decreases owner’s equity and decreases in owner’s equity have to be debited (cf. Table 5.1).
debit Cash credit debit Inventory credit

Dec 31 9, 950 Jan 03 1, 200 Dec 31 2, 000 Jan 2 − 31 12, 000
Jan 01 10, 000 Jan 05 8, 000 Jan 06 18, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 2 − 31 15, 000 Jan 25 700
Jan 29 1, 600
Jan 31 3, 600
Cost of
debit goods sold credit debit Revenues credit
Jan 2 − 31 12, 000 Jan 2 − 31 15, 000

January 02 − 31 GreenTees sells and delivers 250 T-shirts on credit at a sales price of e 27
per T-shirt. Customers will pay the bill in February.

Again, there are actually two transactions: a credit sale of 250 T-shirts and the delivery of 250
T-shirts. The credit sale gives GreenTeesa claim on customers to receive e 6, 750 in cash. The
delivery of 250 T-shirts with a purchase value of e 5, 000 reduces GreenTeesinventory of T-shirts
by the same amount. Because the T-shirts are sold at a higher price than the purchase price,
GreenTees makes a profit on this sale.

For the credit sale transaction: the accounts receivable increase by e 6, 750 and revenues increases
by e 6, 750 because the T-shirts have been delivered to the customers. For the delivery: inventory
decreases in value by e 5, 000 and this use of resources thus results in an expense cost of goods
sold of e 5, 000.

Credit sales transaction:
Total Total
= + Equity
assets liabilities
e 6, 750 = e 6, 750
Total Total
= + Equity
assets liabilities
Capital Capital
contr. distr.
−e 5, 000 = − e 5, 000
Journal entry:
Credit sales transaction:

Jan 2 − 31 Accounts receivable 6, 750
Revenues 6, 750
The journal entry is comparable to the previous one except that receiveables is debited instead of
cash. Because accounts receivable is an asset and increases in value, the receivables account has to be
debited. (cf. Table 5.1).

Inventory 5, 000
Accounts
debit receivable credit debit Inventory credit
Dec 31 1, 250 Jan 11 1, 250 Dec 31 2, 000 Jan 2 − 31 12, 000
Jan 2 − 31 6, 750 Jan 06 18, 000 Jan 2 − 31 5, 000
Cost of
Jan 2 − 31 12, 000 Jan 2 − 31 15, 000
Jan 2 − 31 5, 000 Jan 2 − 31 6, 750

Summary
On January 31, the journal of GreenTees contains all journal entries for the Janaury transactions. The
journal thus contains the following information:

Jan 01 Cash 10, 000
Bank loan 10, 000
Jan 03 Prepaid rent 1, 200
Cash 1, 200
Jan 05 Suppliers payable 8, 000
Cash 8, 000
Jan 06 Inventory 18, 000
Cash 6, 000
Jan 11 Cash 1, 250
Jan 14 Expense payable 100
Cash 100
Cash 900
Jan 27 Cash 2, 100
Jan 29 Capital distributions 1, 600
Cash 1, 600
Jan 31 Equipment 3, 600
Cash 3, 600
Jan 2 − 31 Cash 15, 000
Revenues 15, 000
Inventory 12, 000
Jan 2 − 31 Accounts receivable 6, 750
Revenues 6, 750
Inventory 5, 000

On January 31, the ledger accounts contain the following information:
Owner’s
debit Equipment credit debit equity credit
Jan 31 3, 600 Jan 01 6, 500
debit Prepaid fee credit
Jan 03 1, 400
Total 1, 400
debit Prepaid rent credit debit Bank loan credit
Jan 03 1, 200 Jan 01 10, 000
Total 1, 200 Total 10, 000
Unearned
debit Inventory credit debit revenue credit
Dec 31 2, 000 Jan 02 − 31 12, 000 Dec 31 0
Jan 06 18, 000 Jan 02 − 31 5, 000 Jan 27 2, 100
Total 20, 000 Total 17, 000 Total 2, 100
Accounts
Suppliers
debit receivable credit debit payable credit
Dec 31 1, 250 Jan 11 1, 250 Jan 05 8, 000 Dec 31 8, 000
Jan 02 − 31 6, 750 Jan 06 12, 000
Total 8, 000 Total 1, 250 Total 10, 000 Total 20, 000
Expense
Dec 31 9, 950 Jan 03 1, 200 Jan 14 100 Dec 31 100
Jan 01 10, 000 Jan 05 8, 000 Total 100 Total 100
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 02 − 31 15, 000 Jan 25 900
Jan 29 1, 600
Jan 31 3, 600
Total 38, 300 Total 21, 400

Cost of
Jan 02 − 31 12, 000 Jan 02 − 31 15, 000
Jan 02 − 31 5, 000 Jan 02 − 31 6, 750
Total 17, 000 Total 21, 750
Subscription
debit fee expense credit
Wages
debit expense credit
Jan 25 900
Total 900
Advertizing
debit expense credit
Capital
debit distributions credit
Jan 29 1, 600
Total 1, 600

6.4 Trial balance
At the end of the reporting period a trial balance is made. The trial balance presents the net values
of all ledger accounts at the end of the reporting period. The net value of a ledger account is the
difference between the total of debit values and the total of credit values. When the total of debit
values exceeds the total of credit values, the net value of a ledger account is presented as a debit value.
Similarly, when the total of credit values exceeds the total of debit values, the net value of the ledger
acocunt is presented as a credit value.
For the GreenTees example, the trial balance of Janaury 31 is as follows:
Trial Adjusting Correcting Adjusted

balance journal entries journal entries trial balance
Debit Credit Debit Credit Debit Credit Debit Credit
Equipment 3, 600
Prepaid fee 1, 400
Prepaid rent 1, 200
Inventory 3, 000
Cash 16, 900
Capital dsitributions 1, 600
Bank loan 10, 000
Expense payable 0
Revenues 21, 750
Subscription fee expense
Wages expense 900
Advertizing expense
Totals 52, 350 52, 350
Observe that the net value of the cash account is a debit value of e 16, 900. The total of debit values
equals e 38, 300 and the total of credit values equals e 21, 400 so that the difference is 38, 300−21, 400 =
e 16, 900 debit.
An important control check for the trial balance is that the total of debit values is equal to the total
of credit values. For the GreenTees example, the debit and credit totals are both e 52, 350. If there
is a difference in debit and credit totals, there must be an error in the trial balance. This error may
arise from
• An error in calculating the net values of each ledger account.

