Chapter 3 - accrual vs. Cash basis
Accrual basis - records the impact of a business transaction as it occurs. You record the transaction even though you didn't receive
cash. Corporations use this to record their transactions.
Cash basis - records only cash transactions - cash receipts and cash payments. Cash receipts are treated as revenues and cash
payments are handled as expenses. Cash basis isn't used because it has a defect of ignoring important information. And makes the
financial statement incomplete. Like, when you have a sale on account. Your balance sheet and income statement is understated.
Accrual basis is based on the time-period concept, the revenue principle, and guidelines for recording expenses.
• Time period concept: ensures that accounting information is reported at regular intervals.
• The revenue principle: this governs when to record revenue (make a journal entry), and the amount of revenue to record. Revenue
should be recorded when it is earned and not before. Revenue is earned when the business has delivered a good/service to a
customer. The amount of revenue to record is the cash value of the good transferred.
• Recording expenses: as revenue is earned, companies incur expenses during the normal day-to-day operations. They occur when
inventory is sold or salaries are paid or payable to employees.
• Cash, accounts payable, common shares, and dividends, and other accounts don't need to be adjusted
• Accounts receivables, supplies, prepaid rent and furniture need to be adjusted.
• The cost of supplies used up ends up as an expense. So you would need to make an adjusting entry at the end of the period like:
DR supplies expense and CR supplies.
Types of adjusting entries: deferrals, depreciation and accruals.
• Deferrals this is an adjustment for which the business paid or received cash IN ADVANCE. Like the supplies ending up as
supplies expense, prepaid rent/insurance and all other prepaid accounts (normal balance of debit). Adjustments for liabilities like
unearned service revenue!! The adjustment for this process is to decrease the liability account (the unearned account) and
increase the revenue account.
• Depreciation allocation of the cost of a capital asset to expense over the asset's useful life. Like when you buy furniture, the value
of it will decrease over time. The furniture account will not be affected by that though. But as it decreases, the amounts add up in
the contra-asset account (which when finding the total assets of the balance sheet, you subtract the depreciated accounts from it)
that comes right after the normal asset account. Like Furniture, and then right after it is the Accumulated Depreciation - Furniture
(normal balance of credit). TO ADJUST FOR IT, you DR depreciation expense, and CR accumulated. The furniture account is
always at its CARRYING AMOUNT or BOOK VALUE, it doesn't change.
• Accruals the opposite of deferral. For an accrued expense, you record the expense before paying cash. For an accrued revenue,
you record it before receiving cash. So like for the expense you record and pay for it later. Since you'll pay for it later, you'll have a
payable account for that expense. Likee, salary expense will have a salary payable account.
• OKAY FOR PREPAID EXPENSES -> DEFERRAL -> YOU NEED TO: when you first purchase that insurance for three months for
$3000. The entry for this is: DR prepaid insurance 3000, CR cash 3000. And as time goes by, let's say the first period ends, that
means that it's already been a month, so you have to make an adjustment to this. $3000*1/3=$1000. That $1000, is how much you
have to pay for that month. So you DR insurance expense 1000, and CR prepaid insurance 1000. Get it? Good.
• FOR SUPPLIES -> DEFERRAL -> YOU NEED TO: LET'S SAY, you bought $700 worth of supplies. And by the end of the period
you find that you have only $400 left of supplies left. This means that you used up $300 worth of supplies. So to do this you: DR
supplies expense 300, and CR supplies 300.
• UNEARNED REVENUE -> LIABILITYACCOUNT (CR BALANCE) -> DEFERRAL: This is similar to accounts receivable. But for
accounts receivables you have already performed the service, but haven't received the money. But unearned is like..you haven't
earned or performed any service yet. Like a magazine prescription, you pay for that whole season, but you won't get the magazines yet. Each time a new