The regulators do not permit a business organized as a C-corporation (in the United States) to use cash basis accounting. Instead, these companies must use accrual accounting. Do you want to understand the fundamental of accrual-basis accounting? Here is the post you want, it is a must read to those who need to get a basic base of accounting. I composed this post in the way that anybody (even non-accountant) can understand the concepts easily.

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Accrual accounting includes income and expenses in the income statement in an organized and systematic way to try to get a more accurate view on the timing and size of revenues and expenses. Accordingly, accountants recognize and incorporate revenues and expenses based on a number of basic accounting rules I describe in this post (despite the various standards maybe exist for the topic).

 

Speeding Up Revenue Recognition (Accruing Revenue)

Most business managers would like to recognize revenue as soon as possible. When a business provides a service to a customer, it is customary to recognize the revenue before the customer has paid the cash for the service.

As long as the business is on the accrual basis, the accountants are willing to recognize the revenue as soon as the service has been provided if there is a reasonably good chance that the revenue will be collected from the customer.

The following transactions recognize income for a service provided a month before the customer pays for the service.

For example: (Corrected. Thanks to ~Helen, for pointing the error)

On The 10/14/2010:

[Debit]. Accounts Receivable = $12,000
[Credit].  Professional Service Income = $12,000

When payment is received (11/13/2010):

[Debit]. Accounts Receivable = $12,000
[Credit]. Cash = $12,000

Managers of companies are frequently compensated based on accounting results. These managers may benefit from compensation plans that exceed certain financial milestones. Following is a list of some accrued revenues, or revenues on contract using percentage completion:

Delayed Revenue Recognition (Deferring Revenue)

Some businesses demand payment at the point a transaction is made, with the actual delivery of goods occurring later. Suppose, for example, that a company wants to shift production of a product to a contract manufacturer.

A contract manufacturer may accept a contract only if the customer makes a substantial prepayment in advance. The contract manufacturer uses the payment to buy materials and pay other expenses during the production processes. Still, the manufacturer may delay recognizing the income until the goods are finished and shipped to the customer. Here are entries made:

10/15/2010:

[Debit]. Cash = $100,000
[Credit]. Unearned Sales Revenue = $100,000

This pair of transactions reflects the payment of cash on the books of the contract manufacturer. The offsetting transaction is not “Sales” because the company has not yet manufactured the goods. Instead, it is a liability account “Unearned Sales” which reflects the deposit made at the start of the manufacturing period.

Following is a list of deferred income:

  • Prepaid phone revenue
  • Subscriptions
  • Professional retainers
  • Access to pipeline
  • Legal retainers
  • Broadband capacity

In each case, a company has been paid for benefits it has not provided. Holding the amount equal to the cash payment as a liability allows the company to postpone recognizing revenue before the company has earned the revenue.

Speeding Up Expense Recognition (Accruing Expenses)

The accounts payable department of any company receives piles of bills for goods and services already provided to a company. If the company is on the cash basis, expenses that are paid 60 or 90 days later would enter the accounting records only when the cash is paid. This delay means that the expense may be recognized well after the benefits have been realized. To better match the timing of the expense to the benefit derived from the service, accrual accounting will post the expense when the benefit is realized.

For example, if a company hires outside contractors to provide manufacturing or administrative support, and if the contractor invoices the company in the middle of the following month, an accountant would create the following entries to recognize the expense before the contractor is paid:

On The 12/31/2009:

[Debit]. Professional Expense = $10,000
[Credit]. Accounts Payable = $10,000

Later, the company receives an invoice and pays it (1/18/2010):

[Debit]. Accounts Payable = $10,000
[Credit]. Cash = $10,000

Notice that, in this case, the company recognizes the expense in the month the service was provided, even though the contractor receives the money in the next calendar year.

[Info_Box]When a company using accrual accounting receives a service or good that should be recognized as an expense, the company should recognize the expense when the benefit is realized.[/Info_Box]

It may be difficult to identify a precise date when the expense should be realized. In fact, it may be impossible to identify a single day when the benefits are enjoyed. Accountants make reasonable decisions, and the statements reflect many such choices. The statements will be useful if the company takes reasonable care to recognize the expenses reasonably.