• A ledger account for which the value is listed in the wrong column.
• One or more journal entries have posted to the ledger accounts incorrectly.
• An incorrect journal entry for one or more transactions, i.e., the total of debit values in the
journal entry is not equal to the total of credit values.
In this case, one needs to carefully check all preceding steps to detect any errors and correct them.
Observe that this control check does not reveal all types of errors that can be made. For example, the
transaction of January 25 where the accountant records the wrong value of e 900 in the journal entry
will not be detected by this control check because the format of the journal entry is correct: the total
of debit values equals the total of credit values. We will return to this error in Section 6.6.
6.5 Adjusting journal entries

In the previous steps of the accounting cycle, a journal entry was recorded when a transaction occured.
In these cases, the transaction itself served as the trigger to record the journal entry. However, it
may also happen that the value of assets and liabilities change due to the passage of time. In these
cases, there is no actual transaction that initiates the recording of a journal entry. We refer to such
journal entries as adjusting journal entries; the adjusting journal entries are recorded at the end of the
reporting period (i.e., when another period of time has passed).
Adjusting journal entries usually arise from transactions that relate to more than one reporting period.
Example 6.1 Consider a company that buys property insurance for her buildings and equipment.
Assume that the company pays the monthly insurance premium of e 50 at the start of each month.
In this case, the company records the following journal entry at the start of each month:

Insurance expense 50
Cash 50
Observe that the payment of the bill at the start of each month is the trigger to record the journal
entry.
Next, assume that the company pays the annual insurance premium of e 600 in advance on May 1.
The insurance covers the period May 1 - April 30. In this case, the transaction arises on the date that
the company purchases the insurance and pays the insurance premium and the following journal entry
arises on May 1:

May 01 Prepaid insurance 600
Cash 600
The expense recognition principle states that each month an insurance expense of e 50 should be
recorded (instead of e 600 insurance expense in May and e 0 insurance expense for June to April).

However, observe that there is no event or transaction that triggers the company to record this expense
in each of the subsequent 12 months. This expense arises because of the passage of time. In this case,
the company should just remember to record the following adjusting journal entry at the end of each
month:

Insurance expense 50
Prepaid insurance 50
In other words, the company needs to remember that the prepayment of the annual insurance premium
on May 1 gives rises to adjusting journal entries at the end of each of the subsequent 12 months.
The purchase of long term assets like land, buildings, machines and other manufacturing equipment
also give rise to adjusting journal entries as illustrated in the following example.
Example 6.2 Consider a company that buys manufacturing equipment. This equipment will be used
for multiple periods and the expense recognition principle states that the cost of this equipment needs
to be allocated over the periods that the equipment is being used. When the equipment has a cost of
e144, 000 and is expected to be used for 10 years (i.e., 120 months), one could allocate the cost evenly
and allocate e1, 200 to each month that the equipment is being used. This monthly cost for using the
equipment is called depreciation expense and represents the cost of using the equipment. Observe that
in this case the purchase transaction of the equipment triggers the following journal entry:

Equipment 144, 000
Cash 144, 000
However, there is no event or transaction that triggers the journal entry to record the depreciation
expense. This is an adjusting journal entry that arises due to the passage of time. In this case, the
adjusting journal entry recorded at the end of each month is:2

Depreciation expense 1, 200
Equipment 1, 200
Summarizing, adjusting journal entries arise due to the passage of time. At the end of each reporting
period, the adjusting journal entries need to be recorded and posted to the corresponding ledger
accounts. The frequency at which a company records adjusting journal entries depends on the reporting
period that the company uses. When the company uses a reporting period of one month, it records
adjusting journal entries at the end of each month. If the reporting period is a quarter (year), the
company records adjusting journal entries at the end of each quarter (year). For the recording of the
adjusting journal entries, one needs to carefully analyze a company’s past transactions and identify the
transactions that give rise to adjusting journal entries in the current (and future) reporting periods.
2 For ease of exposition, the account equipment is credited. However, the appropriate account to credit here is the
(contra) account accumulated depreciation-equipment. The use of this account will be explained in detail in the chapter
on property, plant and equipment.

Example: GreenTees
Because GreenTeesuses a reporting period of one month, GreenTees needs to record adjusting journal
entries at the end of each month. For GreenTees, the following transactions give rise to adjusting
journal entries on January 31:
month. The annual subscription fee of e 2, 400 is paid in cash on August 1.
December 31.
August 1: The prepayment on August 1 of the annual subscription fee of e 2, 400 gives rise to the
following journal entry on August 1 (cf. Section 3.1.7):

Prepaid fee 2, 400
Cash 2, 400
Recall that the asset prepaid fee is a deferred expense meaning that expenses will be recorded in later
periods. More specifically, the subscription fee of e 2, 400 represents the monthly subscription fee of
e 200 for the next 12 months. Hence, GreenTees needs to record for each month a subscription fee
expense of e 200. For the motnh of January, GreenTees records the following adjusting journal entry:

Subscription fee expense 200
Prepaid fee 200
Observe that the asset prepaid fee decreases in value by e 200 as the subscription has been used for
another month. Because the asset decreases in value, it needs to be credited.
January 1: The loan contract is such that at the end of the year on December 31,GreenTees has to
pay the bank 12% × 10, 000 = e 1, 200 in interest. Interest is an example of an expense that arises
with the passage of time. Hence, it would not present a true and fair view to record e 1, 200 in interest
expense when it is paid on December 31 and to report e 0 in interest expense for the months January
- November. Because GreenTees incurs e 100 interest after each month has passed, GreenTees has to
record interest expenses at the end of each month by means of the following adjusting journal entry:

Interest expense 100
Expense payable 100

Observe that the liability expense payable is credited as the obligation to pay interest to the bank has
increased in value by e 100.
January 3: The prepayment of annual rent of e 1, 200 is similar to the prepayment of the subscription
fee on August 1. Hence, GreenTees has to record a monthly rent expense of e 100 at the end of each
month using the following adjusting journal entry:

Rent expense 100
Prepaid rent 100
Observe that the purchase of equipment on January 31 does not result in a depreciation expense for
January. GreenTees records adjusting journal entries for depreciation expenses only from February
onwards.
We can summarize the adjusting journal entries in the trial balance:

Equipment 3, 600
Prepaid fee 1, 400 200
Prepaid rent 1, 200 100
Inventory 3, 000
Cash 16, 900
Capital distributions 1, 600
Bank loan 10, 000
Revenues 21, 750
Wages expense 900
Advertizing expense
Rent expense 100
Totals 52, 350 52, 350 400 400
Again, one can perform a control check: the total debit values and total credit values for all adjusting
journal entries should be equal. In this example, both totals equal e 400. If the totals are not equal,
there is an error in one or more of the adjusting journal entries and this error should be identified and
corrected.

