There are different accounting methods of reporting financial statements. The three most common methods are the cash basis, modified accrual basis and accrual basis. Each method has its own rules, justifications and limitations. The common goal is the objective to provide a user with a financial snapshot of an entity. It is important to note the differences because that helps understand how to convert from one basis to the other.
Example 1:
Adequate Disclosure, Inc. purchases two trucks for $67,000, in cash.
Example 2:
Adequate Disclosure, Inc. purchases two trucks for $67,000, on credit.
- Under the cash basis, accounts payables are not recorded. In reality when Adequate Disclosure, Inc. purchased the two trucks on account; the two trucks are physically in its possession and can be used. However since it is not recorded on the financial statements, it gives the financial statement user the illusion that Adequate Disclosure, Inc. does not have the asset and debt. Therefore the cash basis is not permitted under US GAAP since it does not accurately portray the financial position of an entity.
Example 3:
Adequate Disclosure, Inc. receives $200,000 in cash for bookkeeping services performed.
Example 4:
Adequate Disclosure, Inc. receives $200,000 on account for bookkeeping services performed.
- Under the cash basis, accounts receivables are not recorded. When Adequate Disclosure, Inc. receives revenue on account, in reality that implies that Adequate Disclosure, Inc. has already performed or is currently performing the service, therefore is indeed entitled to that revenue. However under the cash basis it is not recorded since cash was not received; therefore giving financial statement users the illusion that Adequate Disclosure, Inc. has not generated revenue. Hence the cash basis is not permitted under US GAAP because it does not accurately portray the financial position of a company.
The modified accrual basis of accounting is used by governmental funds. This method is a hybrid method of accounting that is used by governmental entities such as towns, cites and the federal government. It only accounts for current assets and current liabilities. Liabilities and revenues are recorded in the period they are expected to be collected and or due. The two factors that distinguish the modified accrual basis of accounting from the accrual accounting basis of accounting is the fact that revenue is recorded when it is "available" and "expected" to be collected within a 12 month period with an additional 60 day period; while liabilities are recorded when "incurred" also within a 12 month period with an additional 60 day period.
Example 5:
The town Adequate Disclosure purchases two trucks for $500,000, in cash.
- Under the modified accrual basis of accounting long term assets are recorded as “expenditures”, but not recorded as an asset. Since the asset is not recorded as an asset, depreciation will not be accounted for.
Example 6:
The town of Adequate Disclosure purchases two trucks for $67,000, on credit.
- Under the modified accrual basis of purchases on credit can be recorded as both “vouchers payable” and “accounts payable”. The modified basis of accrual accounting does not delay the recording of expenses.
Example 7:
On January 1st, year 1, the town of Adequate Disclosure levies sales taxes of $500,000 to be collected by December 31st of year 1. Out of this amount $50,000 is deemed uncollectible and delinquent, while $40,000 will be collected by February 15th of next year. The journal entry on January 1st is:
- This entry displays how the town of Adequate Disclosure “levies” taxes. All receivables are reported under the Net Realizable Value ($500,000 - $50,000 = $450,000). It is important to remember that revenue is recorded when expected to be available within a 12 month period including a 60 day period after the initial first year.
The journal entry on December 31st is:
- The first journal entry is to record the recognition of cash received and also removal of the receivable off the books. The second entry is to remove the deferred revenue off the books and recognize the revenue earned.
- The third journal entry is the revenues expected to be collected on February 15th of the following year which are still recorded as revenues earned since it is expected to be collected by February 15th. Therefore the account “deferred revenues” must be debited to be removed off the books.
The accrual basis of accounting is required and mandated to be implemented by US GAAP. It complies with the matching and revenue recognition policies. It records all transactions as they occur. The most common phrase that describes accrual accounting is: “it recognizes revenues when it is earned and expenses when the obligation is incurred” (Wiley Intermediate Accounting 2012). That basically means revenue is recognized when the company is entitled to it; whether it is on account or in installments or in cash. It must be recorded immediately. Likewise with expenses, they are recorded the instant they are incurred.
Example 8:
Adequate Disclosure, Inc. purchases two trucks for $67,000, on credit.
- This example contains the same fact pattern as example 2. However that example was under the cash basis and required no entry. Under the accrual basis, debt and liabilities are recognized as incurred, immediately.
Example 9:
Adequate Disclosure, Inc. receives $200,000 on account for bookkeeping services performed.
- This example contains the same fact pattern as example 4. However that example was under the cash basis and required no entry. Under the accrual basis, revenues are recognized when earned which follow the revenue recognition principle.
Example 10:
On January 1st, Adequate Disclosure, Inc. purchases a 4 year liability insurance policy on its employees that cost $50,000. The Journal entry for January 1st is:
- The first entry recognizes the liability insurance paid for on January 1st. Under the cash basis, this entry would be the only one recorded; however under the accrual basis this is the first entry and it requires a yearly expense since the insurance policy covers a four year period.
The journal entry for December 31st:
- The second entry on December 31st recognizes ¼ of the insurance policy that has been used up. This is where the cash basis and accrual basis differ.
- Under the cash basis, this policy would have been paid for on January 1st and would not be recognized and expensed evenly over four years. That violates the matching principle since all of the policy is expensed immediately on the first year.
- Under the accrual basis, this policy is depreciated evenly over four years and the expense is recognized in the correct accounting period.