Accounting 1 Dersi 3. Ünite Özet

Differences Between Cash Basis Accounting and Accrual Basis Accounting

Accounting is based on either the cash basis or the accrual basis. The main difference between these two is in the dictation of how the companies’ transactions are recorded. Revenues and expenses may be recorded when the cash related with them is received/paid or when they are earned/incurred.

In cash basis accounting, companies record revenues when they receive the cash and they record expenses when the cash is paid. Cash basis accounting records only cash transactions—cash receipts and cash payments.

On the other hand, accrual basis accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the transaction will be recorded even if the business did not receive or did not pay any cash. In accrual basis accounting, companies record revenues when they are earned and record expenses when they are incurred. Recording regardless of monetary inflows and outflows forms the basis of accrual basis accounting. So, the profitability of the company applying accrual basis accounting can be measured much better when compared with applying the cash basis accounting.

Related Concepts and Principles and Applied to Accrual Basis Accounting

The timing and recognition of revenues and expenses are the basic differences between cash basis and accrual basis accounting.

Time Period Concept

Each company is set up with the expectation that it will have an unlimited lifetime (remember the going concern assumption). But companies’ related parties (such as government, creditors, investors, management, customers, etc.) wish to have information about the activities and financial position of the company over certain periods. In order to meet these demands and give feedback, the unlimited economic lifetimes are divided into artificial time periods by accountants. The time-period concept (or alternatively periodicity concept) assumes that unlimited economic life of a company will be divided into artificial time periods and that financial statements can be prepared for specific periods such as a month, quarter, or year.

Accounting periods may be monthly, quarterly, semiannually or yearly. All small, medium, and large sized companies are required to prepare their financial reports at certain time periods. Because related parties are examining these financial reports in order to give right decisions, they want to reach the right information on time. Even though the basic accounting period is one year, some of the companies might prepare their financial reports monthly, quarterly or semi-annually.

The 12-month accounting period used for the annual financial statements is called as fiscal year. Sometimes companies can prepare their financial statements for shorter time periods for internal reporting purposes. If the accounting period is shorter than one year, then it is called as an interim period. Interim periods may be monthly or quarterly.

The Revenue Recognition Principle

Revenue is the gross inflow of economic benefits during the period arising from the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions from equity participants. Expense is outflows or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

In revenue recognition principle, revenue is recorded when it is earned, not when the cash is received just the same as the accrual basis accounting. If cash is received in advance (before revenue is earned), a liability account (called as deferred revenue) will be used as a correspondence to cash account, a liability account called deferred revenue is used as a correspondence to cash account.

In accrued revenue, revenue is recognized before the cash is received. It is important to note that accrued means outstanding or unpaid.

Matching Principle

Matching Principle, also referred as Expense Recognition Principle is used to explain the relationship between expense and revenues. It means that you record the expenses at the same time with the revenues related with these expenses which are recorded regardless of the time cash is paid. Also, it is important to allocate the costs through all the periods that are benefitted. The same as the deferred and accrued revenues, there are also deferred and accrued expenses. When an expense is recognized after the cash paid, then it is called as deferred expense. Please note that expense is recognized when there is a consumption. Deferred expense does not mean that there is a usage or a consumption. It can also be named as prepaid expense. When an expense is recognized before the cash is paid, then it is called as accrued expense. When expenses are incurred but not yet paid, a liability must be recorded.

Adjusting Process and Adjusting Entries

At the end of each accounting period, companies present their financial statements in order to communicate with information users. To present the company’s true and fair situation all accounts must be updated because recording some revenue and expense transactions are omitted during the period. That means some accounts must be adjusted, and some adjusting entries must be made.

The Basics of Adjusting Entries

Information users need to know how well company is performing. Actually, companies will identify and record the company’s financial events on daily basis. To summarize and give information about the company’s ending position at the end of the period, they must prepare their financial statements by using the accounts balances. This trial balance is unadjusted because the accounts are not yet ready to prepare the financial statements. The reasons that are as follows:

1. Some financial events are not recorded on a dayto-day basis because it is unwise to do so such as consumption of supplies or the earnings of salaries by employees.
2. Some costs are not recorded during the current accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions such as rent expense or insurance expense.
3. Some types of expenses may be unrecorded. For example, an electricity bill may not be received until next accounting period.

The process of analysing and updating of accounts at the end of the period before the financial statements are prepared is called the adjusting process. The journal entries that bring the accounts up to date at the end of the accounting period are called adjusting entries.

At the end of the accounting period, an adjusting entry is completed, and it records revenues to the period in which they are earned and expenses to the period in which they occur. Adjusting entries also update the asset and liability accounts. Adjustments are necessary to properly measure several items such as:

1. Net income (loss) on the income statement
2. Assets and liabilities on the balance sheet

All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an adjusting entry will always involve a revenue or an expense account and an asset or a liability account.

