In this particular episode, you will learn
- Accrual and cash basis accounting
- Double entry accounting
Accrual Basis Accounting and the Matching Principle
Accrual basis accounting is based upon Generally Accepted Accounting Principles (GAAP). This system is double entry and matches revenues and expenses during the proper period. For example, a company could have $50,000 in amounts billed to clients in December that it will not collect until January. Under the accrual basis of accounting, the company would record $50,000 of revenue because the amount was both earned and realizable. It was earned because services were performed to satisfaction, and realizable because the amounts were already billed to the client. The $50,000 is recorded in revenue and the asset account, accounts receivable (in this case, amounts owed to company for services). Since the revenue is recorded in December, the expenses for this same time period also match the revenue earned.
Accrual accounting takes into consideration liabilities that a company is increasing during the accounting period. For example, Shady Manufacturing does not pay $75,000 cash for employees, contractors, electricity, and supplies during the month of December. Under the accrual basis of accounting, Shady would record $75,000 of expense and $75,000 of liabilities in the form of accounts payable (money owed to suppliers) and accrued expenses (such as wages owed to employees). Accrual accounting matches the expenses to the proper time period (periodicity).
Accrual accounting is based on the principal that requires a company to match revenues to related expenses in the correct time period. Revenue must be recognized (recorded in the accounting record) when earned and realizable, meaning that services have been performed, goods have been shipped, and that payment is expected. Expenses must be recognized when incurred. The actual payment of cash is recorded, but will not affect revenue or expense accounts at that time.