Section 4:) Accrual vs. Cash Basis of Accounting
As you dig further into accounting, you will see that there is more than just one way to maintain bookkeeping. The method used depends on the ultimate purpose. For example, a company may need to keep records for tax reporting, for internal reporting, and perhaps to meet other external requirements. In addition, the methods and principles used may sometime depend on the type of company and the regulations that they have to abide by. If a company is publicly traded on United States Stock Exchanges, they are required to abide by United States Generally Accepted Accounting Principles (GAAP).
US GAAP requires the use of the accrual basis of accounting, versus the cash basis of accounting. This section discusses the differences. Under the cash basis of accounting, revenues are recorded when the cash is received, regardless of whether that is before or after the corresponding sale or service. Likewise, expenses are recorded when the cash is paid, regardless of when the event that the expense relates to occurred. Although this method is very straightforward, there is a risk that the results are misleading.
For one example, if 2 years’ worth of insurance is paid in advance, the cash basis of accounting would record all 2 years of insurance expense in year 1. This is improper, as the insurance benefits the company for two years. Likewise, if we are the insurance company, we would count all of that money as insurance revenue, even though we would be providing a service (coverage) over the two-year period.
Under the accrual basis of accounting, we are more concerned with when revenue is “earned” and when expense is “incurred”, rather when the cash changes hands.
To be considered “earned”, the service or product generating the revenue must be completed, and the likelihood of collection should be reasonably assured. In some cases, earning occurs over time. Some examples of this may be rental income, insurance income, interest income, etc.
To be considered “incurred”, the benefit related to the item that is generating the expense must have been used up. For example, if the benefit comes from employees that have worked for us, the salaries expense would be incurred when they work, not when payday occurs. In the case of interest expense, the expense is recognized as the time passes and the borrowed cash remains used.
There are two main concepts behind the accrual basis of accounting:
1.) The revenue recognition principle states that revenue should be recognized in the period earned, regardless of when the cash is received.
2.) The expense recognition principle (aka the matching principle) states that all costs that are used to generate revenue are recorded as expenses in the period the revenue is recorded.
The understanding of the accrual basis of accounting will help as we continue into the next section covering adjusting entries. Adjusting entries are the way that a company converts from the cash basis of accounting back to the accrual basis of accounting for certain transactions.
This below video goes through the difference between the accrual and cash bases of accounting.
Section 5:) Adjusting Journal Entries
Adjusting Entries
At the end of the accounting period, before issuing financial statements, accountants often have to record adjustments to certain accounts to reflect accrual accounting. You can think of this as an adjustment from the cash basis of accounting to the accrual. This is essentially the opposite of what we were doing with the cash flow statement.
There are a few special types of accounts that need to be defined in order to fully understand accrual accounting:
1.) Accounts Receivables – This is an asset that generally represents a sale to a customer where cash has not yet been received. When the sale is generated, the asset is increased (just like cash would have been increased if the sale was for cash.) When the cash is eventually collected, the accounts receivable will be decreased, and the cash will be increased.
2.) Notes Receivables – This is an asset very similar to Accounts Receivables, except that it generally occurs when money is lent to someone (vs. earning money from customer sales.) Notes Receivables generally have a longer period to collect, are more formal, and accrue interest over time.
Note: There are a variety of different receivable accounts you may see (e.g., interest receivable, etc. These are all assets.
3.) Accounts Payable – This is a liability that represents the purchase of a product or service from another company, where money is not paid immediately, but rather due in the future. When the cash is eventually paid, the cash will be decreased and the accounts payable will be decreased as well.
4.) Notes Payable – This is a liability that generally represents the borrowing of money to be paid over a slightly longer period of time. This is similar to the Accounts Payable, but Notes Payables generally have a longer period to pay, are more formal, and accrue interest over time.
Note: There are a variety of different payable accounts you may see (etc., utilities payable, interest payable, salaries payable, etc.) These are all liabilities.
5.) Accumulated Depreciation – This is an account that relates to the usage of a long-term asset over time (e.g., equipment.) Under the matching principle, we cannot record all of the expense for the asset up front when it is purchased. Instead, we must expense it bit by bit over time as the equipment is used to generate revenue. The debit to that journal entry will be depreciation expense (to increase the expense.) However, instead of crediting the asset itself to decrease it, we credit this accumulated depreciation account, which will eventually show up as an offset to the asset’s value on the balance sheet. This allows us to keep track of the original cost of the asset, as well as what it is currently worth after accounting for how much of it has been used over time. See the example of this entry later.
