What is the Difference Between Cash Basis Accounting and Accrual Basis Accounting?

Learning Objective 1 Differentiate between cash basis accounting and accrual basis accounting There are two ways to record transactions—cash basis accounting or accrual basis accounting.

 Cash Basis Accounting records only transactions with cash: cash receipts and cash payments. When cash is received, revenues are recorded. When cash is paid, expenses are recorded. As a result, revenues are recorded only when cash is received and expenses are recorded only when cash is paid. The cash basis of accounting is not allowed under Generally Accepted Accounting Principles (GAAP); however, small businesses will sometimes use this method. The cash method is an easier accounting method to follow because it generally requires less knowledge of accounting concepts and principles. The cash basis accounting method also does a good job of tracking a business’s cash flows.

 Accrual Basis Accounting records the effect of each transaction as it occurs—that is, revenues are recorded when earned and expenses are recorded when incurred. Revenues are considered to be earned when the services or goods are provided to the customers. Most businesses use the accrual basis as covered in this book. The accrual basis of accounting provides a better picture of a business’s revenues and expenses. It records revenue only when it has been earned and expenses only when they have been incurred. Under accrual basis accounting, it is irrelevant when cash is received or paid.

Example: Suppose on May 1, Smart Touch Learning paid $1,200 for insurance for the next six months ($200 per month). This prepayment represents insurance coverage for May through October. Under the cash basis method, Smart Touch Learning would record Insurance Expense of $1,200 on May 1. This is because the cash basis method records an expense when cash is paid. Alternatively, accrual basis accounting requires the company to prorate the expense. Smart Touch Learning would record a $ expense every month from May through October. This is illustrated as follows:

Example: Suppose on April 30, Smart Touch Learning received $600 for services to be performed for the next six months (May through October). Under the cash basis method, Smart Touch Learning would record $600 of revenue when the cash is received on April 30. The accrual basis method, though, requires the revenue to be recorded only when it is earned. Smart Touch Learning would record $100 of revenue each month for the next six months beginning in May.

Notice that under both methods, cash basis and accrual basis, the total amount of revenues and expenses recorded by October 31 was the same. The major difference between a cash basis accounting system and an accrual basis accounting system is the timing of recording the revenue or expense.

What Concepts and Principles Apply to Accrual Basis Accounting?

Learning Objective 2 Define and apply the time period concept, revenue recognition, and matching principles As we have seen, the timing and recognition of revenues and expenses are the key differences between the cash basis and accrual basis methods of accounting. These differences can be explained by understanding the time period concept and the revenue recognition and matching principles.

The Time Period Concept Smart Touch Learning will know with 100% certainty how well it has operated only if the company sells all of its assets, pays all of its liabilities, and gives any leftover cash to its stockholders. For obvious reasons, it is not practical to measure income this way. Because businesses need periodic reports on their affairs, the time period concept assumes that a business’s activities can be sliced into small time segments and that financial statements can be prepared for specific periods, such as a month, quarter, or year.

The basic accounting period is one year, and most businesses prepare annual financial statements. The 12-month accounting period used for the annual financial statements is called a fiscal year. For most companies, the annual accounting period is the calendar year, from January 1 through December 31. Other companies use a fiscal year that ends on a date other than December 31. The year-end date is usually the low point in business activity for the year. Retailers are a notable example. For instance, Wal-

What are Adjusting Entries, and How Do We Record Them?

Learning Objective 3 Explain the purpose of and journalize and post adjusting entries The end-of-period process begins with the trial balance, which you learned how to prepare in the previous chapter. Exhibit F:3-1 is the unadjusted trial balance of Smart Touch Learning at December 31, 2024.

This unadjusted trial balance lists the revenues and expenses of the e-learning company for November and December. But these amounts are incomplete because they omit various revenue and expense transactions. Accrual basis accounting requires the business to review the unadjusted trial balance and determine whether any additional revenues and expenses need to be recorded. Are there revenues that Smart Touch Learning has earned that haven’t been recorded yet? Are there expenses that have occurred that haven’t been journalized?

