Accrual Basis Accounting

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Accrual Basis vs. Cash Basis Accounting

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Accrual Basis Accounting

Under the accrual basis accounting, revenues and expenses are recognized as follows:

Revenue recognition: Revenue is recognized when both of the following conditions are met:
a. Revenue is earned.
b. Revenue is realized or realizable.

Revenue is earned when products are delivered or services are provided.
Realized means cash is received.
Realizable means it is reasonable to expect that cash will be received in the future.

Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).

Cash Basis Accounting

Under the cash basis accounting, revenues and expenses are recognized as follows:
Revenue recognition: Revenue is recognized when cash is received.
Expense recognition: Expense is recognized when cash is paid.

Timing differences in recognizing revenues and expenses

There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting.

Four types of timing differences

    a. Accrued Revenue: Revenue is recognized before cash is received.
    b. Accrued Expense: Expense is recognized before cash is paid.
    c. Deferred Revenue: Revenue is recognized after cash is received.
    d. Deferred Expense: Expense is recognized after cash is paid.

An Example of Accrued Revenue

Example: Products are sold at $5,000 on May 1, 2006 and cash is received on May 10, 2006.

	May 1, 2006	May 10, 2006
	Revenue is recognized.	Cash is received.

[Journal entry on May 1, 2006]

		Debit	Credit
Accounts receivable		5,000
	Sales		5,000

[Journal entry on May 10, 2006]

		Debit	Credit
Cash		5,000
	Accounts receivable		5,000

An Example of Accrued Expense

Example: On May 1, 2006, Company A borrowed $100,000 from a bank and promised to pay 12% interest at the end of each quarter.

	May 31, 2006	June 30, 2006
	Interest expense is recognized for May.	Cash is paid at the end of the quarter.

[Journal entry on May 1, 2006]

		Debit	Credit
Cash		100,000
	Borrowings from bank		100,000

[Journal entry on May 31, 2006]

		Debit	Credit
Interest expense		1,000
	Interest payable		1,000

$100,000 x 12% x 1/12 = $1,000 for each month.

Interest payable is a liability account.
Credit side of interest payable (a liability account) represents an increase.

[Journal entry on June 30, 2006]

		Debit	Credit
Interest expense		1,000
	Interest payable		1,000

Credit side of interest payable (a liability account) represents an increase.

		Debit	Credit
Interest payable		2,000
	Cash		2,000

Company pays $2,000 as interests for May and June.
Debit side of interest payable (a liability account) represents a decrease.

An Example of Deferred Revenue

Example: On May 1, 2006, Company A had a new lease contract with a tenant and received $6,000 for two month rent.

	May 1, 2006	May 31 and June 30 2006
	Cash is received.	Revenue is recognized at the end of May and June.

Revenue is recognized when Company A provides service. In this example, service is provided when time passes.

[Journal entry on May 1, 2006]

		Debit	Credit
Cash		3,000
	Unearned rent revenue		3,000

Unearned rent revenue is a liability account.
Credit side of unearned rent revenue (a liability account) represents an increase.

"Unearned revenue" accounts represent the amount of cash received before services are provided. Since services have not been provided yet, it is not revenue.

"Unearned revenue" accounts are liabilities of the company, because they should be paid back to the other party if service is not provided in the future.

[Journal entry on May 31, 2006]

		Debit	Credit
Unearned rent revenue		3,000
	Rent revenue		3,000

Debit side of unearned rent revenue (a liability account) represents a decrease.
Credit side of rent revenue (a revenue account) represents an increase.

[Journal entry on June 30, 2006]

		Debit	Credit
Unearned rent revenue		3,000
	Rent revenue		3,000

Debit side of unearned rent revenue (a liability account) represents a decrease.
Credit side of rent revenue (a revenue account) represents an increase.

An Example of Deferred Expense

Example: Company A purchased an insurance for a period from May 1, 2006 to July 31, 2006 and paid $6,000 cash for three month insurance premium.

	May 1, 2006	May 31, June 30, July 31, 2006
	Cash is paid.	Expense is recognized at the end of May, June and July.

[Journal entry on May 1, 2006]

		Debit	Credit
Prepaid insurance		6,000
	Cash		6,000

Prepaid insurance is an asset account.
Debit side of prepaid insurance (an asset account) represents an increase.

[Journal entry on May 31, 2006]

		Debit	Credit
Insurance expense		2,000
	Prepaid insurance		2,000

Credit side of prepaid insurance (an asset account) represents a decrease.

[Journal entry on June 30, 2006]

		Debit	Credit
Insurance expense		2,000
	Prepaid insurance		2,000

Credit side of prepaid insurance (an asset account) represents a decrease.

[Journal entry on July 31, 2006]

		Debit	Credit
Insurance expense		2,000
	Prepaid insurance		2,000

Credit side of prepaid insurance (an asset account) represents a decrease.

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