Categories of Adjusting Entries

Adjusting entries are important in order to prepare correct and up-to-date financial reports. There are two basic categories of adjusting entries. These are deferrals and accruals. In a deferral adjustment, cash will be paid before an expense is incurred or the cash will be received before the revenue is earned. Accruals adjustments are the opposite of deferrals. An accrual records an expense before the cash is paid, or it records the revenue before the cash is received. The two basic categories of adjustments can be divided into four different types as follows:

1. Deferred (Prepaid) Expenses
2. Deferred (Unearned) Revenues
3. Accrued Expenses
4. Accrued Revenues

Adjusting Entries for Deferred Expenses (Prepaid Expenses)

Deferred expenses (prepaid expenses) are advance payments of future expenses. At each financial statement date, companies make the necessary adjusting entries related with deferred expenses. As deferred expense is considered as an asset before the adjustments, positions of assets are overstated and positions of expenses are understated.

Adjusting Entries for Depreciation

Most of the companies own a variety of productive facilities such as machinery, equipment, buildings in the operation of business for a long term. They are called as plant assets or fixed assets that are long lived and tangible. Examples include buildings, land, machinery, ship, office equipment, furniture, motor vehicle, etc. As all these assets have a life longer than 1 year, and they will be used through their useful lives by the business, their costs must be allocated to their useful lives. But land is exception. As Land has an indefinite useful life so, it is not subject to depreciation.

Value and usefulness of plant assets will decline when the business uses them in its operations. The decline in usefulness of a plant asset is an expense which is called as a depreciation expense. Here the concept of depreciation emerges. Depreciable amount is the cost of an asset minus its residual value, and depreciation is the systematic allocation of the depreciable amount of an asset over its useful life.6 In other words, depreciation is a cost allocation process over the plant asset’s useful life.

The business believes that the office building will remain useful for 40 years, and at the end of 40 years, it will be worthless. Some of the plant assets will still have value at the end of their useful life, which is called residual value.

As you realized, you have to know about the cost value, useful life and residual value of the plant asset to calculate the depreciation expense. Useful life is the estimated lifespan of a plant asset, and at the end of this period, it is expected that the plant asset will have only a residual value. Residual value is the expected value of the plant asset at the end of its useful life.

Accumulated Depreciation is a contra asset account and it will accumulate the depreciation expense during the useful life of depreciable asset.

The book value represents the cost invested in the asset that the business has not yet expensed or unexpired.

Adjusting Entries for Deferred (Unearned) Revenues

It is useful to define the term deferred (unearned) revenue before going to adjusting entries related with it. Deferred (unearned) revenues occur when the company receives cash before it gives the service or delivers a product to earn.

Adjusting Entries for Accrued Expenses

Some types of services, such as insurance, are normally paid for before they are used. As you learned before, these prepayments are deferrals. Rent, interest, salaries, wages, utilities, etc. are the other examples of accrued expenses over time. Expenses incurred but not yet paid or recorded at the end of the accounting period are accrued expenses. Accrued expenses are the ones that are firstly incurred and not recorded as an expense until a future accounting period.

Adjusting Entries for Accrued Revenues

Revenues earned by performing a service or delivering goods but not yet recorded at the end of the period are accrued revenues. According to the accrual basis accounting, earned revenues are recorded when they are earned. Any revenues earned but not recorded during an accounting period require an adjusting entry that debits an asset account and credits a revenue account.

Adjusted Trial Balance and Financial Statements

The trial balance lists the balances of all accounts but it is unadjusted. In another words, it is not completely up-todate. Accrual basis accounting requires the business to review the unadjusted trial balance and determine whether any additional revenues and expenses are needed to be recorded. It means, we cannot directly prepare the company’s financial statements by this unadjusted trial balance. Adjusted trial balance is the last step before preparation of financial statements.

The company has journalized and posted all adjusting entries. Next, it prepares another trial balance from the ledger accounts. This is called an adjusted trial balance. An adjusted trial balance is a list of all the accounts with their adjusted balances. The purpose is to ensure that total debit balances are equal to total credit balances in the ledger after all adjustments. Adjusted trial balance is the last step to prepare financial statements.

Illustration for Adjusted Trial Balance of TRApps Company

Data needed for adjusting entries include the following:

a. Office supplies on hand at the end of January, 200 TL
b. Company has an equipment of 4,000 TL which was purchased on January 2, 2018. Useful Life is 4 years and residual value is 0, and straight-line depreciation method is used.
c. Accrued salary expense is 500 TL d. Accrued service revenue is 400 TL

Financial Statements

Remember the adjusted trial balance is used to prepare financial statements. If adjusting entries are not recorded, the ledger accounts will not reflect the correct balances, and financial statements will be incorrect.

The book value represents the cost invested in the asset that the business has not yet expensed or unexpired, in other words, reminder usefulness of plant asset.