6.6 Correcting journal entries
The control check for the trial balance is not sufficient to eliminate all errors. A company thus needs
to use additional internal control procedures to detect possible errors. How these internal control
procedures work is beyond the scope of this course. Instead, we confine to the administrative process of
correcting any erroneous journal entries that have been identified by these internal control procedures.
The process to correct erroneous journal entries is straightforward and consists of two steps: first,
reverse the erroneous journal entry and, second, record the correct journal entry.
Example: GreenTees
is recorded incorrectly by GreenTees accountant: the accountant records a
payment of e 900.
Assume that the internal control procedures of GreenTees have indicated that the journal entry for the
transaction of January 25 is incorrect. For example, the error could have been detected because there
is e 200 more in cash (e.g., in the bank account) than the ledger account cash indicates. Recall that
the incorrect journal entry is:

Wages expense 900
Cash 900
To correct this error, we first reverse the erroneous journal entry using the following journal entry:

Cash 900
Wages expense 900
Hence, the cash account is now debited for e 900 to undo the credited amount of the original journal
entry. Similarly, the account wages expenses is credited for e 900 to undo the debited amount.
The second step is to record the correct journal entry. In this case, the error is in the amount: it
should e 700 instead of e 900. Hence, the correct journal entry is:

Wages expense 700
Cash 700
Observe that one can combine the above two steps into one correcting journal entry:

Cash 200
Wages expense 200

Observe that the net effect of the two journal entries is that the cash account increases by e 200, i.e.,
the cash account should be debited for e 200. Similarly, the net effect on the wages expense is that it
decreases by e 200. Hence, the account wages expense needs to be credited for e 200 (cf. Table 5.1).
Observe that one can also derive the above correcting journal entry by analyzing what went wrong in
the incorrect journal entry. In this example, the incorrect journal entry recorded a wages expense of
e 900 instead of e 700. Hence, it overstated the wages expense by e 200 and it overstated the cash
outflow by e 200. To correct this error, the account wages expense needs to be credited by e 200 as
this reduces the expense and the account cash needs to be debited by e 200 as this increases the cash
balance.
We can include the correcting journal entries in the trial balance:

Equipment 3, 600
Prepaid fee 1, 400 200
Prepaid rent 1, 200 100
Inventory 3, 000
Cash 16, 900 200
Bank loan 10, 000
Revenues 21, 750
Wages expense 900 200
Advertizing expense
Rent expense 100
Totals 52, 350 52, 350 400 400 200 200
6.7 Adjusted trial balance

The adjusted trial balance presents the net values of all ledger accounts after the adjusting journal
entries and correcting journal entries have been processed. For the GreenTees example, the adjusted
trial balance is as follows:

Equipment 3, 600 3, 600
Prepaid fee 1, 400 200 1, 200
Prepaid rent 1, 200 100 1, 100
Inventory 3, 000 3, 000
Accounts receivable 6, 750 6, 750
Cash 16, 900 200 17, 100
Capital distributions 1, 600 1, 600
Bank loan 10, 000 10, 000
Unearned revenue 2, 100 2, 100
Revenues 21, 750 21, 750
Subscription fee expense 200 200
Wages expense 900 200 700
Advertizing expense
Interest expense 100 100
Rent expense 100 100
Totals 52, 350 52, 350 400 400 200 200 52, 450 52, 450
Again, the total of debit values and the total of credit values in the adjusted trial balance should be
equal to each other. If it is not, identify and correct the errors.
6.8 Financial statements

The adjusted trial balance is the basis to write up the balance sheet and income statement by distin-
guishing between the balance sheet accounts and the income statement accounts:

Adjusted trial Income Balance
balance Statement sheet
Debit Credit Debit Credit Debit Credit
Equipment 3, 600 3, 600
Prepaid rent 1, 100 1, 100
Inventory 3, 000 3, 000
Cash 17, 100 16, 900
Bank loan 10, 000 10, 000
Revenues 21, 750 21, 750
Advertizing expense
Totals 52, 450 52, 450 18, 100 21, 750 34, 350 30, 700
Observe that net income is the difference between the total credit value and total debit value of the
income statement. The total credit value, i.e., total revenues, equal e 21, 750 and the total debit value,
i.e., total expenses, equal e 18, 100 so that net income equals e 3, 650.
Furthermore, observe that in the balance sheet the total debit value equals e 34, 350 and the total
credit value equals e 30, 700. The fact that the total debit and credit values are different may suggest
there is an error. However, that is not the case. Recall from the accounting equation that equity is
the difference between total assets and total liabilities. Applying this definition of equity, the account
owner’s equity on the balance sheet of Janaury 31 should be e 34, 350 - e 24, 200 = e 10, 150 instead
of e 6, 500. Further, recall that net income is equal to the change in equity. Observe that net income
equals e 3, 650 and this is exactly equal to the change in equity: e 10, 150 - e 6, 500 = e3, 650. This
latter step, i.e., adding net income to owner’s equity, has not been recorded in the accounts yet. We
will do this in the closing journal entries in the next section.
Finally, observe that the adjusted trial balance contains all information to compose the balance sheet,
income statement and statement of changes in equity:

Balance sheet of GreenTees
(January 31)
Equipment 3, 600
Prepaid fee 1, 200
Prepaid rent 1, 100
Inventory 3, 000
Cash 17, 100
Total assets 32, 750
Equity 8, 550
Bank loan 10, 000
Expense payable 100
Equity and total liabilities 32, 750
Income statement of GreenTees

(January)
Revenues 21, 750
Subscritpiton fee expense 200
Wages expense 700
Rent expense 100
Net income 3, 650
Statement of changes in equity of GreenTees

(January)
Owner’s equity (December 31) 6, 500
+ Net income +3, 650
+ Capital contributions 0
− Capital distributions −1, 600
Owner’s equity (Janaury 31) 8, 550
The statement of cash flows follows from the ledger account cash. Recall that on January 31, the ledger
account cash is as follows:

debit Cash credit
Dec 31 9, 950 Jan 03 1, 200
Jan 01 10, 000 Jan 05 8, 000
Jan 11 1, 250 Jan 06 6, 000
Jan 27 2, 100 Jan 14 100
Jan 02 − 31 15, 000 Jan 25 700
Jan 29 1, 600
Jan 31 3, 600
Total 38, 300 Total 21, 200
The total cash receipts equal e 28, 350 (i.e., 38, 300 minus beginning value of 9, 950) and the total cash
payments equal e 21, 200 so that the change in cash position equals e+7, 150. Observe that the cash
receipt of the bank loan of e 10, 000 on January 1 and the capital distribution of e 1, 600 are cash flows
from financing activities. Furthermore, observe that the cash investment in computer equipment of
e 3, 600 is a cash flow from investing activities. All other cash flows are related to operating activities.
Hence, the statement of cash flows will be as follows:
Statement of cash flows of GreenTees

