- Explain the accrual accounting concept
What is Accrual Basis Accounting?
Imagine that you start a landscaping business in December. You hire a few employees and decide to operate as a sole proprietor for now. In December, you and your crew mow and edge 20 lawns (assume it’s Florida or Arizona.) At each home you leave an invoice for $100 payable within 30 days. On December 31, at a party, an acquaintance asks you about your new business. If you were prone to share such information, you could tell your friend that you made $2,000, even if you hadn’t collected any of it yet. This is the gist of the accrual basis of accounting: recognizing revenue as it is earned, as opposed to recognizing it as it is received. If you take the entire month of January off, doing no work, but you get paid by all of your December customers, you then have your $2,000 in cash. However, under the accrual basis of accounting, you already accounted for the revenue in December. You don’t count it again in January. Conversely, if you opt to use a cash basis of accounting, you would recognize and report the revenue in January when you receive it, not in December, even though that’s when you earned it.
The term “accrual basis” is based on the idea of accruing revenue, which means reporting it when it becomes a legally enforceable claim. To accrue is to come about naturally—it’s the effect in cause and effect. You do the work, you have earned the revenue, and GAAP requires a company to report that revenue as it is earned. Your small landscaping business will likely not be subject to GAAP—in fact, the tax law may require you to report revenues and expenses on a cash basis, but, for publicly traded companies, auditors will only certify financial statements if they have been prepared using the accrual basis of accounting.
The critical point in this example is not how much you earned, but rather when you report it. That’s why the time period concept in accounting is so important, so let’s tackle that next.
What is the Time Period Concept?
Because we cut financial reporting into discrete time periods, usually a year or a quarter, we have to decide when to recognize revenue—in which period. For instance, let’s say in the landscaping example above, you hired employees to mow and edge lawns, and you now owe them $500 for services they have rendered (ignore employment taxes for this example.) You’ll pay them in January on the tenth for all work done in December, and then again on February 10 for work done in January, and so on. The question then arises: if you recognize the revenue of $2,000 in December, when you run your financial statements for that month, do you include the wages incurred but not yet paid as a cost of doing business that offsets the revenue for that month?
In other words, do you show for December $2,000 in revenue and $500 in expenses for a net income of $1,500, or do you show $2,000 in revenue for December and an expense of $500 in January when you pay the salaries of the workers for December?
The answer that the FASB came up with in creating GAAP was the former: show $2,000 in revenue and $500 in expenses for a net income of $1,500 for the month of December.
This can cause some timing differences between internal (managerial) accounting reports and external (financial) accounting reports. For instance, if you offer a commission to your employees based on cash collected, they wouldn’t get commissions on $2,000 in December, even though financial accounting reports would show that as revenue earned. Assuming all the cash is collected in January (and assume no cash collected from any January sales) the internal reports would show $2,000 in revenue while the external would show revenue earned (whatever that might be.)
What is a Fiscal Year?
Many retail stores choose a fiscal year end that is different than the calendar year. One of the most popular fiscal year ends is the 52/53 week fiscal year, that would end on a particular day of a particular month. For instance, Macy’s fiscal year ends on the Saturday closest to January 31, so for 2017 it ended on January 28, 2017 but for 2016 it ended on January 30. Many companies adopt a fiscal year that allows them to process transaction, like sales returns, letting the holiday dust settle before trying to manage the timing and recognition of both year end sales and expenses. As a corollary, the cut-off point is not as critical during the rest of the year, only at the very beginning and the very end, unless the company is producing quarterly reports or wishes to have an accurate reflection of the timing and extent of transactions for monthly (probably internal) analysis.
What is the Difference Between Realizing and Recognizing Revenue?
In accounting, when we say we recognize revenue, we mean that we are recording it in the books on that date. In our landscaping example, we recognize revenue in December, even though we receive it in January. Receiving the income is the point at which we realize it.
