Cash vs Accrual
Ok, so you are a first year accounting student and you hear the professor use the term accrual and you are scratching your head about what this really means. After all, you understand how to record an expense or a revenue item and you believe to have mastered the debit and credit side of things. So you know that an entry has to be made when an organization releases or gains cash. Right? Well this would be true if the company recorded their transactions on a cash basis. The problem with that is it violates some important accounting principles. More on that at some other time. For now you must know that 99% of companies need to record their transactions on what is called the accrual basis. So what is that?
The accrual basis of accounting is simply this. A transaction is recorded (ie; a journal entry is made) when a transaction has taken place, regardless of when the actual cash was distributed. All that is needed is for the earnings or expense process to be complete. For example; You purchase a 6 month insurance plan for your company and you pay the entire premium up front. So here is the entry;
Debit Credit
Insurance expense 1200.00
Cash 1200.00
Now, this entry is fine if you are on the cash basis of accounting. You just expense the entire amount as soon as it's paid. But it does not reflect what really is happening in the transaction. Here is the entry according to the accrual method of accounting.
Debit Credit
Pre-paid Insurance 1200.00
Cash 1200.00
This is the original entry. It's debited to a pre-paid account because you have not received a benefit yet. Remember it's a 6 month policy. So that 1200.00 is spread out over 6 months. So you record an expense when you have incurred it. Now, after the first month you can finally record a partial expense.
Debit Credit
Insurance expense (1200/6) 200.00
Pre-paid Insurance 200.00
Since the Pre-paid Insurance account is an asset account it carries a debit balance. So what is the balance in this account at the end of the first month?
Yes, it's 1000 (1200 - 200). And that makes sense because you have paid for 5 more months of insurance which you did not use yet.
Accounting Equation
One of the things that attracted me to the study of Accounting was the theory behind the practice. Of course this was acquired in college and I take great joy in providing a place of study on my web site for any one interested. So lets start with the very basic accounting equation. Who has heard it?
Assets = Liabilities + Equity
You must realize that an entities books or balance sheet will always = this equation. If it doesnt then there is something wrong and that error would occur in the transactions point of entry. Or in accounting terms, the "Journal entry".
The journal entry is the method by which transactions are reflected in the balance sheet. And there are two entry points (and only two) for each account in a transaction. A Debit or a Credit. This is referred to as the double entry system for recording transactions. Now, this can be confusing. A debit can increase some accounts and decrease others. It depends on what type of account it is. So here are some rules.
1) A debit will increase any asset account. A credit will decrease any asset account.
2) A credit will increase any liability or equity account. A debit will decrease any liability or equity account.
So by means of the double entry system (which states that for every debit there must be a corresponding credit) the accounting equation is satisfied.
Lets see an example;
XYZ Co
Assets
Cash 500.00
A/R 300.00
Equipment 7500.00
Inventory 900.00
Total Assets 9200.00
Liabilities
Accounts Payable 1100.00
Wages Payable 800.00
Total Liabilities 1900.00
Owners Equity 7300.00
So, Assets (9200.00) = Liabilities (1900.00) + Equity (7300.00)
Now lets see what happens when some transactions take place. (And keep in mind that for instructional purposes we are ignoring revenue and expense accounts)
The XYZ company buys some furniture for 500.00. It pays 200.00 cash and signs a note for the remaining 300.00.
Here's the entry;
Debit Credit
Furniture 500.00
Cash 200.00
Note Payable 300.00
And here is the updated balance sheet
XYZ Co
Assets
Cash 300.00
A/R 300.00
Equipment 7500.00
Furniture 500.00
Inventory 900.00
Total Assets 9500.00
Liabilities
Accounts Payable 1100.00
Notes Payable 300.00
Wages Payable 800.00
Total Liabilities 2200.00
Owners Equity 7300.00
So, Assets (9500.00) still = Liabilities (2200.00) + Equity (7300.00)