Individuals and most small businesses use a method of accounting known as “cash accounting.” In order to be in accordance with GAAP, however, businesses must use a method known as “accrual accounting.”
The Cash Method
Under the cash method of accounting, sales are recorded when cash is received and expenses are recorded when cash is sent out. It’s straight forward and intuitive. The problem with the cash method, however, is that it doesn’t always reflect the economic reality of a situation.
EXAMPLE: Pam runs a retail ice cream store. Her lease requires her to prepay her rent for the next 3 months at the beginning of every quarter. For example, in April, she is required to pay her rent for April, May, and June.
If Pam uses the cash method of accounting, her net income in April will be substantially lower than her net income in May or June, even if her sales and other expenses are exactly the same from month to month. If a potential creditor was to look at her financial statements on a monthly basis, the lender would get the impression that Pam’s profitability is subject to wild fluctuations. This is, of course, a distortion of the reality.
The Accrual Method
Under the accrual method of accounting, revenue is recorded as soon as services are provided or goods are delivered, regardless of when cash is received. (Note: This is why we use an Accounts Receivable account.)
Similarly, under the accrual method of accounting, expenses are recognized soon as the company receives goods or services, regardless of when it actually pays for them. (Accounts Payable is used to record these as-yet-unpaid obligations.)
The goal of the accrual method is to fix the major shortcoming of the cash method: Distortions of economic reality due to the frequent time lag between a service being performed and the service being paid for.
EXAMPLE: Mario runs an electronics store. On the 5th of every month, he pays his sales reps their commissions for sales made in the prior month. In August, his sales reps earned total commissions of $93,000. If Mario uses the accrual method of accounting, he must make the following entry at the end of August:
Dr. Commissions Expense 93,000
Cr. Commissions Payable 93,000
Whenever an expense is recorded prior to its being paid for—such as in the above entry—the journal entry is referred to as an “accrual,” hence, the “accrual method.” The need for the above entry could be stated by saying that, at the end
of August, “Mario has to accrue for $93,000 of Commissions Expense.”
Then, on the 5th of September, when he pays his reps for August, he must make the following entry:
Dr. Commissions Payable 93,000
Cr. Cash 93,000
A few points are worthy of specific mention. First, because Mario uses the accrual method, the expense is recorded when the services are performed, regardless of when they are paid for. This ensures that any financial statements for the month of August reflect the appropriate amount of Commissions Expense
for sales made during the month.
Second, after both entries have been made, the net effect is a debit to the relevant expense account and a credit to Cash. (Note how this is exactly what you’d expect for an entry recording an expense.)
Last point of note: Commissions Payable will have no net change after both entries have been made. Its only purpose is to make sure that financial statements prepared at the end of August would reflect that—at that particular moment—an amount is owed to the sales reps.
Let’s run through a few more examples so you can get the hang of it.
EXAMPLE: Lindsey is a freelance writer. During February she writes a series of ads for a local business and sends them a bill for the agreed-upon fee: $600.
Lindsey makes the following journal entry:
Dr. Accounts Receivable 600
Cr. Sales 600
When Lindsey receives payment, she will make the following entry:
Dr. Cash 600
Cr. Accounts Receivable 600
So far, all of our examples have looked at scenarios in which the cash exchange occurred after the goods/services were delivered. Naturally, there are occasions in which the opposite situation arises.
Again, the goal of the accrual method is to record the revenues or expenses in the period during which the real economic transaction occurs (as opposed to the period in which cash is exchanged). Let’s revisit our earlier example of Pam with the ice cream store.
EXAMPLE: Pam’s monthly rent is $1,500. However, Pam’s landlord—Retail Rentals—requires that she prepay her rent for the next 3 months at the beginning of every quarter. On April 1st, Pam writes a check for $4,500 (rent for April, May and June). She makes the following entry:
Dr. Prepaid Rent 4,500
Cr. Cash 4,500
In the above entry, Prepaid Rent is an asset account. Over the course of the three months, the $4,500 will be eliminated as the expense is recorded. Assets caused by the prepayment of an expense are known, quite reasonably, as “prepaid expense accounts.”
Then, at the end of each month (April, May, and June), Pam will make the following entry to record her rent expense for the period:
Dr. Rent Expense 1,500
Cr. Prepaid Rent 1,500
Again, by the end of the three months, Prepaid Rent will be back to zero, and she will have recognized the proper amount of Rent Expense each month ($1,500). Of course, the process will start all over again on July 1st when Pam prepays her rent for the third quarter of the year.
From Pam’s perspective, the early rent payment created an asset account (Prepaid Rent). Naturally, from the perspective of her landlord, the early payment must have the opposite effect: It creates a liability balance known as “unearned revenue.”
EXAMPLE: On April 1st, when Retail Rentals receives Pam’s check for $4,500, they must set up an Unearned Rent liability account. Then, they will record the revenue month by month.
On April 1st, Retail Rentals receives the check and makes the following entry:
Dr. Cash 4,500
Cr. Unearned Rent 4,500
Then, at the end of each month, Retail Rentals will record the revenue by making the following entry:
Dr. Cash 4,500
Cr. Unearned Rent 4,500