ACCOUNTANCY

PROCESS AND BASES OF ACCOUNTING

Accruals and accrual accounting; accounts receivable and salary payable; interest receivable, interest revenue, interest payable, and interest expense.

1. Cash and accrual bases of accounting

We have discussed transactions that include direct and immediate cash flows. Cash was received in the period of earning revenues, or cash was paid in the period of incurring expenses. This is called cash accounting.

Cash (or cash-basis) accounting recognizes the effects of accounting events when cash is exchanged regardless of the time events occur. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).

However, more than often another situation takes place. Cash flows do not match with revenue and expense recognition. This situation falls under the accrual accounting.

Accrual (or accrual-based) accounting recognizes the effects of accounting events when such events occur regardless of the time cash is exchanged.

Accrual accounting closely relates to the definition of accounting event recognition.

Recognition is the fact of recording an event in financial records (books).

A recognition act may occur before or after cash has been collected or paid.

The term accrual means that recognition is made before cash is paid or collected.

Illustration 1: Cash accounting and accrual accounting

2. First illustration of accrual accounting

The following illustration will provide a good example of accrual accounting.

Candely Services started its operations on January 1, 20X6 when the business owner contributed $3,500 in cash. During the accounting period of 20X6 the owner, Mr. Candely, provided consulting services to customers and billed them $2,800. By the end of the accounting period he was able to collect $2,000 of $2,800 billed, leaving a balance of $800 due at the year-end. In addition, Mr. Candely incurred $1,500 liabilities for the only employee's salary. The company had paid $1,000 of this amount in 20X6, leaving a year-end balance due of $500. As of December 31, 20X6 Mr. Candely also had outstanding contracts for consulting services to be performed in 20X7 that amounted to $1,600.

The paragraph above includes the following five accounting events that we will discuss:

1. The owner contributed $3,500 to the business.
2. Assets obtained in 20X6 accounting period through performing services amounted to $2,800 and contracts for services to be performed in 20X7 amounted to $1,600.
3. $2,000 cash was collected from the customers who had been billed for services provided.
4. Salary expense for the employee amounted to $1,500.
5. The employee was only paid $1,000 during 20X6 (see Event No. 4) and was to receive another $500 during 20X7.

Let us look at each of these accounting events.

2.1. Capital acquisition transaction analysis

1) Capital acquisition of $3,500 is an asset source transaction. The transaction acts to increase assets (Cash) and equity (Contributed Capital).

Note: While looking at the scheme below ignore account titles that are unfamiliar at this time; they will be explained later when introduced:

Illustration 2: Effect of capital acquisition

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$0		$0	=	$0		$0		$0
Capital Acquisition	3,500						3,500
Ending Balances	$3,500	+	$0	=	$0	+	$3,500	+	$0

2.2. Recording revenue on account transaction analysis

2) According to the accrual accounting rules, the $2,800 of revenue should be recognized in 20X6, although only $2,000 of this amount is collected in that period. As you can see, revenue recognition ($2,800) and cash collection ($2,000) do not go side by side (they are separated in time). In our case, Mr. Candely's productive activity has resulted in an asset increase of $2,800. This asset is called an account receivable.

Accounts receivable refer to amounts of future cash receipts that are due from customers (i.e., amounts to be collected in the future). Accounts receivable are shown on the asset side of the balance sheet.

The transaction of revenue recognition is an asset source transaction:

Illustration 3: Effect of recognizing accounts receivable and revenue

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$3,500	+	$      0	=	$      0	+	$3,500	+	$      0
Recognizing Assets / Revenue			+2,800						+2,800
Ending Balances	$3,500	+	$2,800	=	$      0	+	$3,500	+	$2,800

Note that the contracts for $1,600 of consulting services to be performed in 20X7 are not recognized in 20X6. The reason is that revenue can be recorded only when services have been provided. Thus we will leave this $1,600 without recording until Mr. Candely provides services in 20X7.