(January)
Cash flow from operations +2, 350
Cash flow from investing activities −3, 600
Cash flow from financing activities +8, 400
Change in cash position +7, 150
Cash (December 31) 9, 950

Change in cash position +7, 150
Cash (January 31) 17, 100
6.9 Closing journal entries

The closing journal entries serve two purposes: first, to set the net value of all income statement
accounts (i.e., temporary accounts) back to zero for the start of the new reporting period and, second,
to record the changes in the owner’s equity account.
6.9.1 Closing revenue and expense accounts
For the first purpose, we make use of a new account called income summary. To close the revenues
accounts, we debit the revenues account and credit the income summary account with the same amount.
For the GreenTees example, the revenues account has a credit balance of e 21, 750. To close the
revenues account, we record the following closing journal entry:

Jan 31 Revenues 21, 750
Income summary 21, 750
To close the expense accountsm we credit all expense accounts and debit the income summary account
for the value of total expenses. For the GreenTees example, we record the following closing journal
entry to close the expense accounts:

Jan 31 Income summary 18, 100
Wages expense 700
Rent expense 100
After these two closing journal entries, the account income summary is as follows:
Income
debit summary credit
Total expenses 18, 100 Total revenues 21, 750
The account income summary is also a temporary account. The balance of the income summary
account shows the difference between total revenues and total expenses, i.e., net income. The closing
journal entry for the account income summary is used to transfer net income to the owner’s equity
account. In case of positive net income (i.e., profit), the income summary account is closed by debiting
the account income summary for net income and crediting the owner’s equity account. Hence, in case
of positive net income the value of onwer’s equity is increased by the value of net income. In case of
negative net income (i.e., loss), the income summary account is closed by crediting the account income
summary and debiting the owner’s equity account. Negative net income thus results in a decrease of
the value of owner’s equity.
For the GreenTees example, the closing journal entry for income summary equals:

Jan 31 Income summary 3, 650
6.9.2 Closing the capital distributions account
Capital distributions reduce owner’s equity so the net value in the capital distributions account needs
to be debited to owner’s equity. For the GreenTees example, the closing journal entry for the capital
distributions account is as follows:

Jan 31 Owner’s equity 1, 600
Observe that the net value in the capital distributions account now equals zero.
6.10 Post-closing trial balance

Processing the closing journal entries in the adjusted trial balance gives the post-closing trial balance.
For the GreenTees example, the post-closing trial balance is as follows:
Adjusted trial Closing Post-closing

balance journal entries trial balance
Debit Credit Debit Credit Debit Credit
Equipment 3, 600 3, 600
Prepaid rent 1, 100 1, 100
Inventory 3, 000 3, 000
Cash 17, 100 17, 100
Owner’s equity 6, 500 1, 600 3, 650 8, 550
Bank loan 10, 000 10, 000
Revenues 21, 750 21, 750
Advertizing expense
Income summary 18, 100 21, 750
3, 650
Totals 52, 450 52, 450 43, 500 43, 500 32, 750 32, 750
Observe that for the post-closing trial balance the total debit value and total credit value should again
be equal to each other. Furthermore, observe that the post-closing trial balance shows the balance
sheet of GreenTees on Janaury 31 (cf. Section 6.8). Finally, observe that in the post-closing trial
balance all income statement accounts (i.e., temporary accounts) have a net value of e 0.
The final step of the accounting cycle has now been completed. The accounting cycle starts all over
again for the next reporting period.

Part III
Accounting for the financing

activities of the company
101
Chapter 7
Equity capital
Equity represents the part of the company that belongs to the owner(s) of the company (see Section
3.1.3). The terminology for equity and the ledger accounts related to equity depends on the legal form
of the company. In this chapter we present the terminology and introduce the basic accounting for
equity for two types of companies: the sole proprietorship and the corporation.
7.1 Sole proprietorship

A sole proprietorship is usually a small company run by its owner. The local bakery or butcher shop
are examples of a sole proprietorship. A sole proprietorship is not a legal entity in the sense that the
company can be the legal party in a contract or transaction. In a sole proprietorship, the owner is the
legal party who signs contracts, buys inventory and owns equipment. A sole proprietorship does not
own anything. The economic entity assumption is particularly important in a sole proprietorship as the
activities of the sole proprietorship need to be clearly separated from the owner’s private transactions
(cf. Example 3.9).
Another important feature of a sole proprietorship is that a sole proprietorship features unlimited
liability. This implies that the owner of a sole proprietorship is personally liable for the company’s
activities and the company’s liabilities. For example, when a sole proprietorship goes bankrupt, the
owner needs to use his private wealth to repay the company’s debts.
The GreenTees company used in the previous chapters is presented as a sole proprietorship. Equity
related ledger accounts in a sole proprietorship are owner’s equityand capital distributions. The account
owner’s equity represents the part of the company that belongs to the owner. If the owner invests capital
in the company, the account owner’s equity is credited .Net income of the company is also credited to
owner’s equity and a loss is debited to owner’s equity (see Section 6.9, pp. 98 for details). If the owner
withdraws capital from the company to the owner’s private account, the account capital distributions
is debited (see the January 29 transaction in Section 6.3 for details).
For completeness sake, we now show the journal entries related to the establishment of GreenTees as
a sole proprietorship on July 31, 2021. On July 31, 2021, the student invests e6, 000 to set up the
102
webshop GreenTees. The corresponding journal entry is:

Jul 31 Cash 6, 000
7.2 Corporations
A corporation is a legal entity with limited liability. As a legal entity, a corporation can be the legal
owner of equipment and inventory and can be a party in legal contracts. Limited liability implies
that the owners of the corporation are not legally liable for the corporation’s liabilities. Hence, when
a corporation goes bankrupt, the owners of the corporation do not have to use their private wealth
to pay off the corporation’s debts. They can only loose the capital that they have invested in the
corporation.
Ownership of a corporation is structured through equity shares that are sold to third parties. The
owners of a corporation are called shareholders and shareholders are not necessarily involved in the
day to day operations of the corporation. Shareholders provide capital to the corporation that the
corporation uses to fund her operating activities. The number of shareholders in a corporation can
vary from a few shareholders to thousands or millions of shareholders. An important distinction
between corporations is whether or not the ownership shares are publicly traded on a stock market
like Euronext, NASDAQ, or New York Stock Exchange.
When equity shares are publicly traded, investors can easily buy and sell equity shares on the stock
market at the current market price. Corporations whose equity shares are publicly traded usually have
many different shareholders ranging from large institutional investors like pension funds, insurance
companies and investment banks to small private retail investors who invest some of their personal
savings in the stock market.
When equity shares are not publicly traded, the number of shareholders is usually limited. In this case,
it is more difficult to trade equity shares. When a shareholder wants to sell some of his equity shares,
he needs to find a buyer and they also need to agree on the price of these equity shares. Similarly,
when an investor would like to buy equity shares of the corporation, she needs to convince one or more
current shareholders to sell some of their equity shares.
Ownership of a corporation is separated from the management of a corporation when the shareholders
are not involved in the day to day operations of the corporation. This, however, does not mean that
they have no influence on the corporation at all. When a shareholder’s ownership share is sufficiently
large, this shareholder may be able to influence the strategy of the corporation or have a say in the
hiring and firing of the corporation’s management.
In the remainder of this section we present the accounting for basic equity-related transactions for
corporations, namely the issue of (ordinary) equity shares, the retained earnings account, and the
declaration and payment of dividends.

7.2.1 Share issues
When a corporation is established, the articles of incorporation specify the different types of equity
shares of the corporation and how many units of each type exist. In this course, we focus only on one
type of equity: ordinary shares. We briefly discuss other types of equity in Section 7.2.5. Ordinary
shares ususally have a par-value or nominal value assigned to it. The par-value is the minimum price
at which the corporation can issue the shares. Depending on a country’s legislation, the par-value of a
share may also determine how much capital the corporation can redistribute to its shareholders. The
par-value of shares is usually a very small amount and can also be equal to zero. For the purpose of
this course, however, the precise meaning of par-value and its legal consequences is not relevant.
When a corporation issues equity shares, the following information is available:
• n: The number of ordinary shares sold.
• c: The par-value of each ordinary share.
• p: The price at which each ordinary share is sold.
Assuming that shareholders pay cash for the ordinary shares, the corporation receives n × p in cash
for the issued shares. This amount is called the proceeds of the share issue. For accounting purposes,
the proceeds are separated into two components. The first component is called share capital and is
equal to the par-value of the issued shares, i.e., n × c. The second component is called share premium
and is equal to the excess of the par-value of the issued shares, i.e., n × (p − c). The general ledger
of a corporation includes separate accounts for share capital and share premium. Commonly used
names for these accounts are share capital - ordinary (or, in short, share capital) and share premium
- ordinary (or, in short, share premium).
Example:GreenTees
Assume that on July 31, GreenTees was not established as a sole proprietorship but as a corporation:
on July 31, GreenTees issues 100 ordinary equity shares at par-value of e 10 to the student for e 60
per equity share.
In this example, the share capital equals 100 × 10 = e 1, 000 and the share premium equals 100 × (60 −
10) = e 5, 000. Hence, the journal entry recorded for this share issue is as follows:

Jul 31 Cash 6, 000
Share capital 1, 000
Share premium 5, 000
The balance sheet on July 31 is presented below. Observe that the difference with the balance sheet in
Table 3.2 (page 21) is only in the equity accounts: the account owner’s equity is replaced by the two
accounts share capital and share premium.

Balance sheet:
Inventory
Accounts receivable
Cash 6, 000
Total assets 6, 000
Share capital 1, 000
Share premium 5, 000
Unearned revenue
Suppliers payable
Fee payable
Equity and
6, 000
Total liabilities
7.2.2 Retained earnings
At the end of the reporting period, the closing journal entries in sole proprietorships (see Section 6.9)
add net income for the period directly to the account owner’s equity. In corporations it is common to
record net income in the account retained earnings. The account retained earnings thus accumulates
all profits and losses of the preceding periods. Observe that it would not be proper to record net
income in the account share capital or share premium as these accounts represent the proceeds of a
share issue and net income is not the result of a share issue.
Example: GreenTees
Over August, GreenTees reports revenues and expenses of e 7, 500 and e 7, 000 respectively (cf. Table
3.4). The closing entries that the corporation GreenTees records on August 31 are as follows:

Aug 31 Revenues 7, 500
Income summary 7, 500
Aug 31 Income summary 6, 000
Wages 700
Aug 31 Income summary 500
Retained earnings 500
Observe that the difference only arises in the third closing journal entry where e 500 is credited to the
account retained earnings instead of the account owner’s equity.
The balance sheets and income statements for August-October are presented below. Observe the
difference with Table 3.10 (page 42): the equity of GreenTees is now represented by three different

accounts: share capital, share premium, and retained earnings. Furthermore, observe that the reported
equity on the balance sheet now distinguishes between the amount of e 6, 000 that has been invested by
the owner and the amount of e 500 that accrued to the owners in August as a result of the operating
activities of GreenTees. For October 31, the account retained earnings reveals that GreenTees has
accumulated earnings of e 1, 500 over the three month period August-October.

Balance sheet:
Inventory 1, 000 2, 000 1, 000
Prepaid fee 2, 200 2, 000 1, 800
Cash 6, 000 3, 400 10, 100 4, 800
Total assets 6, 000 6, 600 14, 100 12, 600
Share capital 1, 000 1, 000 1, 000 1, 000
Share premium 5, 000 5, 000 5, 000 5, 000
Retained earnings 500 1, 000 1, 500
Unearned revenue
Equity and
6, 000 6, 600 14, 100 12, 600
Total liabilities
Income statement:
Revenues 7, 500 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000 6, 000
Subscription fee 200 200 200
Advertizing expense 100 100 100
Wages 700 700 700
Income 500 500 500
7.2.3 Dividends
When a corporation redistributes capital to the shareholders, this is called a dividend. This section
only covers cash dividends, i.e., the dividend is paid in cash to the shareholders. The alternative is a
share dividend where the corporation gives shares to the shareholders instead of cash. Share dividends
are beyond the scope of this course.
The procedure to pay cash dividend usually includes the following two steps:
• The corporation declares that it will pay a dividend to her shareholders. This declaration includes
– The amount of dividend per share.

– The date of record, i.e., shareholders are entitled to receive the dividend when they own
shares on this particular date.