6.) Prepaid Expense – Although the word “expense” may sometimes appear in this account name, it is actually an asset. The fact that it is prepaid means that we have already spent the cash to purchase the “benefit” of using this item later. Some examples of this may include prepaid rent expense, prepaid insurance expense, etc. Supplies are also a form of prepaid expense, even though the word expense generally does not show up in the name of this asset. In all cases, we have traded one benefit (cash) for another, and at some point in time these prepaids will be used up and actually converted to the corresponding expense. For example, the prepaid expense asset will eventually be used up and converted to rent expense, supplies will be converted to supplies expense, etc. See the reclassification/deferral adjusting entry examples later.
7.) Unearned Revenue - Although the word “revenue” may sometimes appear in this account name, it is actually a liability. This reflects a cash payment that has been made to our company even before we have provided the service or delivered the product to earn the money. As such, we cannot call it a revenue yet. We have received the cash, and thus we owe the customer something (the product, the service, or perhaps their money back down the road.) Once we have earned the money, we will reduce the unearned revenue liability and convert it to actual revenue. See the reclassification/deferral adjusting entry examples later.
Two main categories of adjustments
Accruals- This is when the company has not yet received cash, but we want to force recognition of the revenue or expense to reflect accrual accounting. As such, we accrue the transaction and will handle the cash payment/receipt in the next period.
Reclassifications (aka deferrals) – This is where the company has received cash, but it does not yet meet the rules for recognition as expense or revenue under accrual method. As such, we have to defer the recognition of the expense or revenue and temporarily reclassify the transaction as something else (generally an asset or liability that can be converted into revenue or expense at a later time.)
These two main categories can be broken down further into the following four main types of adjustments:
1a. Accrued Revenue (aka Accrued Assets) - Example would be revenue that has been earned even though we haven’t formally completed the transaction yet. For example, if we have earned revenue from providing service but haven’t yet billed the customer by the end of the period. Since it has been earned, we need to count it in this period.
With accruals, there will also be a subsequent transaction that takes place in the next period. This is to reflect the eventual cash transaction.
1b. Accrued Expense (aka Accrued Liability) – An example of this is when we owe our employees money by the end of the period even though the related paychecks won’t be issued until after the period is over. Since the expense has been incurred, we need to report it in this period.
With accruals, there will also be a subsequent transaction that takes place in the next period. This is to reflect the eventual cash transaction.
2a. Deferred Revenue (aka Unearned Revenue) – An example of this is when we are the landlord and we have received a year’s worth of rental income from a tenant. We cannot count this all as income yet because we have to wait for the year to pass. Until that time, we still owe a “service” (i.e., letting the tenant stay in the rental.)
2b. Deferred Expense (aka Prepaid Expense) - An example of this is when we are the tenant and we have paid a year’s worth of rent to the landlord. We cannot count this all as an expense yet because we have to wait for the year to pass. Until that time, we will count it as an asset. It is a benefit to us because the rent has already been paid and it is an asset we can “use up” over time by staying in the rental.
Note: One example of a prepaid expense is the purchase and eventual use of supplies. The only difference is that the asset in the above example will generally be called “supplies” without the word “prepaid” in front of it.
Yet another example of a prepaid expense is the purchase of long-term assets that will be used over time. This entry looks different than a normal prepaid expense because the asset itself is not directly reduced. Instead, an account known as “accumulated depreciation” is used. This account (known as a contra-asset) will be discussed further in a later chapter on long-term assets. See the example below for the purchase and use of the equipment.
Note both names for each type of transaction as it will often help you with the related entry. In the case of the accruals, the two different names will tell you both sides to the transaction. For example, accrued revenues will always have an entry to a revenue account and an asset account.
Very Important: There are two rules that come into play here.
Generally, every adjustment will affect a balance sheet account and an income statement account. The one exception to this is the adjustment for declared dividends that were not paid in the period and need to be carried over to the next period. In this case, the dividends account takes the place of the income statement (expense) account. Throughout accounting
Generally, although the original transaction may involve cash, an adjustment transaction will not. The one exception to this is the adjusting entry that may need to be made after a bank reconciliation.