For example, consider the Office Supplies account in Exhibit F:3-1. Smart Touch Learning uses office supplies during the two months. This reduces the office supplies on hand (an asset) and creates an expense (Supplies Expense). It is a waste of time to record Supplies Expense every time office supplies

are used. But by December 31, enough of the $500 of Office Supplies on the unadjusted trial balance (Exhibit F:3-1) have probably been used that we need to adjust the Office Supplies account. This is an example of why we need to adjust some accounts at the end of the accounting period.

An adjusting entry is completed at the end of the accounting period and 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 needed to properly measure several items such as:

There are two basic categories of adjusting entries: deferrals and accruals. In a deferral adjustment, the cash payment occurs before an expense is incurred or the cash receipt occurs before the revenue is earned. Deferrals defer the recognition of revenue or expense to a date after the cash is received or paid. Accrual adjustments are the opposite. 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 adjusting entries can be further separated into four types:

The focus of this chapter is on learning how to account for these four types of adjusting entries.

Deferred Expenses Deferred expenses, also called prepaid expenses, are advance payments of future expenses. They are deferrals because the expense is not recognized at the time of payment but deferred until they are used up. Such payments are considered assets rather than expenses until they are used up. When the prepayment is used up, the used portion of the asset becomes an expense via an adjusting entry.

Prepaid Rent Remember Transaction 10 in Chapter F:2? Smart Touch Learning prepaid three months’ office rent of

on December 1, 2024. The entry to record the payment was as follows:

After posting, Prepaid Rent has a $3,000 debit balance.

The December 31 unadjusted trial balance, therefore, still lists Office Supplies with a $500 debit balance. But Smart Touch Learning’s December 31 balance sheet should not report office supplies of $500. Why not?

During November and December, the e-learning company used office supplies to conduct business. The cost of the supplies used becomes Supplies Expense. To measure Supplies Expense, the business first counts the office supplies on hand at the end of December. This is the amount of the asset still owned by the business. Assume that office supplies costing $100 remain on December 31. Then the business uses the Office Supplies T-account to determine the value of the supplies that were used:

So, we can solve for the office supplies used as follows:

The December 31 adjusting entry updates Office Supplies and records Supplies Expense for November and December as follows:

After posting the adjusting entry, the December 31 balance of Office Supplies is correctly reflected as $100, and the Supplies Expense is correctly reflected as $400.

The Office Supplies account then enters January with a $100 balance. If the adjusting entry for Office Supplies had not been recorded, the asset would have been overstated and Supplies Expense would have been understated. In making the adjusting entry, the correct balance of Office Supplies, $100, is now reported on the balance sheet as of December 31, and the income statement is correctly reporting an expense of $400.

Depreciation Property, plant, and equipment (also called plant assets) are long-lived, tangible assets used in the operation of a business. Examples include land, buildings, equipment, furniture, and automobiles. As a business uses these assets, their value and usefulness decline. The decline in usefulness of a plant asset

is an expense, and accountants systematically spread the asset’s cost over its useful life. The allocation of a plant asset’s cost over its useful life is called depreciation. For example, a business might pay cash for an automobile when purchased, but the automobile will last for years, so depreciation allocates the cost spent on the car over the time the business uses the car. All plant assets are depreciated, with the exception of land. We record no depreciation for land because, unlike buildings and equipment, it does not have a definitive or clearly estimable useful life, so it is difficult to allocate the cost of land.

Similarity to Prepaid Expenses The concept of accounting for plant assets is similar to that of prepaid expenses. The major difference is the length of time it takes for the asset to be used up. Prepaid expenses usually expire within a year, but plant assets remain useful for several years. As a business uses its plant assets, an adjusting entry is required to allocate the assets’ costs. The adjusting entry records the cost allocation to an expense account called Depreciation Expense.