• The corporation pays out the dividend to her shareholders.
Observe that the declaration date of the dividend usually differs from the payment date of the dividend.
Furthermore, observe that the date of record is important as equity shares can be traded. Especially
when equity shares are traded on stock markets, equity shares are traded every day and so the number
of equity shares that shareholders own can change on a daily basis. Hence, it is important to indicate
which date determines whether a shareholder is entitled to a dividend and to how much dividend. For
example, when the declaration date is June 1 and the date of record is June 10, you are not entitled
to receive a dividend when you buy shares on June 11. Similarly, you are also not entitled to receive
a dividend when you sell all your shares on June 9.
Example: GreenTees
The sole proprietorship GreenTees redistributed e 2, 000 to the owner on November 10. Assume that
for corporation GreenTees, this transaction consists of declaration of dividend on November 3 and a
payment date on November 10:
November 3 GreenTees declares a cash dividend of e 20 per share. The record date is
November 5; the payment date is November 10.
November 10 GreenTees pays out the cash dividend.
On November 3, when GreenTees declares the cash dividend, GreenTees promises her shareholder
to pay 100 × 20 = e 2, 000 in cash. This results in a liability and this liability is recorded on the
account dividends payable. Because the declaration of a cash dividend does not result in an asset,
the accounting equation implies that the equity of GreenTees decreases by e 2, 000. Furthermore, a
cash dividend is a capital distribution, i.e., it is a transaction between GreenTees and her owners, and
hence it is not recorded as an expense. The question that remains here is which component of equity
decreases as a result of the declaration of dividend: share capital, share premium, or retained earnings?
The appropriate account to use here is retained earnings. The accounts share capital and share premium
represent the initial investment of the owner. Furthermore, a cash dividend can be interpreted as the
reward for the shareholder for investing his capital in the company. In this case, GreenTees uses this
capital to buy and sell T-shirts. The net income that results from these operating activities accrue
to the owner and are recorded in retained earnings. Hence, if GreenTees wants to return cash to the
shareholder as a reward for his investment, it is logical to take this out of the retained earnings account.
Observe that this also explains the name of the account retained earnings: retained earnings represent
the sum of all past profits and losses that have been retained in the company and that have not been
redistributed to the shareholders (yet).
The journal entry for the declaration of the cash dividend thus equals:

Nov 03 Retained earnings 2, 000
Dividends payable 2, 000

The record date of November 5 does not affect the accounts of GreenTees. The record date is just part
of the administrative process of paying dividends but it does not affect the assets, liabilities and/or
equity of GreenTees. Hence, no journal entry is required on November 5.
Observe that GreenTees only has one shareholder that owns all 100 shares. If the shareholder would
sell some of these shares, this does not affect the accounts of GreenTees. Because this transaction does
not involve GreenTees but only the current shareholder of GreenTees and the new shareholder, the
economic entity assumption implies that this is not a transaction of the economic entity GreenTees.
When GreenTees pays the cash dividend of e 2, 000 on November 10, the cash position of GreenTees
decreases and GreenTees fulfills the obligation to pay her shareholder the cash dividend of e 2, 000.
The accounting equation implies:

− e2, 000 = − e2, 000
The corresponding journal entry equals:

Nov 10 Dividends payable 2, 000
Cash 2, 000
The balance sheets and income statements for July-November are presented below. Observe that the
account retained earings has decreased by e 1, 500 in November. This change consists of an increase
by e 500 for net income and a decrease by e 2, 000 for the cash dividend.

Balance sheet:
Inventory 1, 000 2, 000 1, 000 0
Prepaid fee 2, 200 2, 000 1, 800 1, 600
Accounts receivable 5, 000 0
Cash 6, 000 3, 400 10, 100 4, 800 10, 750
Total assets 6, 000 6, 600 14, 100 12, 600 12, 350
Share capital 1, 000 1, 000 1, 000 1, 000 1, 000
Share premium 5, 000 5, 000 5, 000 5, 000 5, 000
Retained earnings 500 1, 000 1, 500 0
Suppliers payable 7, 000 5, 000 5, 000
Expense payable 100 100 100 100
Equity and
6, 000 6, 600 14, 100 12, 600 12, 350
Total liabilities
Income statement:
Revenues 7, 500 7, 500 7, 500 7, 500
Expenses
Cost of goods sold 6, 000 6, 000 6, 000 6, 000
Subscription fee 200 200 200 200
Advertizing expense 100 100 100 100
Wages 700 700 700 700
Income 500 500 500 500
7.2.4 Statement of changes in equity
For corporations, the statement of changes in equity is presented in a more extensive format because
of the different components of equity. For corporations, the statement of changes in equity is usually
presented as follows:

(period)
Share Share Retained Total
capital premium earnings equity
Beginning of period (date) ... ... ... ...
+ Accounting income ... ...
+ Capital investments ... ... ...
− Dividends ... ...
End of period (date) ... ... ... ...
For each component of equity it shows how the value changed over the reporting period. The changes

in retained earnings can also be presented in a separate statement called the statement of changes in
retained earnings:
Statement of changes in retained earnings

(period)
Retained earnings (beginning of period) ...
+ Accounting income ...
+ Capital investments ...
− Dividends ...
Retained earnings (end of period) ...
Example: GreenTees
On November 30, the statement of changes in equity of GreenTees is as follows:

(period)
Share Share Retained Total
capital premium earnings equity
October 31 1, 000 5, 000 1, 500 7, 500
+ Accounting income +500 +500
+ Capital investments 0 0 0
− Dividends −2, 000 −2, 000
November 30 1, 000 5, 000 0 6, 000
Observe that the statement of changes in equity of GreenTees over November provides valuable infor-
mation in addition to the balance sheet of GreenTees on November 30. On November 30, the balance
sheet shows that retained earnings of GreenTees equals e 0. The information that users of the financial
statement can infer from this balance sheet information is that either:
• On November 30, GreenTees has paid out all past profits and losses to the shareholders of
GreenTees; or
• The sum of all past profits and losses of GreenTees equals zero.
To be certain which inference is correct, users need to consider the statement of changes in equity.
The statement of changes in equity shows that GreenTees has made e 2, 000 in profits over the period
July-November and that all past profits have been paid as dividends to the shareholders.
7.2.5 Other equity related concepts
The preceding sections have presented only the very basic equity related transactions in a corporation.
Besides the accounts share capital, share premium, and retained earnings, corporations may distinguish