Operationally, it works like this:
We record revenue as it is earned (recognize) and we also record a receivable, which is basically and IOU from the customer to us. We show the revenue as income on our income statement then. Later, when the cash is received, we eliminate the receivable, which is an asset to us because we own it and it is worth money, and we show a deposit in our bank account. Basically, the receivable (IOU) turned in to cash. Similarly, revenue is realizable when there is good reason to believe it will be collected, and that is the test for accruing revenue. In other words, in order for revenue to be recognized, it must be realizable—it must be fairly certain that the company will collect it.
Technically speaking, revenue is an increase in assets or decrease in liabilities caused by the provision of services or products to customers. If you think back to the accounting equation, where Assets = Liabilities + equity, either an increase in assets or a decrease in liabilities will result in an increase in equity, meaning that the owners of the business have increased their stake—in essence, revenues are an increase in wealth. The business is like a wealth-generating machine, churning out increases in equity by producing goods or services that sell for more than they cost, hopefully. Net income, as you may recall, is the difference between revenues generate by the company and the expenses. Expenses are the ordinary and necessary costs of doing business, like wages, rent, and communications. Revenues minus (net of) expenses is net income, and a positive net income increases the wealth of the owners. It’s that straight-forward.
Revenue is realizable when there is every good reason to believe it will be received. For instance, in some sales situations the customer is allowed to use the item for a period of time as a way to decide whether or not to buy. In that case, revenue from the sale may not be realizable. However, if the customer signs a sales agreement and title to the item passes to the buyer, there is a legal obligation for the buyer to pay and the revenue becomes realizable. When the customer pays, the revenue is realized. Recognition of the revenue usually happens when it is realizable, rather than when it is realized (although in a cash sale the two usually happen simultaneously.)
What is the Matching Concept?
There are two kinds of expenses: those directly related to producing income, and those that are period costs. The timing of expenses is determined by the timing of the revenue. The goal is to match expenses against the revenues, either directly or indirectly. This is called the matching principle and it’s at the heart of accrual basis accounting.
For instance, in our landscaping example, the wages of our employees are both period costs and direct costs of generative revenue. However, if we received a business phone bill in January for our December marketing efforts, would we post that (recognize it) in December, when it was incurred, or in January, when we received it, or maybe even in February, when we pay it (assuming we pay it in February, of course.)
Accrual basis accounting requires matching expenses to revenues whenever possible. The matching principle requires that revenues and any related expenses be recognized together in the same period. Thus, if there is a cause-and-effect relationship between revenue and the expenses, record them at the same time. If there is no such relationship, then charge the cost to expense at once. This is one of the most essential concepts in accrual basis accounting, since it mandates that the entire effect of a transaction be recorded within the same reporting period.
Therefore, under the cash basis of accounting, we would post the phone bill in February, but under the accrual basis of accounting we would post it in December so that it shows as a cost of generating the $2,000 in December revenue, even though the whole bill may not be directly related to the revenue, it still belongs in the same period as it was incurred. That’s the basic rule: recognize expenses as incurred, matching them to revenue either by period or by direct effort.
Here is one more example of the matching principle:
Under a bonus plan, an employee earns a $5,000 bonus. The bonus is paid in 2018 based on 2017 results of operations as shown on the audited financial statements. Under GAAP, the bonus would be recorded and shown as an expense in 2017, matching it against 2017 sales revenue.
You may hear accountants talk in terms of debits and credits. Debit literally means left, and credit means right. Accountants use a two-column journal to record transactions, so the above bonus would be recorded like this in 2017:
|Accrued Bonus (liability)||5,000|
In this entry, the bonus is recognized before the cash payment to the salesperson actually occurs, along with a liability in the same amount. In the following month, when the company pays the bonus, it would record the following entry:
|Accrued Bonus (liability)||5,000|
|Checking Account (asset)||5,000|
The cash balance declines as a result of paying the commission, which also eliminates the liability. The reason your debit card is called a debit card is because the bank shows your balance as a liability because they owe your money to you—in essence, they are just holding it for you. A liability usually has a credit balance (balance on the right side of the ledger) and so when you spend money and they pay it out on your account, they debit your account (a debit offsets a credit.)
For more on debits and credits, watch the video below.