Once adjusting entries are entered, they would then be posted to the ledger (just like the initial entries.) The balances would then be carried forward to the adjusted trial balance. Those amounts are then used to create the financial statements.
Example of a Trial Balance
The below videos go through the accrual and deferral categories of adjusting entries.
Accrual
Deferral
The below videos go through practice examples for the different types of adjusting entries.
Practice #1-
Practice #2 –
Practice #3 –
Section 6.) Closing Journal Entries
Once the initial and adjusting entries have been completed and posted to the T accounts (general ledger), the financial statements will be completed. Then, the temporary accounts (revenues, expenses, and dividends) will be closed out to retained earnings, while the permanent accounts (the balance sheet accounts) will keep a running balance.
There are two options for the closing entries. The first is using a very temporary account known as “income summary” to close out revenues and expenses. Then the “income summary” account gets closed to retained earnings. The second option is to close revenues and expenses out straight to retained earnings (not using the income summary account.)
Note that “closing” an account is done by identifying what the final balance is and then entering the opposite entry. For example, if an account had a $500 debit balance, then the entry would be to credit that account for $500. Just like all journal entries, there must be an opposite entry to offset it. Debits and credits must balance.
Option 1:
Close Revenues to “Income Summary” account
Close Expenses to “Income Summary” account
Close “Income Summary” account to Retained Earnings
Close Dividends account to Retained Earnings
Option 2:
Close Revenues to Retained Earnings account
Close Expenses to Retained Earnings account
Close Dividends to Retained Earnings account
Note that this entire process very closely resembles the retained earnings statement itself, as these same activities were used to determine the final retained earnings amount.
The income summary account is called a clearing account as it is only used to summarize your net income (revenue minus expenses) for the year in order to close it to retained earnings. Remember from the statement of owner’s equity that net income increases the owner’s equity.
This below video goes through the topic of the closing entries.
Wrap-Up:
There are quite a few things to keep track of this week. The biggest thing is understanding the normal balance rules. Then, understand the rule of formatting journal entries (debits must go first and must equal credits that are indented to the right.) Practicing the initial and adjusting journal entries is important as well. Finally, understand how to carry over the amount from a journal entry over to the T account (general ledger) and then eventually to the trial balance.
Section 1.) Accounting Cycle
A large portion of this chapter is dedicated to the discussion of journal entries. These are the basis for accounting now and into the future weeks. To understand journal entries, we first need to discuss the accounting cycle. This is the process that the company goes through each period from the time the transaction occurs to the time when the financial statements are issued and beyond that.
The life of a company is broken into various financial periods so that users can see how well the company is doing from time to time instead of having to wait until the end of the company’s life. Some companies choose to produce financial statements or other reports on a monthly basis. Others may only choose to do them on an annual basis.
If a company is publicly traded on the stock market, it must file quarterly and annual financial statements to meet the requirements of the Securities and Exchange Commission (SEC.)
In order to prepare these financial statements, a company goes through what is known as the Accounting Cycle. This lecture will discuss the various steps of the accounting cycle. It should be noted that different textbooks and different courses may discuss these in different levels of depth, merging some steps, or expanding on others. Below are the various steps of the accounting cycle as laid out in this text.
Step 1: Analyze Transactions
In this step, we are reviewing the source documents that have accumulated throughout the period (receipts, invoices, etc.) to identify what transactions have taken place. Then, we identify what accounts they belong in, whether they were increased or decreased, etc. This step goes back to the accounting equation exercises that we worked on in week 1.
Step 2: Journalize (Recording Journal Entries)
Once we have an idea what accounts were impacted by the various transactions, we can create the journal entry. The journal entry is a chronological record of the transactions that have occurred throughout the period. The journal entry requires at least one debit and at least one credit. The number/quantity of debits and credits in each entry do not necessarily have to balance out. However, the total dollar amounts of debits and credits must balance out.
Step 3: Post to the Ledger
Once the journal entries have been created, each piece of every journal entry is posted to its corresponding account in the general ledger. For example, if the journal entry required a debit to cash and credit to revenue, then we would take the debit to cash and post it to the cash account itself. This will adjust the cash balance and eventually will provide us with a running total.
