4 - Accrual vs. Cash Basis and the Accounting Cycle

Overview of Accounting Methods

Topic: Accrual vs. Cash BasisPresenter: S. Levkoff, PhD, CAP®Affiliation: UC San Diego Department of Economics & Rady School of Management

Accrual vs. Cash Basis

There are two primary accounting methods used by businesses to record financial transactions:

Cash Basis Accounting

  • Definition: Cash Basis accounting records revenues and expenses only when cash is actually received or paid.

  • Perspective: This method reflects a cash flow perspective, providing insight into the actual cash position of the business at a given time, which can be beneficial for small businesses.

  • Limitations: It may not accurately reflect the company's overall financial position since it ignores accounts receivable and accounts payable.

Accrual Basis Accounting

  • Definition: Accrual Basis accounting recognizes revenues when they are earned and expenses when they are incurred, regardless of when cash is exchanged.

  • Importance of Concepts: Understanding the concepts of 'earned' and 'incurred' is crucial for accurate financial reporting. The timing of recognition can significantly affect the financial statements.

  • Popularity: Accrual accounting is the more commonly utilized method among larger businesses as it provides a more comprehensive view of financial performance. Both methods are considered legitimate under Generally Accepted Accounting Principles (GAAP).

Revenue Recognition in Accrual Accounting

  • Revenues are recognized when the delivery of goods/services occurs, not solely upon receipt of payment.

  • Critical Distinction: There is a significant difference between revenue recognition and cash inflows; revenue can be recognized without cash changing hands at that moment.

  • Revenue Recognition Criteria: Adhering to revenue recognition criteria ensures that financial statements accurately reflect business performance.

Revenue Recognition Guidelines (GAAP)

  • Definition: Revenue is defined as an increase in Stockholders’ Equity resulting from the provision of goods/services.

  • Conditions for Revenue Recognition:

    • Earned: Services/goods must be delivered.

    • Realized: Payment must be received in cash or must be convertible to cash value.

Revenue Recognition Criteria Established by SEC

  • Several conditions may impact the recognition of revenue:

    • Collection Probability: Companies should delay recognition until payment is confirmed if there is uncertainty regarding collection.

    • Delivery Complete: The risks and ownership must transfer to the buyer for revenue to be recognized.

Additional SEC Criteria for Recognition

  • Persuasive Evidence of Arrangement: There must be definitive evidence showing that a sale has occurred (no mere consignment arrangements).

  • Price Determinability: The buyer should not have the ability to unilaterally cancel the order and demand reimbursement.

Example Cases

  • Realized but Not Earned: A software company may receive $1000 for an annual license upfront; however, the revenue is not fully recognized until the services have been rendered.

  • Earned but Not Realized: A controversial strategy may involve a CEO sending unordered goods to record revenue, even with a high probability of returns—resulting in revenue being 'realized' with invoicing but not collectible.

Conservatism Principle in Accounting

  • This principle emphasizes being cautious in accounting practices:

    • Cost Recognition: Anticipated losses should be accounted for immediately, while profits should not be recognized until they are realized.

    • Behavior Impact: This leads to a conservative bias in financial estimates, affecting how organizations report earnings.

Examples of Revenue and Expense Recognition

  • Example 1 - AllCorp: Revenue for $100,000 of Bitcoin hardware delivered in December is recognized as $100,000.

  • Example 2 - BuzzbeeCorp: Cash collection of $70,000 in December correlates with October deliveries; hence, the recognized amount remains $0, as recognized in October.

  • Example 3 - C-Corp: For a $20,000 lease covering December and January (paid in December), only $10,000 is recognized for December, reflecting revenue for services rendered.

  • Example 4 - DAir Corporation: A December order for a $12 million fighter jet to be delivered in July results in a recognized amount of $0, as it is neither earned nor realized.

  • Example 5 - EBank: Interest revenue of $100,000 for December, with payment received in January, is recognized as $100,000 due to service provision in December.

  • Example 6 - Fun Corp: Sale of shares yielding $10/share with no goods/services provided results in a recognized amount of $0, as stock sales do not count as revenue.

Accrual Accounting Key Points

  • Revenues are recognized upon provision of goods/services, creating an ongoing engagement with cash flows.

  • The Matching Principle advocates that expenses linked to revenues should be recognized concurrently.

Understanding Expenses and the Matching Principle

  • Expenses are defined as decreases in Stockholders’ Equity arising from revenue generation processes, and are recognized based on their relationship with revenues.

    • Product Costs: Recognized when the related revenues are recognized.

    • Period Costs: Incurred expenses directly when matching is difficult.

Cookie Factory Cost Example

  • Production Costs: Includes materials and labor directly related to cookie production.

  • Period Costs: Includes rent, utilities, and salaries not directly tied to output.

  • Unusual Events: May include potential liability from lawsuits linked to defective products sold.

Various Example Cases for Expenses

  • Example 7 - Gee Corps: Purchase of $2,000,000 worth of engines in December shows a recognized expense of $0, as costs are only recognized when revenue is generated.

  • Example 8 - H Corps: The utilization of engines in vehicles costing $10,000,000 in December yields a recognized expense of $0; expense is recognized only upon sale.

  • Example 9 - IRace Corps: Sales of cars in December worth $12,000,000 with a cost of $10,000,000 lead to a recognized expense of $10,000,000, reflecting actual sales.

  • Example 10 - Company J: Marketing salaries amounting to $180,000 in December are fully recognized as $180,000.

  • Example 11 - Company K: Legal counsel payment of $60,000 for services over three months will show a recognized expense of $20,000 attributed to December.

  • Example 12 - Company L: Dividend payments to shareholders totaling $100,000 in December are recognized as $0 since these are not operating expenses.

The Accounting Cycle Overview

The accounting cycle consists of multiple steps designed to accurately reflect a company’s financial activities:

  1. Analyze Transactions: Assess the nature of financial transactions.

  2. Journalize: Create and record journal entries for these transactions.

  3. Post: Transfer journal entries into the general ledger.

Unadjusted Trial Balance

  • An unadjusted trial balance summarizes account balances to ensure that total debits match total credits, confirming the integrity of the ledger entries.

Adjusting Entries

  • These are crucial updates that reflect revisions to account balances, acknowledging accrued and deferred items:

    • Accruals and Deferrals: Recognize revenues and expenses in the period incurred, regardless of cash flow timing.

Adjusted Trial Balances

  • Computed post-adjustments to validate that accurate balances exist after incorporating all necessary adjustments into the accounting system.

Financial Statements Preparation

  • Preparation Steps: Consist of compiling balance sheets, income statements, and cash flow statements using the adjusted balances to ensure comprehensive representation of the company's financial health.

  • Closing Entries: Involves closing out temporary and permanent accounts to prepare for the next accounting period.