Few companies are tempted to recognize expenses early. However, there are cases, following a re-organization or in a period when the company is expecting to report poor accounting results anyway, a company may be tempted to frontload or otherwise overstate expenses.

These companies may think that a larger loss may not matter much to investors, and front-loading expenses sets the stage for a recovery in net income.

Companies have been found guilty of arbitrarily accelerating expenses to manipulate future results.

Following is a list of some accrued expenses:

  • Salary
  • Interest Expense
  • Depreciation
  • Depletion
  • Amortization
  • Warranty Expense

 

Do Not Confuse Prepaid Expenses With Accrued Expense

Companies may pay for services in advance for a number of reasons. It is common to pay subscriptions for a year or more in advance. Rental agreements may require the renter to pay one or more months of rent in advance. Contracts to use pipeline capacity or telecommunications bandwidth may require advance payments.

[Info_Box]Companies that use accrual accounting are able to postpone recognizing expenses.[/Info_Box]

Suppose, for example, that the company pays $120,000 rent up front for a year of access to a property. The cash in the company bank account is immediately lower, but the net worth of the company is not lower because the company has to access the facility. During the year, the company uses that access to the property to carry on business operations. At the end of the year, the company has no remaining right of future access, so that value is gone, and the company net worth is lower by $120,000 (all else being equal).

Under the cash basis of accounting, the company would post an expense of $120,000 when the payment is made:

[Debit]. Rent Expense = $120,000
[Credit]. Cash = $120,000

This method places a lump-sum expense at the beginning of the rental period and no expenses later. The balance sheet reflects no value for the prepaid use of the rental property.

In contrast, the accrual method recognizes that the cash payment represents an exchange of one asset (cash) for another (future use of the property). The transaction may be posted as:

[Debit]. Prepaid Expense = $120,000
[Credit]. Cash = $120,000

The account “Prepaid Rent” is an asset that reflects the value of the future use of the rental property.

Using the standard assumption of historical cost, the value of that access is equal to the price actually paid. The balance sheet will reflect this future value, and the income statement will not immediately show an expense for the rent.

[Info_Box]Accountants say that the expense has been deferred or capitalized. In everyday English we can say that the impact of the rental expense has been delayed.[/Info_Box]

Each month of the rental period, the company recognizes a portion of the $120,000 prepayment as a rental expense and reduces the value of the “Prepaid Rent” asset by an equal amount:

[Debit]. Rent Expense = $10,000
[Credit]. Prepaid Expense = $10,000

Using the accrual method to spread the $120,000 payment out over the life of the lease, the income statement avoids the swings in profitability caused by the timing of this rental payment. For a going concern that can make good use of the property, the accrual of the rental expense makes the income statement more meaningful.

The balance sheet includes a declining value of the future use of the property, which makes the balance sheet a better measure of the financial position of the company.

It is, admittedly, more typical for a landlord to charge monthly rent. As it turns out, the accrual accounting creates a pattern of expenses that match traditional monthly rent. It is, however, not important to match this more typical cash flow pattern. Rather, the account seeks to match the recognition of the expense to the benefits received.

A company may capitalize (that is, postpone recognizing expense and instead include on the balance sheet as an asset) a number of expenses. Following is a partial list of deferrable expenses:

  • Prepaid rent
  • Prepaid insurance
  • Drilling/mineral rights
  • Access to pipeline
  • Professional retainers
  • Broadband capacity

 

Delayed Expenses Recognition (Deferred Expenses)

When we created balance sheets early in the text, we made an effort to include all business transaction directly on the balance sheet. Any outflow of cash was either a purchase of an asset, which had no effect on the net worth of the company, or something we later called expenses, which lowers the equity of the company.