other components of equity. This section briefly explains several of these other components; the
accounting for these items is beyond the scope of this course though.
In addition to ordinary shares, corporations can also issue other types of equity shares that differ in
the rights and privileges that are assigned to these shares. One prominent example in this respect
are preference shares. Preference shares differ from ordinary shares in that the corporation promises
the shareholders of preference shares to pay a pre-determined amount of dividends in each period,
whenever the financial position allows to pay dividends. The name preference shares refers to the fact
that when the corporation pays dividends, the corporation first has to pay dividends to the shareholders
of the preference shares before she can pay dividends to the shareholders of the ordinary shares. When
preference shares have been issued, one usually encounters the accounts share capital - preference and
share premium - preference in the general ledger.
A corporation whose equity shares are traded on a stock market can also buy her own equity shares.
The corporation may do so because she wants to use these shares to compensate management for
their services or because she believes that the current market price of the shares is too low. When a
corporation buys her own equity shares, these shares are called treasury shares and are also reported
as such. In that case, the total equity of the corporation is equal to share capital + share premium +
retained earnings − treasury shares. Because the corporation cannot invest equity capital in itself,
the value of the treasury shares needs to be subtracted to determine the net value of the firm that
belongs to the shareholders.
Accounting standards like IFRS and US-GAAP distinguish two types of income: net income and other
comprehensive income (OCI). Net income is added to retained earnings and OCI is added to accumu-
lated other comprehensive income. Accumulated other comprehensive income is also a component of
equity. Roughly speaking, net income includes revenues and expenses for the period and OCI includes
valuation gains and losses for which it may not be certain that these valuation gains and losses will
be realized. The example below illustrates the difference. This course, however, does not cover these
valuation issues or OCI in further detail.
Example 7.1 Many companies invest their excess cash in shares and government bonds so that this
excess cash also generates returns. Suppose GreenTees does the same and on February 3 invests e 5, 000
of cash in shares, i.e., GreenTees buys 400 shares in renewable energy company GreenWatts at e 12.50
per share. Suppose that on February 28, the share price of GreenWatts has increased to e 13.00 per
share. Did GreenTees make a profit of 400 × 0.50 = e 200 in February on the GreenWatts shares?
This is not an easy question to answer. On the one hand, the GreenWatts shares have increased in
value. On the other hand, GreenTees have not sold the 400 GreenWatts shares at e 13.00. Hence, if
the GreenWatts share price would decrease again in March to e 12.00, recording a profit of e 200 in
February would seem improper. In short, accountants have solved this issue by introducing a second
concept of income called other comprehensive income. In this case, GreenTees does not report the
e 400 in net income but as other comprehensive income of e 200 over February. Usually, corporations
cannot use accumulated comprehensive income to pay dividends. Hence, GreenTees cannot use the
valuation gain of e 200 that is reported as OCI to pay dividends to her shareholder.

Chapter 8
Debt capital
Debt capital is one of the two major sources of funding for a company; the other one being equity
capital. Equity capital is provided by the owners of the company and debt capital is provided by
third parties. Roughly speaking, the main difference between debt and equity capital is in the way
that these investors are rewarded for their investment: the reward for the providers of debt capital is
specified in a contract whereas the providers of equity capital (i.e., the owners of the firm) are residual
claimants, that is, they receive whatever is left over from the company’s assets when all liabilities have
been fulfilled. The reward for the providers of debt capital is usually set by the interest rate that
the company pays over her debts. The only risk that the providers of debt capital face is the risk of
bankruptcy as in that case the company is not able to repay the debt. The reward for the providers
of equity capital is uncertain and depends on how well the company performs financially. When the
company performs well, the reward will be high; when the company performs bad, the reward will be
low. In the extreme case that the company goes bankrupt, the reward is zero and the providers of
equity capital have lost the equity capital that they have invested in the company.
There are various types of debt capital. This chapter focuses only on two: a long term loan with a
fixed term and a fixed, simple interest rate and a short term loan (i.e., short term note payable). Other
types of debt like long term loans with variable interest rates or compound interest rates, bonds, or
convertible loans are beyond the scope of this course.
8.1 Long term loans

A long term loan is characterized by the following characteristics:
• Principal amount: the amount of money borrowed by the company and that has to be repaid to
the lender.
• Term of the loan: the time at which the borrower needs to repay the principal amount to the
lender. For a long term loan, the term is longer than than one year.
• Interest rate: the amount of interest that the borrower has to pay to the lender. Interest rates
112
are presented on an annual basis. The payment of interest can vary; payment can occur on a
monthly, quarterly, semi-annual or annual basis.
Example 8.1 The loan of GreenTees on January 1 (page 68) has the following characteristics: prin-
cipal amount is e 10, 000, the term is 3 years, and the annual interest rate is 12%. The interest is paid
annually at the end of each year.
8.1.1 Loan issue
When the loan is issued, the company receives the principal amount in cash from the lender and incurs
the obligation to pay the principal amount to the lender at the end of the term. Hence, both the total
assets of the company and the total liabilities of the company increase. Equity does not change.
Example 8.2 For the loan of GreenTees in Example 8.1, GreenTees receives e 10, 000 in cash on
January 1 and incurs a liability of e 10, 000. The latter follows from applying the accounting equation.
The journal entry that GreenTees records for this transacton on January 1 is:

Jan 01 Cash 10, 000
Bank loan 10, 000
8.1.2 Interest
Because interest expenses arise due to the passage of time, interest expenses are recorded in adjusting
journal entries at the end of each reporting period. The company records an interest expense and
incurs the liability to pay the lender the interest on the interest payment date. The adjusting journal
entry debits the interest expense and credits the account expense payable.
To determine the amount of the interest expense, one needs to take into account the length of the
company’s reporting period. Because we assume a simple interest rate (i.e., we ignore interest on
interest), the annual interest expense is allocated evenly over the reporting periods. Hence, when
the company’s reporting period is one month (quarter), the monthly (quarterly) interest expense is
one-twelveth (one-fourth) of the annual interest expense.
Example 8.3 For the loan of GreenTees in Example 8.1, the annual interest expense is 12%×10, 000 =
e 1, 200 so that the monthly interest expense equals 1, 200/12 = e 100. The adjusting journal entry
that GreenTees records for this transacton on January 31 is:

Jan 31 Interest expense 100
Interest payable 100
Observe that the account expense payable is an accrued expense: the company has recorded the expense
before the corresponding cash payment takes place. Furthermore, observe that this adjusting journal

entry is recorded at the end of each month. Hence, on December 31, this adjusting journal entry has
been recorded 12 times so that the account expense payable has a credit value of e 1, 200.
On the interest payment date, the company pays the interest to the lender. In this case, the company’s
cash position decreases and the obligation to pay interest decreases. Hence, the cash account is credited
and the acocunt expense payable is debited.
Example 8.4 For the loan of GreenTees in Example 8.1, suppose GreenTees pays the annual interest
on January 1. The corresponding journal entry is:

Jan 01 Interest payable 1, 200
Cash 1, 200
Example 8.5 Observe that if GreenTees would pay the interest on a monthly basis instead of an
annual basis, GreenTees does not make adjusting journal entries for the interest expense and hence
it does not incur a liability. When interest is paid at the end of each month, GreenTees records the
following journal entry on the day the interest is paid:

Jan 31 Interest expense 100
Cash 100
8.1.3 Loan repayment
At the end of the term of the loan, the borrower needs to repay the principal amount to the lender. In
this case, the cash position of the company decreases and the obligation to repay the lender reduces to
zero.
Example 8.6 After 3 years, GreenTees has to repay the loan of e 10, 000 to the lender. The journal
entry that GreenTees records for this transaction is:

Jan 01 Bank loan 10, 000
Cash 10, 000
Observe that on January 1, GreenTees also has to pay the interest over the preceding year. Hence, it
also records the journal entry in Example 8.4. It is also possibe to combine both journal entries into
one journal entry:

Jan 01 Bank loan 10, 000
Interest payable 1, 200
Cash 11, 200

8.2 Short term loans
Short term loans are loans with a term of at most one year and is referred to as notes payable. The
accounting for short term loans is similar to the accounting for long term loans. One simplification
arises when the term of the short term loan is shorter than the reporting period. In this case the
company does not record interest expenses through adjusting journal entires; instead, the company
records the interest expense at the same time as the repayment of the loan arises.
Example 8.7 Suppose a company uses a reporting period of one year and that the reporting periods
end on December 31 of each calendar year. Further, suppose this company receives a short term loan
on May 1 with principal amount e 6, 000, annual interest rate of 9% and a term of 4 months. On May
1, this company records the following journal entry:

May 01 Cash 6, 000
Notes payable 6, 000
On September 1, the company needs to repay the loan and it needs to pay the interest on the loan.
4
The interest on the loan equals 6% × 12 × 6, 000 = e120. Hence, on September 1, the company records
the following journal entry:

Jan 01 Notes payable 6, 000
Cash 6, 120
Example 8.8 Suppose the company in Example 8.7 receives the short-term loan on October 1. This
implies that the repayment of the short term loan happens in the next reporting period. Hence, on
December 31, the company now has to record the following adjusting journal entry:

Dec 31 Interest expense 90
Interest payable 90
Observe that the interest expense is for the three months October, November and December, i.e.,
3
6% × 12 × 6, 000 = e90.
On February 1, when the company has to repay the short term loan, the company records the following
journal entry:

Feb 01 Notes payable 6, 000
Interest expense 30
Interest payable 90
Cash 6, 120

Observe that on the repayment date, the company still needs to record the interest expense for January.
Furthermore, observe that it does not need to record the interest expense for the months October-
December. This expense has already been recorded in the adjusting journal entry of December 31. On
February 1, the company fullfills the obligation to pay the interest for October-December of e 90.
8.2.1 Zero-interest short term loans
A special case of short term loan is the zero-interest short term loan or zero-interest-bearing note.
In contrast to what the name implies, the interest on the short term loan is not zero. However, the
interest on a zero-interest short term loan is not explicitly specified. The interest is implicit because
the amount of cash that the borrower receives is less than the amount of cash that the borrower needs
to repay at the end of the term.
Example 8.9 Suppose on May 1, a company receives e 6, 000 in cash from the lender and the company
agrees to pay the lender e 6, 100 on September 1. This is a zero-interest short term loan with a term
of 4 months. The implicit interest on this short term loan is e 100, i.e., the difference between the
cash received and the cash that has to be repaid.
On May 1, the company records the following journal entry for this zero-interest short term loan:

May 01 Cash 6, 000
Observe that the liability notes payable is credited for e 6, 000 and not e 6, 100. This follows from
applying the accounting equation:

e 6, 000 = e 6, 000
If liabilities would increase by e 6, 100, the assets should also increase by e 6, 100. However, the
company only receives e 6, 000 in cash. The difference of e 100 does not represent an asset: it does
not meet the definition of an asset as this e 100 does not represent something that generates future
benefits.
When the company repays the short term loan on September 1, the company records the repayment
of the loan and the payment of the (implicit) interest:

Sep 01 Notes payable 6, 000
Cash 6, 100
Example 8.10 Suppose the company receives the zero-interest short term loan in Example 8.7 on
October 1. On October 1, the company records the following journal entry for this zero-interest short
term loan:

Oct 01 Cash 6, 000
On December 31, the company needs to record an adjusting journal entry for the interest expense.
The interest on the loan is e 100 for a four month period. Hence, for the period October-December
the interest expense equals 34 × 100 = e 75. The adjusting journal entry equals:

Oct 01 Interest expense 75
Notes payable 75
Observe that the account notes payable is credited for e 75 so that the net value in the account notes
payable equals e 6, 075 debit. For zero-interest short term loans, it is common procedure to debit the
interest expense to the account notes payable instead of the account expense payable.
When the company repays the short term loan on February 1, the company records the repayment of
the loan, the interest expense for January, and the payment of the (implicit) interest on the loan:

Feb 01 Notes payable 6, 075
Interest expense 25
Cash 6, 100

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Introduction Accrual Accounting

Syllabus for Accounting (FEB11018)

Erasmus School of Economics

This version: August 18, 2022

I Basic principles of accounting 5

4 Issues and challenges in financial accounting 52

II The recording process 61

5 The accounting information system 62

6 The accounting cycle 67

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III Accounting for the financing activities of the company 101

7 Equity capital 102

8 Debt capital 112

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• explains the basic concepts of accrual accounting,

• illustrates why we do accrual accounting in practice,

• discusses the main issues in accrual accounting,

• explains the recording process in the accounting cycle.

Basic principles of accounting

• And how should this be presented in the financial statements?

1.1 Economic value and economic net income

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1.2 Accounting value and accounting net income

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2.1 Example: GreenTees

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Accounting net income:

Table 2.2: Monthly financial statements for GreenTees.

2.2 True and fair view

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Sales - cash 300 300 100 350 200

Income −2, 600 6, 700 −5, 300 5, 950 −800

Jul 31 Aug 31 Sep 30 Oct 31 Nov 30 Dec 31

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In financial accounting, a possession of the firm is called an asset.

In financial accounting, an obligation of the firm is called a liability.

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3.1.4 The accounting equation

The definition of equity gives rise to the accounting equation:

Total assets = Total liabilities + Equity

Change in Change in Change in

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Total assets = Total liabilities + Equity

3.1.5 The balance sheet

Balance sheet of company X (date)

or in horizontal format (i.e., a so-called T-account):

Balance sheet of company X (date)

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3.1.6 Recognition criteria for assets and liabilities

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3.1.7 Example: GreenTees

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Table 3.2: Financial statements for GreenTees for July 2021.

Total assets = Total liabilities + Equity

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Change Capital Capital

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