Cash vs Accrual Basis & Revenue Recognition Financial Accounting (edited)
Introduction to Financial Accounting
Professor Alexander Sannella
Lecture 6
0:00 Introduction
0:31 Comprehensive Problem
18:25 General Ledger
21:48 Trial Balance
24:50 Income Statement
26:33 Retained Earnings
30:37 Balance Sheet
Chapter 3
Learning Objective 1
40:19 Cash Basis vs Accrual
43:12 Summary
Questions and Explanations
44:34 Question 1
47:10 Question 2
47:25 Question 3
50:18 Question 4
Learning Objective 2
57:15 Time Period Concept
59:51 Example
1:05:18 Companies Year end
1:05:43 Accrual Basis Accounting
1:06:25 Revenue Recognition Principle
1:08:44 Summary
1:10:36 The Matching Concept
Questions and Explanations
1:13:05 Question 1
There are two approaches to accounting for entities - the cash basis and the accrual basis. A cash basis approach focuses on actual cash collections and payments. Under the cash basis, revenues are recorded when the cash is collected, and expenses are recorded when cash payments are made.
An accrual basis approach recognizes that the recognition of revenues and expenses should not be affected by the timing of cash collections and disbursements. Rather, revenues and expenses should be recognized when the underlying economic activities actually take place. Revenue is recorded when it is earned, even if the collection of the cash takes place at a later date. Expenses are recorded when they are incurred, even if cash collection takes place at a later date. The accrual basis measures economic activity rather than cash collections and disbursements.
The need for accounting adjustments results from the time period assumption (periodicity concept). It should be noted that the profit or loss of a particular business venture cannot be determined until the business is terminated and all assets are liquidated. However, due to the fact that the business community, investors, creditors, and the government cannot wait for the business to end for financial information to be supplied, the environment in which accounting operates demands information on a timely basis.
Accounting information is only useful if it is capable of making a difference in a decision. Thus, it must be presented on a timely basis. For example, the Internal Revenue Service (IRS) will not wait for tax information until a business liquidates. The Securities and Exchange Commission requires quarterly (10Q) and annual reports (10k) from filers. To satisfy user needs, accountants must truncate the life of the business into artificial reporting periods of equal length; a fiscal year or calendar year, quarters, months, etc. This is the basis of the time period assumption. The time period concept assumes that the life of an economic entity can be divided into artificial time periods of equal length for the purpose of providing periodic reports on the economic activities of the entity. Application of the time period concept requires that we used accrual basis accounting.
A business's activities are separated into small segments, and the financial statements can be prepared for specific time periods, such as a month, quarter, or year. Any twelve month period is referred to as a fiscal year (not necessarily a full calendar year). The time period concept simply states that it is appropriate to report a company's information periodically at a predefined time interval.
The application of the time period concept in practice requires the use of the accrual basis of accounting. The fundamental principles of accrual accounting are the revenue recognition principle and the matching principle (also known as the expense recognition principle).
Under the revenue realization principle, revenue is recognized when an exchange has taken place and the earning process is essentially completed. The earning process is complete when there are no material uncertainties as to future costs to be incurred and as to collection. The earnings process is also deemed "complete" when the seller has either delivered a product or performed a service. Revenue is recognized when it is earned, regardless of the timing of cash collection.
The matching principle states that expenses (also known as costs before they are matched to revenues) are to be recognized only in the period in which the related revenues (benefits) are received. Expenses must be recognized when incurred, regardless of when cash is actually paid. Expensing sales commissions earned in the same period as a sale is made, even if the sale is not collected, is an application of the matching principle.
At times, expenses are not easily related to revenues and here, we can recognize expense based on the passage of time (e.g. insurance policies expire as each month of coverage passes). As insurance coverage is used, it represents an expense. However, it is not possible to relate or match this expense to specific revenues earning over the same period.
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