In addition, there are a variety of transactions that are a bit less clear. These are examples of deferred expenses, and two are listed here:

  • Inventories
  • Investment in equipment

Accountants so universally use inventory to match the timing of costs to revenues that it is easy to forget that the technique postpones recognition of expenses. In fact, a company may be able to hold costs in inventory accounts even if the company is on a cash basis instead of accrual.

When a company buys equipment that will be used for many years, it does not recognize the purchase price as an expense. Instead, accrual accounting posts the equipment as an asset at the purchase price. Then, over time, accountants create other entries to reflect the wear and tear over the useful life of the equipment. These types of accrual transactions will be described later in this post.

 

The Downside to Deferring Expenses (Be Careful)

In the preceding example, postponing the prepayment of rental expense probably makes both the income statement and balance sheet more useful to most readers of the financial statements. In this example, the accrual method better matches the expense to the production of revenue for the company. As a fringe benefit, the financial results of this company will be more comparable to the results of a company that has a lease with monthly payments.

Companies have improperly deferred expenses that should have been recognized as a way to overstate the net income of a company. If a company deferred or capitalized expenses in cases where there is no future service or other value to enjoy, then the company would understate current expenses and therefore overstate current income. The abuse of expense deferral would also overstate later expenses, which should have been recognized in a prior period.

 

Depreciation: A Different Kind of Deferred Expense

Suppose XYZ Corporation bought an asset for $300,000. The asset should last 10 years. If the asset is a machine, XYZ will depreciate the machine. If the asset is a natural resource, XYZ will deplete the resource. If the asset is intangible, XYZ will amortize the value. These alternatives are described next. The Asset Is a Machine, it is simple to account for the exchange of one asset for another (purchase with cash) or to acquire a new asset and assume a liability for future repayment.

Entries for the acquisition of the asset may look like the following:

A cash basis company might debit an expense account such as “Cost Of Goods Sold” even though the machinery has an expected useful life of 10 years. They would recognize the entire purchase price as an expense:

[Debit]. Cost Of Goods Sold = $10,000
[Credit]. Cash = $10,000

Alternatively, an accrual-based customer may decide to treat the purchase of the machinery as an acquisition of an asset (machinery) in return for another asset (cash).

[Debit]. Machinery = $10,000
[Credit]. Cash = $10,000

This method postpones recognizing income indefinitely. Perhaps when the equipment wears out, the accrual accountants might recognize an expense or loss on the equipment:

[Debit]. Loss On Equipment = $10,000
[Credit]. Machinery = $10,000

If the equipment has some salvage value, the amounts to post may be a little more complicated but would follow the preceding patterns. Each of the methods postpones recognizing expenses for a time, then recognizes expenses on disposition of the equipment.

None of the preceding methods meets the basic requirements of modern accounting because the timing of the revenues for the company is not matched to the expenses for the company.

[Info_Box]Accountants use a method called “depreciation” to better match the revenues and expenses incurred to earn the revenue.[/Info_Box]

Suppose the money spent to buy the equipment was spread out over the 10-year expected life of the equipment. The company needs to record the reduction in cash when the equipment is purchased. The company also creates an asset of equal value as presented in the entries above. In addition, the company recognizes $1,000 of expense in the form of wear and tear on the equipment each year.

Therefore, each year, the value of the equipment decreases and some of that value gets included in the income statement as an expense. After 10 years, the $10,000 has been included in the income statement, and the balance sheet reflects the decline in value of the machinery.

The actual entries to accomplish the preceding sequence do not follow the simplest and most intuitive pattern. Generally, the initial acquisition of the equipment looks logical enough:

10/2/2010:

[Debit]. Machinery = $10,000
[Credit]. Cash = $10,000

Then, at the end of one year, one tenth of the value is removed from the “Machinery” account and included as an expense. These entries do not follow the most obvious pattern:

12/31/20X1:

[Debit]. Depreciation Expense = $1,000
[Credit]. Accumulated Depreciation = $1,000

[Info_Box]The expense category “Depreciation Expense” is a place to hold the expenses that represent the loss in value over time and with use.[/Info_Box]

As an expense, it represents a temporary account that will eventually reduce the net worth of the company. This expense reduces the income for each of the 10 years the company anticipates using the equipment. The expense approximately matches the decline in value of the machinery. As seen earlier, however, the “Machinery” account is not altered. Instead, an ‘‘Accumulated Depreciation” account is created.