Step 4: Prepare Unadjusted Trial Balance
After all of the transactions have been journalized and posted, the final balances from each of the accounts will be brought forward to an unadjusted trial balance, the first of three trial balances. The purpose of this is to give a concise report of all accounts and their debit/credit balances. Furthermore, it allows us to ensure that the total debit balances equal the total credit balances.
Step 5: Prepare and Post Adjusting Entries
As part of the accrual basis of accounting, entries are needed at the end of the period to reflect what prepaid assets have been used up during the period, what unearned revenue has been earned, what expenses/liabilities have been accrued throughout the period, and what revenues/assets have been accrued. More detail on adjusting entries is available later in this section.
Step 6: Prepare Adjusting Trial Balance
Once all of the adjusting entries have been journalized and posted, a second trial balance is created. Although the same basic purposes as the unadjusted trial balance are present, there is also an added purpose of using the adjusted trial balance to prepare the financial statements.
Step 7: Prepare Financial Statements
This step requires us to prepare each of the four financial statements; the income statement, retained earnings statement, balance sheet, and cash flow statement. Most of the amounts come straight from the adjusted trial balance, with the exception of the various subtotals and grand totals.
Step 8: Prepare and Post Closing Entries
The main purpose of the accounting cycle is to prepare financial statements. At the end of the period, many of the accounts must be closed to a zero balance to start the next year fresh. The closing process is discussed in more detail in another lecture.
Step 9: Prepare Post Closing Trial Balance
Once the closing entries have been prepared and posted, the third trial balance (post-closing trial balance) is prepared to ensure that debits and credits still balance out and that only the permanent accounts (balance sheet accounts) still have a balance.
Step 10: Prepare and Post Reversing Entries (Optional)
This final step is completely optional, and relatively few companies use it. The reversing entries basically reverse the adjusting entries. The only purpose of the adjusting entries is to get accurate balances for the purposes of the financial statements. Once the financial statements are completed it really doesn’t matter what the company does with the adjusting entries. Reversing entries essentially allow the provider to revert back to the cash basis of accounting, reflecting the balances of the various accounts before any adjusting entries were applied. Of course, the adjusting entries would again need to be made before the next set of financial statements.
This below video goes through the various steps in the accounting cycle.
Section 2.) Normal Balances
Before you can record a journal entry you must understand the meaning of debit and credit and what it means to each specific account. A debit would increase one account while a credit would decrease it. Another account may be increased by a credit and decreased by a debit. Understanding how a debit or credit impacts an account is critical.
Another word for this is normal balance. Specifically, the normal balance of account represents the entry that increases a particular account. Some accounts have a normal debit balance. Others have a normal credit balance. The normal balance of an account is also the side we need it to be on to be positive. If it is on the opposite side (the abnormal balance) then it would be a negative amount.
To understand this term “normal balance”, we first must understand how to calculate the balance of an account in general. One way to understand the calculation of the balance is by using a T account. A T account is a visual representation of the general ledger for an account. It is an informal way of showing a running balance after a series of transactions.
The T account for the cash account is shown below. In this case, there were $250 of debits and $100 of credits. The balance is the difference between the two and it would be on the side that had the highest amount. In other words, there are $150 more in debits than credits, so the balance would be $150 debit.
For cash this is a good thing, because as we will see shortly, cash (an asset) has a normal debit balance. That means that the cash account is positive. In reality, virtually all accounts end up with their normal balance. Very few accounts can even logically go negative and even then, it is only temporary. Think of the example of a company’s checking account. In the unfortunate situation that they overdrew their account, it would be negative temporarily and that would be a credit balance for cash.
In a T account, the only thing that is consistent across every account is that the left-hand side is a Debit (abbreviated DR) and the right side is a Credit (abbreviated CR.) Before considering whether debit or credit means positive or negative you have to know the type (classification) of account
Classifications of accounts and the normal balance
One way to remember the debit/credit rules is to use the DEAD mnemonic to remember those accounts that have a normal debit balance.
A normal balance simply states that this type of account should normally have this type of balance (DR or CR). When an account has its normal balance, this means it is reflecting a positive balance. For example, an asset will normally have a debit balance. If the current balance of the account is debit, then it is positive, if it is credit then it is a negative balance. In addition, to increase an account you will always report the entry on its normal balance side. To decrease an account, you will always report the entry on the opposite of its normal balance side.