2.3. Cash collection transaction analysis

3) Now we will record the collection of $2,000 in cash. Because we have already recorded that amount as an account receivable (Event No. 2), we just need to transfer the amount from the account receivable to cash $2,000. The Cash account will increase and the Account Receivable account will decrease. This is an asset exchange transaction.

Asset exchange transactions occur when only asset accounts are engaged in a transaction. For example, collection of cash on accounts receivable is an asset exchange transaction. Total assets remain unchanged after such transactions.

Illustration 4: Effect of cash collection

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$3,500	+	$2,800	=	$      0	+	$3,500	+	$2,800
Cash Collection	+ 2,000		(2,000)
Ending Balances	$5,500	+	$800	=	$      0	+	$3,500	+	$2,800

Also make certain to note that in this transaction revenue is not affected. The revenue recognition of $2,800 already happened when we recorded the increase in the account receivable (Event No. 2). If we had recorded revenue again when we received cash, then the revenue would have been recorded twice. This would not be in accordance with generally accepted accounting principles.

2.4. Recording salary payable transaction analysis

4) Liabilities and corresponding expenses can also be recorded before cash is paid (the same accrual accounting principle). Mr. Candely would recognize salary obligations and expenses in the amount of $1,500 in 20X6.

Salary payable represents amounts of future cash payments to employees for work that has already been performed.

Such accruals as salary payable are also called accrued expenses.

Accrued expenses are expenses incurred but not yet paid in cash. When recorded, such expenses are usually shown in the liabilities section of the balance sheet.

The transaction to record the accrued salary is shown as follows:

Illustration 5: Effect of recognizing liability and expense

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$5,500	+	$800	=	$      0	+	$3,500	+	$2,800
Recognizing Liability / Expense					+1,500				(1,500)
Ending Balances	$5,500	+	$800	=	$1,500	+	$3,500	+	$1,300

Liabilities increase (Salaries Payable) and equity decreases (Retained Earnings) by $1,500. However, total claims remain unchanged. This expense recognition is a claim exchange transaction.

Claim exchange transactions occur when only claim accounts are engaged and impacted. For example, recording salaries payable is an example of a claim exchange transaction.

2.5. Cash payment on salary payable transaction analysis

5) Cash payment to creditors (an employee, in our example) is an asset use transaction. When the employee is paid, both Cash (asset account) and Salaries Payable (liability account) decrease by $1,000:

Illustration 6: Effect of cash payment

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$5,500	+	$800	=	$1,500	+	$3,500	+	$1,300
Cash Payment	(1,000)				(1,000)
Ending Balances	$4,500	+	$800	=	$500	+	$3,500	+	$1,300

Again, note that the cash payment does not cause expense recognition. The expense was already recognized in full when we recorded the salary liability. Doubling of the expenses would take place if we recorded the expense again.

Finally, the summary of all transactions is presented below. If you would like to check whether your understanding of these transactions is correct, try to perform their reverse identification. That means you look at the accounts and identify the type (nature) of the transaction without looking at its description.

Illustration 7: Summary of transactions for Candely Services for 20X6

	Assets			=	Liabilities	+	Equity
	Cash	+	Accounts Receivable	=	Salaries Payable	+	Contributed Capital	+	Retained Earnings
Beginning Balances	$   0		$      0	=	$      0		$      0		$      0
1) Capital Acquisition	+ 3,500						+ 3,500
2) Recognizing Assets/Revenue			+2,800						+2,800
3) Cash Collection	+ 2,000		(2,000)
4) Recognizing Liability Expense					+1,500				(1,500)
5) Cash Payment	(1,000)				(1,000)
Ending Balances	$4,500	+	$800	=	$500	+	$3,500	+	$1,300

2.6. Financial statements for the first illustration of accrual accounting

The next step is to prepare financial statements.