Note, however, that the $1,000 is a credit to this accumulation account instead of a credit to the “Machinery” account. At year-end, the “Machinery” account will still carry the machinery at cost ($10,000 as a debit) but will also contain a credit for $1,000. The “Accumulated Depreciation” account is a subtotal of the wear and tear on the machinery.

The “Accumulated Depreciation” account is an example of a ‘‘contra account.’’ In this case, the account is an asset account, except that it acts as a way to reduce or cancel out other assets.

At the end of the year, the accounting records will still carry Machinery at $10,000 as a debit and also carry Accumulated Depreciation as a credit of $1,000. The balance sheet will probably net the two values and include the difference on the statement. Therefore, the balance sheet, which sums the value of assets and liabilities, will not be significantly impacted by the preceding accounting treatment. However, this method provides additional information that may be of use to some analysts.

[Info_Box]Accountants use several methods to allocate the decline in value to different years. The simplest method is called the straight-line method, which allocates an equal amount of expense to each year.[/Info_Box]

To calculate the annual expense, the accountant needs to determine the useful life of the asset and the value at the end of that useful life. The value at the end of the useful life is called residual value or salvage value.

There are several common ways accountant allocate the decline of fixed asset value:

1. Straight-Line (SL) Method – It allocates the decline from cost to the salvage value over the expected life. Fractional periods are allocated in an intuitive manner. For example, if an asset is acquired halfway through the year, a fractional portion of a full year’s expense is included in both the first and last years of the expected life. If an asset is still productive after the passage of the original expected useful life, no additional expense is included for the bonus years. The value of the asset remains on the books, but the Accumulated Depreciation reduces the value to the assumed salvage value.

2. Double-Declining-Balance (DDB) Method – The accountant again estimates the expected life of the asset. Then, a percentage decline is calculated solely from the expected life. For example, if the asset is expected to last 10 years, one tenth or 10 percent is the assumed decline in value in each year. For double-declining-balance, however, twice this amount is used. So, for an asset with an expected life of 10 years, depreciation equals 2 x 10 percent, or 20 percent of the depreciated value of the asset. In using the double-declining-balance method, the salvage value of the asset is not used to determine the percentage. The depreciation is repeatedly applied to the shrinking asset value. At the point where the depreciated value of the asset would fall below the salvage value, depreciation is limited, so the value of the asset stops at the salvage value.

[Info_Box]Double-declining-balance depreciation accelerates the recognition of Depreciation Expense. Recognizing expenses faster may provide tax benefits over lower deprecation methods. Although this accelerated method produces lower taxable income, at least in the earlier years, it does not necessarily produce lower financial profits on the company income statement. In fact, companies can use one method for financial reporting and another for tax reporting.[/Info_Box]

3. Sum-of-The-Years Digits Method – Suppose an asset is expected to last 5 years. Add up the numbers 1, 2, 3, 4, and 5. These numbers sum to 15. In the first year, 5/15 or 33 percent of the original asset value gets reported as depreciation. In the second year, 4/15 of the original cost gets reported as depreciation. And so forth. Accountants must be sure to avoid depreciating assets below their salvage value.

4. Modified Accelerated Cost Recovery System (MACRS) – The most recently created commonly used accounting method is called the modified accelerated cost recovery system (MACRS). This accelerated path of depreciation is a series of depreciation schedules published by the Internal Revenue Service. Companies generally use MACRS depreciation for producing depreciation on their tax documents. Companies using MACRS for tax reporting often use straight-line depreciation for financial reporting.

Accrual accounting permits accountants to determine the proper time to recognize revenues and expenses. The intention of accrual accounting is to make financial statements more meaningful. To be meaningful, accountants need to make reasonable assumptions that affect the timing of the revenues and expenses.