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Accounting in a Nutshell 6

Basics of Accrual Accounting

Joel Shapiro,MBA
Accounting Instructor, Ryerson University, Toronto

Abstract: This short article explains the concept of accrual


accounting. All transactions involve an exchange of
resources between two partiesusually cash goes in one
direction and goods and services go in the other. Accrual
accounting covers those common situations where the
cash is not paid or received at the same time as the goods
and services are received or delivered.

Keywords: accruals, deferrals, payables, prepaids,


receivables, unearned revenue

Introduction
All active businesses engage in transactions with their
customers, suppliers, lenders, investors, and regulating
authorities every daysometimes every second! For
accounting purposes, a transaction involves the exchange
of financial resources between two parties. U sually cash
is exchanged for goods or services. H owever, it is quite
common for the exchange of cash and the correspond-
ing exchange of goods and services to happen at differ-
ent times. Either can precede the other. For accounting
Joel Shapiro has been an purposes, a transaction is deemed to have occurred, and
accounting instructor at Ryerson
University in Toronto, Canada for
must be recorded, whenever one party has made its
20 years. Previously, he developed exchange. This could be either the receipt or payment of
an accounting and inventory cash, or the receipt or delivery of goods or services.
management software system for
small businesses. In his spare time,
he enjoys working on Kakuro and
The Accounting Issue
cryptic crossword puzzles and travels One of the fundamental assumptions underlying
throughout Ontario as a bridge Generally Accepted Accounting Principles is that of

tournament director. periodicity. Businesses do not have expiry datesthey
can last, in theory, forever. All of us know of companies
which were founded many decades or even c enturies ago
and have long outlived their original founders. H owever,
users of a companys financial statements would like to
be able to assess the companys recent performancein
other words, did the company earn a profit this year, or
last year? This is the essence of periodicitywe artificially
break the companys life into discrete periods, usually a

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Accounting in a Nutshell 6

year but sometimes even shorter, and we What About Expenses?


measure its revenues and expensesits Once a company has determined how much
net incomefor that period only. We can- revenue is to be recognized in a specific
not wait for the business to finally wind up period, the expenses for that period must
in order to determine whether or not it has also be determined and matched with the
been profitable. Assigning revenues and revenue. Sometimes this is easywhen a
expenses to specific periods of time is the sale of inventory is made, the seller can
goal of accrual accounting. frequently know, or at least estimate, the
cost of that inventory, so both revenue and
How We Recognize Revenue cost of goods sold can be reported together.
Recall from above that a transaction is It is irrelevant whether that inventory has
recognized when EITHER the cash OR the been paid for yetonce again, the timing
goods and services have been exchanged of the cash exchange has nothing to do
between the two parties. This means that with the timing of the exchange of goods.
in the common case where a company In the case of services, determining the
sells goods to (or performs services for) a costs that go along with the provision of
customer, but allows the customer time to services is often difficult. For example,
pay, the company is entitled to recognize how much of a lawyers or an accountants
the value of those goods or services as rev- rent expense should be allocated to each
enue. It does not have to wait until it c olle- individual case or audit? Estimations and
cts the cash from its customerthe sale guesswork are necessary. As you can see,
is recognized when the customer receives since expenses can be recognized before
title to the goods or when the services are the cash changes hands, expenses must be
performed. The selling company records
accrued as well.
revenue along with an account receivable If you, dear reader, have made it through
for the amount still owing and expected this far, and you understand that cash
to be collected later. Recognizing revenue receipts and payments do not necessarily
before cash is received is called accruing correspond with revenues and expenses,
that revenue and the accounting entry that and that revenues and expenses must be
records such revenue is an accrual. accrued, matched with each other, and
This sounds straightforward, but in assigned to specific intervals of time, then
real life there are always complications. what follows is a framework for analyzing
Allowances must be made for after-the-fact transactions that any business can use.
adjustmentswhat if the customer fails to
pay? What if the goods are returned? What Types of Transactions
if the goods are still in transit on the last Although a company can have anywhere
day of the accounting period? Might there from a handful of transactions each day to
be any subsequent price adjustments, or millions, every single transaction can be
discounts allowed? What about warranties? categorized as one of only four basic types.
(Most of these issues are covered in other These are:
Accounting in a Nutshell publications.) In the
case of services, how much of a long-term 1. Sales on accountthis is the provision of
contract should be recognized in each year goods or services for cash to be received
while the service is ongoing? The point to at a later date.
remember here, though, is that the timing 2. Purchases on accountthis is the receipt
of the cash exchange has nothing to do with of goods or services with cash to be paid
the timing of the revenue recognition. The at a later date.
latter is much more complicated and is 3. Cash receipts.
what keeps accountants busy! 4. Cash payments.