Let’s review an example for Smart Touch Learning. On December 2, the business received a contribution of furniture with a market value of $18,000 from Sheena Bright. In exchange, Smart Touch Learning issued shares of stock to Bright and made the following journal entry:

After posting, the Furniture account has an $18,000 balance:

Smart Touch Learning believes the furniture will remain useful for five years, and at the end of five years, Smart Touch Learning believes the furniture will be worthless. The expected value of a depreciable asset at the end of its useful life is called the residual value. Smart Touch Learning will use the straight-line method to compute the amount of depreciation. The straight-line method allocates an equal amount of depreciation each year and is calculated as:

Smart Touch Learning will calculate the depreciation of the furniture for the month of December as:

represents the cost invested in the asset that the business has not yet expensed. For Smart Touch Learning’s furniture, the book value on December 31 is as follows:

Depreciation on the building purchased on December 1 would be recorded in a similar manner. Suppose that the monthly depreciation is $250. The following adjusting entry would record depreciation for December:

Had Smart Touch Learning not recorded the adjusting entries for depreciation on the furniture and building, plant assets would have been overstated and expenses would have been understated. After recording the adjusting entries, property, plant, and equipment (plant assets) are reported at the correct net amount, as shown on the December 31 partial balance sheet in Exhibit F:3-2.

Deferred Revenues Remember, deferred (or unearned) revenues occur when the company receives cash before it does the work or delivers a product to earn that cash. The company owes a product or a service to the customer, or it owes the customer his or her money back. Only after completing the job or delivering the product

does the business earn the revenue. Because of this delay, unearned revenue is a liability and is also called deferred revenue. The revenue associated with the work or product is not recognized when the cash is received but is instead deferred until it is earned.

Unearned Revenue Suppose, for example, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, agreeing to pay $600 in advance. Smart Touch Learning collected the amount on December 21 and recorded the following entry:

The liability account, Unearned Revenue, now shows that Smart Touch Learning owes $600 in services.

During the last 10 days of the month—December 22 through December 31—Smart Touch Learning will earn approximately one-third (10 days divided by 30 days) of the $600, or $200. Therefore, Smart Touch Learning makes the following adjusting entry to record earning $200 of revenue:

This adjusting entry shifts $200 from the liability account to the revenue account. Service Revenue increases by $200, and Unearned Revenue decreases by $200. Now both accounts are up to date at December 31:

Had the adjusting entry not been made, the liability, Unearned Revenue, would be overstated and Service Revenue would be understated.

Accrued Expenses Businesses often incur expenses before paying for them. The term accrued expense refers to an expense of this type. An accrued expense hasn’t been paid for yet. Consider an employee’s salary. Salaries Expense grows as the employee works, so the expense is said to accrue. Another accrued expense is

After posting, both Salaries Expense and Salaries Payable are up to date:

Salaries Expense shows a full two months’ salary, and Salaries Payable shows the liability owed at December 31. This is an example of a liability that was understated before the adjusting entry was made. It also is an example of the matching principle. We are recording December’s Salaries Expense in December so it will be reported on the same income statement as December’s revenues

Future Payment of Accrued Salaries Expense The adjusting entry at December 31 creates a liability that will eventually be paid. In this case, Smart Touch Learning will pay its employee the second half of December’s wages on January 1. Because the expense has already been recorded, Smart Touch Learning will not record the expense again. To do so would record the expense twice, thus overstating the expense account. Instead, the business will decrease the amount of the liability, Salaries Payable, with a debit and record the cash payment. On January 1, Smart Touch Learning would record the following journal entry:

Accrued Interest Expense Borrowing money creates an additional liability for a Note Payable. Remember the purchase of the building on December 1, 2024? Smart Touch Learning purchased a $60,000 building in exchange for a loan. Smart Touch Learning signed a one-year loan and recorded the following entry using the Notes Payable account:

Ethics

When should accrued expenses be recorded? Evan is in the process of recording the adjusting entries for Green Landscaping Services. Bob Green, owner and manager, has asked Evan to record all of the adjusting entries except for accrued expenses. Bob has a meeting with the banker on Monday to apply for a business loan. Bob knows that the banker will review his balance sheet and income statement. Bob is concerned that by recording the accrued expenses, the business’s liabilities will be significantly higher on the balance sheet and a net loss will be reported on the income statement (due to higher expenses). Bob has instructed Evan to delay recording the accrued expenses until after his meeting with the banker. What should Evan do?