The income statement looks as follows:

Illustration 8: Income statement for Candely Services for 20X6

Candely Services Income Statement For the Period Ended 20X6
Consulting Revenue	$ 2,800
Salary Expenses	(1,500)
Net Income	1,300

The income statement shows changes in equity from all sources other than transactions with owners. Equity is the difference between assets and liabilities, so changes in assets and liabilities other than transactions with owners, represent revenues or expenses. In our example, the increase in assets (i.e., the Account Receivable account) from consulting services was $2,800; the increase in liabilities (i.e., the Salaries Payable account) was $1,500. Therefore, the net assets increase was $1,300 ($2,800 - $1,500).

There is one important point to be remembered. Previously we defined expenses as economic sacrifices from a decrease in assets. Now, from the income statement we can see that expenses can also be recorded with an increase in liabilities. Accordingly:

Expenses can be defined as a decrease in assets or an increase in liabilities that result from operating activities undertaken to generate revenue.

Similarly, revenue can increase by decreasing liabilities.

Revenue is an increase in assets or a decrease in liabilities resulting from the operating activities of an entity.

The statement of changes in equity is presented below:

Illustration 9: Statement of changes in equity for Candely Services for 20X6

Candely Services Statement of Changes in Equity Period Ended 20X6
Beginning Contributed Capital	$0
Plus: Capital Acquisition	3,500
Ending Contributed Capital	3,500
Beginning Retained Earnings	$0
Plus: Net Income	1,300
Less: Distribution	0
Ending Retained Earnings	1,300
Total Equity	4,800

The statement of changes in equity provides us with information about the effects of capital acquisitions and distributions (i.e., transactions with owners). In our example, the capital acquisition was $3,500. The statement also provides information about the net income which amounted to $1,300. No distributions to owners took place during 20X6 accounting period. The total equity, therein, is $4,800.

The balance sheet has such a form:

Illustration 10: Balance sheet for Candely Services at 20X6 end

Candely Services Balance Sheet Period Ended 20X6
Assets
Cash	$ 4,500
Accounts Receivable	800
Total Assets	5,300
Liabilities
Salaries Payable	500
Total Liabilities	500
Equity
Contributed Capital	3,500
Retained Earnings	1,300
Total Equity	4,800
Total Liability and Equity (Claims)	5,300

The balance sheet provides information about the entity's assets, liabilities, and equity. In our example we have assets: cash in the amount of $4,500, and accounts receivable of $800; liabilities only include salaries payable amounting to $500; and, finally, equity consisting of contributed capital of $3,500 and retained earnings with a $1,300 balance.

The statement of cash flows follows:

Illustration 11: Statement of cash flows for Candely Services for 20X6

Candely ServicesStatement of Cash FlowsFor the Period Ended 20X6
Cash Flows from Operating Activities
Cash Receipts from Customers	$ 2,000
Cash Payments for Expenses	(1,000)
Net Cash Flow from Operating Activities	1,000
Cash Flows from Investing Activities	0
Cash Flows from Financing Activities
Cash Receipts from Borrowing	0
Cash Receipts from Capital Acquisitions	3,500
Cash Payments for Distributions	0
Net Cash Flow from Financing Activities	3,500
Net Increase in Cash	4,500
Plus: Beginning Cash Balance	0
Ending Cash Balance	$ 4,500

The statement of cash flows explains the movements (inflows and outflows) of cash during an accounting period. Candely Services was established in 20X6. Therefore, the beginning cash balance is zero. Due the cash received for consulting services, the cash account balance increased by $2,000. In the same period $1,000 was spent on operating the business (salary expense). This creates the net cash flow from operating activities of $1,000 ($2,000 - $1,000). In addition, the capital acquisition contributed $3,500 to the cash inflow (financing activities). The combination of these factors explains the $4,500 ($1,000 + $3,500) increase in cash during the 20X6 accounting period.