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Accounting in a Nutshell 6

Corrections of errors and account- How to Account for Transaction 3


ing adjustments such as the recording of One side of the transaction is easywhen
depreciation do not count as transactions cash is received, for whatever reason, the
since they do not involve exchanges with cash account increases. In order to record
other parties. the other side of the transaction, one must
Sometimes these transactions come in answer a couple of other questions.
pairstransactions 1 and 3 go together when In the following analysis we will leave
a sale is made and some, but not all, of the returns and refunds aside, for they would
cash is received. Similarly, transactions 2 and usually be recorded as reversals of previ-
4 go together in the case of a purchase that ously recorded transactions.
is only partly paid for. First of all, from whom is the business
receiving the cash? Is it from a lender, a
How to Account for Transaction 1 shareholder, a customer, or a supplier? We
This is the simplest of all. Both revenues and use the term supplier here in the widest
accounts receivable will increase, by the possible senseany person or entity that
amount of the sale. In accounting jargon, provides anything of value to a business for
that would be a debit to accounts receivable remuneration is a supplier. That includes
and a credit to revenue. D ebits and cred- employees and the government.
its must balance, of coursethats how When cash has been received from a third-
double-entry bookkeeping works. Remem- party lender, it will have to be paid back
ber that there may also be after-the-fact the other side of the transaction is simply
adjustments as mentioned earlier (uncol- an increase to a loan payable account.
lectable accounts, returns, discounts, etc.) When cash has been received from a
Accounts receivable are generated when shareholder, it does not have to be paid
revenue is accrued. back. The shareholder is investing in the
company. The other side of the transaction
How to Account for Transaction 2 is an increase to shareholders equity.
This one is almost as simple. Accounts When cash has been received from a cus-
payable will increase for the cost of what- tomer, recording the other side of the trans-
ever is being purchased (again ignoring action is trickier because of the relative
after-the-fact adjustments). The other side timing of the exchange of goods and services.
of the transaction is to record what is b eing As explained earlier, the two frequently do
purchased. (Credit to accounts payable not coincide. When they do, the company
and debit something else.) If the purchase has merely made a cash sale and the cor-
is something that will give a future ben- responding revenue can be recorded at the
efit to the purchaser, then it is r ecorded as same time.
an asset. Examples are inventory which Where the goods or services have previ-
will be sold and equipment which will be ously been provided and the cash is b eing
used in the business. If it is something received later, the company is merely com-
that has already been used or is to be used pleting the original exchange from transac-
up in the near future, then it is recorded tion 1 and can decrease accounts receivable.
as an expense. Examples could be office An account is no longer receivable once
supplies, most advertising, and the cur- the payment has been received!
rent months rent. Expenses are nothing Where the goods or services have not
more than erstwhile assets whose future yet been provided and the cash is being
benefit has already been used up or will received in advance, the company receiving
be in the very near future. Accounts pay- the cash has a future obligationa liability.
able are generated when expenses are This is (unfortunately) called unearned
accrued. revenue. Despite the word revenue in the

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