Use the DEAD mnemonic to remember those accounts that have a normal debit balance.
Use the CLRC mnemonic to remember those accounts that have a normal credit balance.
It is extremely important to understand these normal balances rules before proceeding on to journal entries.
The two videos below go through the topic of normal balances in more detail.
This video goes through a practice exercise with the normal balances.
Section 3.) Initial Journal Entries
Once you understand the normal balance rules for accounts you can proceed on to recording the actual journal entry. A journal is a chronological record of the various business transactions within a company. A journal entry shows both sides of the transaction. This is where the concept of “double entry accounting” comes from. Every journal entry must have at least two pieces to it (at least one debit and at least one credit) but there may be more than two. No matter what, the sum of all of the debits in a journal entry must match the sum of all of the credits.
Another way to think of a journal entry is that each piece helps to explain the other. For example, if a journal entry shows that the company purchased supplies for cash, then that explains what the cash payment was for, and it also explains how the supplies were purchased.
Journal Entry Format:
Note that the debits will always go first followed by credits, which are right indented for both the account name and the amount.
To summarize the journal entry rules:
1.) The total dollar amount of debits in a journal entry must match the total dollar amount of credits. This does not mean that the quantity of debits entries must match the quantity of credit entries though. For example, there can be two debits and one credit, as long as the sum of the dollar amounts matches.
2.) Debits always go first (aligned to the left)
3.) Credits always go last (indented to the right)
4.) If you are using the normal balance of an account, that means you are increasing it. If you are using the opposite of the normal balance, then you are decreasing it.
Note also that some journal entries end up increasing both accounts, some end up decreasing both accounts, and some increase one account and decrease another.
Ledgers/T-Accounts:
A ledger is a collection of accounts. Each side of the journal entry will be posted to its respective account in the ledger. This allows us to calculate a balance of that account after all of our journal entries up to that point in time. Although within a journal entry debits must always equal credits, within an individual account the debits seldom equal credits. The difference between the debits and credits of an account is the balance of the account. For example, if there are $200 in debits to the cash account and $150 in credits, then the difference of $50 is called the debit balance.
Chart of Accounts:
The chart of accounts lists out all of the accounts for a company. It contains no dollar amounts or debits/credits at all. It simply lists the name of an account and also an account number (internal and specific to the company.)
See the below example of a chart of accounts.
Examples of Journal Entries:
For simplicity, every entry example will be $1,000. These are just example entries to help explain the process. There are many other journal entries that can exist and many of them are discussed in the YouTube videos linked later in the text.
Example #1 – Using cash to purchase supplies (or any other asset)
In this case, the asset that is being purchased is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The cash asset is being credited to decrease it, since a credit is the opposite of the normal balance.
This is an example of an entry where one account is increased, and one is decreased.
Example #2 – Borrowing and receiving cash
In this case, the cash asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The notes payable liability is being credited to increase it, since a credit is the normal balance for a liability account.
This is an example of an entry where both accounts are increased.
Example #3 – Earning revenue, but not collecting it right away
In this case, the accounts receivables asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The revenue account is being credited to increase it, since a credit is the normal balance for a revenue account.
This is an example of an entry where both accounts are increased.
Example #4 – Collecting the money earned from the earlier revenue.
In this case, the cash asset is debited to increase it. This is because an asset has a normal debit balance, thus needs to be debited to increase it.
The accounts receivables account is being credited to decrease it, since a debit is the normal balance for an asset account, and we need to decrease it with the opposite.
This is an example of an entry where one account is increased, and one is decreased.
Example #5 – Paying an Expense with Cash
In this case, the expense account is debited to increase it. This is because an expense has a normal debit balance, thus needs to be debited to increase it.
The cash account is being credited to decrease it, since a debit is the normal balance for an asset account, and we need to decrease it with the opposite.
This is an example of an entry where one account is increased, and one is decreased.
Once the journal entries are completed, each piece will be carried forward to the corresponding T account to show us the overall balance.
Example of T Accounts
Example of a Trial Balance
This below video goes through the topic of source documents and journal entries.
The below three videos go through various practice journal entries.
Practice #1
Practice #2
Practice #3
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