accrual basis accounting

Examples of accrual basis accounting in the following topics:

• Differences Between Accrual-Basis and Cash-Basis Accounting

  • Accrual accounting does not record revenues and expenses based on the exchange of cash, while the cash-basis method does.
  • Under the accrual accounting method, the receipt of cash is not considered when recording revenue; however, in most cases, goods must be transferred to the buyer in order to recognize earnings on the sale.
  • An accrual journal entry is made to record the revenue on the transferred goods even if payment has not been made.
  • An expense account is debited and a cash or liability account is credited.
  • The cash-basis method, unlike the accrual method, relies on the receipt and payment of cash to recognize revenues and expenses.

• Expense Recognition

  • Expense recognition is an essential element in accounting because it helps define how profitable a business is in an accounting period.
  • If the business uses cash basis accounting, an expenditure is recognized when the business pays for a good or service.
  • Generally, cash basis accounting is reserved for tax accounting, not for financial reports.
  • Most financial reporting in the US is based on accrual basis accounting.
  • Under the accrual system, an expense is not recognized until it is incurred.

• Terminology of Accounting

  • Important terminology in accounting includes cash vs. accrual basis, assets, liabilities, and equity.
  • There are two primary accounting methods - cash basis and accrual basis.
  • The cash basis of accounting, or cash receipts and disbursements method, records revenue when cash is received and expenses when they are paid in cash.
  • Accrual accounts include, among others, accounts payable, accounts receivable, goodwill, deferred tax liability and future interest expense.
  • The term accrual is also often used as an abbreviation for the terms accrued expense and accrued revenue.

• Current Guidelines for Expense Recognition

  • Since most businesses operate using accrual basis accounting, expense recognition is guided by the matching principle.
  • Explain how accrual accounting uses the matching principle for expense recognition

• Impact of the Operating Cycle on the Income Statement

  • The accrual method ensures proper reporting on the income statement because the operating cycle doesn't coincide with the accounting cycle.
  • Information enters the income statement via the accounting cycle.
  • Companies choose the length of their accounting cycle by how long it takes to carry out the required accounting—not when the individual business transactions take place.
  • To allow for the fluctuations in the operating cycle, many companies choose to use the accrual basis of accounting.
  • In accrual accounting, companies recognize revenues when the company makes a sale or performs a service, regardless of when the company receives the cash.

• Recognizing Accounts Receivable

  • If you are operating under the accrual basis, you record account receivable transactions irrespective of any changes in cash.
  • Assuming Furniture Palace uses the accrual method of accounting, a journal entry is recorded for the sale of the item and the extension of credit to the customer.
  • If you are operating under the accrual basis, you record transactions irrespective of any changes in cash.
  • To record a journal entry for a sale on account, one must debit a receivable and credit a revenue account.
  • Two methods are available to calculate the amount of bad debt expense and allowance of doubtful accounts at the end of an accounting period -- percentage of accounts receivable or percentage of sales.

• The Importance of Timing: Revenue and Expense Recognition

  • Accounting standards require that companies using the accrual basis of accounting and match all expenses with their related revenues for the period, so that the income statement shows the revenues earned and expenses incurred in the correct accounting period.
  • The matching principle, part of the accrual accounting method, requires that expenses be recognized when obligations are (1) incurred (usually when goods are transferred, such as when they are sold or services rendered) and (2) the revenues that were generated from those expenses (based on cause and effect) are recognized.
  • If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired (e.g., when they have been used up or consumed, spoiled, dated, related to the production of substandard goods, or the services are not in demand).
  • Examples of costs that are expensed immediately or when used up include administrative costs, R&D, and prepaid service contracts over multiple accounting periods.
  • By tying revenues and expenses to the completion of sales and other money generating tasks, the income statement will better reflect what happened in terms of what revenue and expense generating activities during the accounting period.

• Current Guidelines for Revenue Recognition

  • The revenue recognition principle is a cornerstone of accrual accounting together with the matching principle.
  • They both determine the accounting period in which revenues and expenses are recognized.
  • For companies that don't follow accrual accounting and use the cash-basis instead, revenue is only recognized when cash is received .
  • The matching principle's main goal is to match revenues and expenses in the correct accounting period.
  • The principle allows a better evaluation of the income statement, which shows the revenues and expenses for an accounting period or how much was spent to earn the period's revenue.

• Importance of Recognition and Measurement

  • The revenue recognition principle and the matching principle are two cornerstones of accrual accounting.
  • Related revenues as two types of accounts:
  • According to the matching principle in accrual accounting, expenses are recognized when obligations are incurred—regardless of when cash is paid out.
  • The matching principle is a culmination of accrual accounting and the revenue recognition principle.
  • Offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), regardless of when cash is paid out.

• Preparation of the Statement of Cash Flows: Direct Method

  • For example, in order to find out the cash inflow from a customer we need to know the sales revenue, but the sales revenue is also affected by the accounts receivable account.
  • In order to determine the cash paid to suppliers, you need to look at both the inventory and the accounts payable account, and then determine their effect on the cost of goods sold.
  • In this method, each item on an income statement is converted directly to a cash basis, and each cash effect is directly reported.
  • add ending payables (tax, interest, salaries, accounts payable, et al. )
  • In the indirect (addback) method for calculating cash flows, the accrual basis net income is established first.