Observe that the amount of net income ($1,300) reported on the income statement is different from the amount of net cash flows from operations ($1,000) as well as from net change in cash ($4,500). This takes place because of the accrual accounting. Under the accrual accounting, as we stated earlier, cash flows do not go side-by-side with the recognition of revenue and expense.

3. Second illustration of accrual accounting

Let us expand the example with Candely Services to the next accounting period. We will introduce a few more transactions that apply to 20X7. The transactions are listed below:

1. During 20X7 revenue of $2,700 was recognized on account.
2. $3,000 of accounts receivable was collected in cash from customers.
3. Salary expense of $1,400 was incurred.
4. $1,200 cash was paid to settle salaries payable.
5. $500 cash was distributed to the owner.
6. On May 1, 20X7 Mr. Candely's business invested into a $1,000 certificate of deposit (CD). The CD carries a 6% annual interest and 1-year maturity term.
7. On December 31, 20X7 the company adjusted the books to recognize interest revenue earned on the CD.

The table below summaries the effects of the 20X7 transactions on the accounting equation.

3.1. Summary of transactions for the second illustration of accrual accounting

Illustration 2-12: Effects of transactions for Candely Services for 20X7

	Assets							=	Liab.	+	Equity
#	Cash	+	Accounts Receivable	+	% Rec.	+	CD	=	Salaries Payable	+	Cont. Capital	+	Retained Earnings
BB	$4,500		$800		$     0		$     0	=	$500		$3,500		$1,300
1)			+ 2,700										+ 2,700
2)	+ 3,000		(3,000)
3)									1,400				(1,400)
4)	(1,200)								(1,200)
5)	(500)												(500)
6)	(1,000)						+1,000
7)					40								40
EB	$4,800	+	$500	+	$40	+	$1,000	=	$700	+	$3,500	+	$2,140

The first five transactions are familiar to us (see explanations of 20X6 transactions earlier), so we will go straight to Event No. 6 and No. 7.

3.2. Purchase of certificate of deposit transaction analysis

The purchase of a certificate of deposit represents aninvestment. The event acts to decrease the Cash account and to increase the Certificate of Deposit (CD) account. As both accounts involved in the transaction are asset accounts, it is an asset exchange transaction.

When Mr. Candely invested into the CD, he effectively loaned money to the bank. In return for using his money, the bank agreed to pay back an amount greater than the amount borrowed.

The amount initially invested (or borrowed) is called the principal.

Excess of money over the initial invested amount (principal) is called interest and is usually set as a percentage to the principal.

In our situation, the interest on the CD is 6%. That means that on April 30, 20X8 Mr. Candely will get back the principal ($1,000) and the interest in the amount of $60 ($1,000 x 6%), or $1,060 in total.

It is important to note that the interest is earned on a continuous basis even though the payment of investment return is made at the maturity date. In other words, the amount of interest due increases proportionally with the passage of time. When a portion of interest is earned, the Interest Receivable account (i.e., amount due from the bank) increases along with an increase in the Interest Revenue account.

Interest receivable represents future cash receipts of interest by a company. Interest receivable is shown on the asset side of the balance sheet.

Interest revenue is the amount of interest earned. Interest revenue (or just interest) may be earned on an investment such as a savings account or a certificate of deposit. Interest revenue is an income statement account that increases equity.

Later, at the certificate of deposit maturity date, the bank will pay interest to the creditor and the creditor (our company) will decrease the Interest Receivable account and increase the Cash account.

We do not recognize interest revenue until the date of financial statements on December 31, 20X7. At that time, a single entry can be made to recognize the accrual of 8 months of interest (from May 1 to December 31). This entry is called an adjusting entry.

Adjusting entries adjust the account balances before the final financial statements are prepared. Each adjusting entry affects one balance sheet account and one income statement account.

The amount of interest to be recognized at period end represents accrued revenue.

Accrued revenue is revenue earned but not yet received. When recorded, such amounts are usually shown as account receivable (i.e., interest receivable) on the balance sheet and interest revenue in the income statement.