Accrual Basis Accounting

“When revenues and expenses get reported on an income statement is really important in accounting,” Kei G. Gauthier, CPA, MSTax

Example – Why is it so important to record revenues and expenses in the correct accounting period?

Hippo Bike Parts, Inc. earns $10,000 of revenue and incurs $11,000 of expenses every month. Its income statement would therefore look like this:

Hippo Bike Parts, Inc. Income Statement For the year ended December 31, 2020 Revenue ($10,000 x 12 months Jan. 2020 to Dec. 2020) $ 120,000 Less: Expenses (12 months x $11,000) 132,000 Net Income (Loss) $ (12,000)

Net losses do not make a company attractive to investors.

However, to make their businesses look good, dishonest managers sometimes record revenue that will actually be earned in future periods in the current period. For instance, the managers of Hippo Bike Parts, Inc. might report all the revenue from 2020 plus the revenue earned in the first two months of 2021, a span of fourteen months. Of course, they would only report the expenses for the twelve months in 2020. Doing so makes the income statement look like this:

Hippo Bike Parts, Inc. Fraudulent Income Statement For the year ended December 31, 2020 (not really) Revenue ($10,000 x 14 months Jan. 2020 through Feb. 2021) $ 140,000 Less: Expenses (12 months x $11,000) 132,000 Net Income (Loss) $ 8,000

This makes the company look better, but it may also land the managers in jail.

Copyright 2021 – Kei G. Gauthier, CPA, MSTax, Longmeadow, MA – All rights reserved. orchardguides.com When a business reports revenue and expenses is governed by the company’s method of accounting, either cash basis or accrual basis.

Under cash basis accounting, a business records revenues when it collects cash from customers and expenses when it disburses payments to suppliers and other vendors. Nothing is recorded until cash changes hands. • This method is simple and easy to understand. • But the cash basis of accounting makes it easy for dishonest people to manipulate the amounts reported on financial statements. For instance, a business could delay the reporting of wage expense by simply not paying employees when payment is due. Although this would make the expenses on the income statement lower, doing so is a terrible idea because it is both illegal and will result in good employees leaving the company. • Although not allowed under Generally Accepted Accounting Principles, small businesses may sometimes use cash basis accounting for tax purposes.

Under accrual basis accounting, revenues are recorded when earned and expenses are recognized when incurred without regard to the flow of cash into or out of a business. • Generally Accepted Accounting Principles (GAAP) require the use of accrual basis accounting for financial reporting.

Basis of accounting does not impact the amount of either revenues earned or expenses incurred. Rather, basis of accounting affects the timing of when revenues or expenses are reported.

Copyright 2021 – Kei G. Gauthier, CPA, MSTax, Longmeadow, MA – All rights reserved. orchardguides.com Under Cash Basis Accounting • Companies recognize revenues when they collect cash from customers. • A business records rent expense in the period that it pays its landlord. • Companies record supplies expense in the period that cash is paid to a vendor even when the supplies are actually used in a different accounting period. • Companies recognize wage expense in the period that employees are paid without regard to when the employees provide services to the business.

Under Accrual Basis Accounting • Revenue is recognized when a business earns the revenue by providing a service or delivering a product to a customer. • A business records rent expense in the period that it uses leased space even when the business pays cash to the landlord a different accounting period. • Supplies expense is recorded when a company consumes inventory in the operation of its business. • Companies recognize wage expense in the period that employees provide services to the business even when the employees are paid in a different accounting period.

Accounts Receivable: The amount that customers owe to a business, an asset.

Supplies Inventory: An asset account that reports the amount of supplies held by the business at any point in time.

Prepaid Rent: An asset used to report the amount of rent that a business has paid in advance for future periods of time.

Accounts Payable: The amount that a business owes to suppliers and other vendors, a liability.

Wages Payable: A liability account that reports the amount that a business owes to employees for work that they have already provided to the business.

Unearned Revenue: A liability account that reports the amount that a business has been paid for work that the company has not yet done but will do in the future.

Fees Earned or Service Revenue: Revenue accounts that report the amount that a business earned by providing services or delivering products to customers in the current accounting period.

Supplies Expense – An expense account that reports the amount of supplies that a business has used up in the current accounting period.

Rent Expense: Reports the amount of resources that a company consumed by renting property in time periods that have already passed, an expense.

Wages Expense: Reports the amount of resources that a business has used up in the current accounting period by employing workers who provided services to the company, an expense.