Accrual Accounting and Financial Statement Analysis — Adjusting Entries, Closing the Books, and Key Ratios | Chapter 3 of Financial Accounting

Chapter 3 of Financial Accounting (12th Edition) by Thomas, Tietz, and Harrison is where students complete the accounting cycle. This pivotal chapter introduces the key concepts of accrual accounting, financial statement preparation, and financial performance analysis. Through adjusting entries, closing procedures, and ratio analysis, it teaches how to transform raw data into accurate, actionable financial reports.

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📘 Book Overview

This chapter clarifies the difference between accrual accounting and cash-basis accounting. Accrual accounting, the standard under GAAP, recognizes revenues and expenses when they’re earned or incurred—not when cash is exchanged. This distinction forms the basis for accurate financial reporting across industries.

📆 Accrual vs. Cash-Basis Accounting

Cash-basis accounting records revenues and expenses only when cash changes hands. In contrast, accrual accounting uses:

• Revenue Principle — Recognize revenue when earned, not when paid.
• Expense Recognition (Matching) Principle — Recognize expenses in the same period as the revenues they help generate.

This approach gives a more realistic picture of a company’s financial health.

🛠 Adjusting Entries and Account Corrections

Adjustments are essential to ensure all accounts reflect the current period accurately. Common categories include:

• Prepaid Expenses (e.g., prepaid insurance)
• Unearned Revenues (e.g., advance payments for services)
• Accrued Expenses (e.g., wages payable)
• Accrued Revenues (e.g., interest receivable)

The chapter also introduces depreciation and accumulated depreciation as methods for recognizing the wear-and-tear of long-term assets over time, leading to a calculated book value.

📊 Preparing Financial Statements

Once adjustments are complete, the adjusted trial balance is created. This serves as the foundation for producing the core financial statements:

• Income Statement
• Statement of Retained Earnings
• Classified Balance Sheet — Separates current vs. long-term assets and liabilities

Students learn to distinguish between single-step and multi-step income statements, which organize revenue and expense information differently.

🔁 Closing Entries and Temporary Accounts

At the end of the accounting period, temporary accounts (revenues, expenses, dividends) must be closed. This is done through closing entries that transfer their balances to retained earnings. The process is known as closing the books and prepares the accounts for the next period.

📈 Financial Statement Analysis Tools

Chapter 3 concludes by introducing basic tools to evaluate a company’s short-term liquidity and long-term solvency:

• Current Ratio = Current Assets ÷ Current Liabilities
• Debt Ratio = Total Liabilities ÷ Total Assets
• Net Working Capital = Current Assets − Current Liabilities

These ratios provide insight into a company’s ability to meet obligations, manage risk, and operate efficiently.

📚 Summary

This chapter marks the completion of the accounting cycle by integrating accrual concepts with the mechanical process of recording, adjusting, closing, and analyzing. Through practical examples and financial ratios, students gain the tools needed to ensure accurate and ethical reporting while assessing a company’s financial performance.

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