Solution Failing to record the adjusting entries for accrued expenses violates the matching principle. Recording the expenses now (before Monday) accurately matches the occurrence of the expenses with the revenues that were created during that period. If Evan does not record the adjusting entries, the financial statements will not accurately represent the financial position or operating performance of the business. The banker could be tricked into lending the company money. Then, if the business could not repay the loan, the bank would lose—all because the banker relied on incorrect accounting information supplied by the company.

Interest on this note is payable one year later, on December 1, 2025. Although the company won’t make the interest payment for a year, the company must record the amount of interest expense that has been incurred by December 31, 2024. The company will make an adjusting entry to record interest expense for one month (December 1–December 31).

The formula for computing the interest is as follows:

In the formula, time (period) represents the portion of a year that interest has accrued on the note. It may be expressed as a fraction of a year in months (number of months/12) or a fraction of a year in days (number of days/365). This keeps the units for interest and time the same. The note payable has an interest rate of 2% per year so the time accrued is expressed as 1/12 of a year. Smart Touch Learning computes interest expense for the month as follows:

Without the adjustment, Smart Touch Learning’s financial statements would understate both an asset, Accounts Receivable, and a revenue, Service Revenue.

Future Receipt of Accrued Revenues The adjusting entry on December 31 records revenue earned for half a month and also creates an accounts receivable. When Smart Touch Learning receives the payment on January 15, the business will record the following entry:

Notice that on January 15, Smart Touch Learning records revenue only for the remaining half of the month (January 1–January 15). Smart Touch Learning recognizes that $800 of revenue was already recorded in December. The entry on January 15 removes the accounts receivable and records the remaining revenue. If the business had incorrectly recorded $1,600 of Service Revenue on January 15, the revenue would have been overstated in January

The adjusting entries and account balances after posting for Smart Touch Learning at December 31 are shown in Exhibit F:3-4.

 Panel A gives the data for each adjustment.  Panel B shows the adjusting entries.  Panel C shows the T-accounts and balances after posting.

This chapter began with the unadjusted trial balance. After the adjustments have been journalized and posted, the account balances are updated, and an adjusted trial balance can be prepared by listing all the accounts with their adjusted balances. Remember, the purpose of a trial balance is to ensure that total debits equal total credits. Even if the trial balance balances, it does not guarantee that a mistake has not been made. For example, an adjusting entry could have been recorded for the incorrect amount or could have been omitted entirely. The equality of the trial balance ensures only that each posted transaction had an equal debit and credit amount.

The adjusted trial balance for Smart Touch Learning is shown in Exhibit F:3-5.

What is the Impact of Adjusting Entries on the Financial Statements?

Learning Objective 5 Identify the impact of adjusting entries on the financial statements The adjusted trial balance is used to prepare the financial statements. If adjusting entries are not recorded, the ledger accounts will not reflect the correct balances, and the adjusted trial balance will be incorrect. Remember, adjusting entries are completed to ensure that all revenues and expenses for the accounting period examined have been recorded. In addition, adjusting entries update the balance sheet accounts so that all accounts are properly valued. Exhibit F:3-6 summarizes the impact on the financial statements had the adjusting entries not been recorded.

How Could a Worksheet Help in Preparing Adjusting Entries and the Adjusted Trial Balance?

Learning Objective 6 Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance A useful step in preparing adjusting entries and the adjusted trial balance is to create a worksheet. A worksheet is an internal document that helps summarize data for the preparation of the financial statements. The worksheet is not a journal, a ledger, or a financial statement. It is merely a summary device that helps identify the accounts that need adjustments. Most worksheets are completed using Microsoft Excel.

Exhibit F:3-7 shows the partially completed worksheet for Smart Touch Learning.