Oracle Concepts : Accrual Basis vs. Cash Basis Accounting

There are two basic accounting methods available in the business world: Cash or Accrual. The following bulletin is intended to give a simple overview on this important topic;  describe its impact on the accounting entries and reporting and finally how they areimplemented in Oracle applications.

Cash Basis Accounting

With the cash method of accounting, you record income only when you receive cash from your customers. You record an expense only when you write the check to the vendor. Most individuals use the cash method for their personal finances because it’s simpler and less time-consuming. However, this method can distort your income and expenses, especially if you extend credit to your customers, if you buy on credit from your suppliers, or you keep an inventory of the products you sell.

Under the cash basis accounting, revenues and expenses are recognized as follows:

* Revenue recognition: Revenue is recognized when cash is received.

* Expense recognition: Expense is recognized when cash is paid.

Accrual Basis Accounting

With the accrual method, you record income when the sale occurs, whether it be the delivery of a product or the rendering of a service on your part, regardless of when you get paid. On the other hand, you record an expense when you receive goods or services, even though you may not pay for them until later. The accrual method gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is truly earned, and you record expenses when they are incurred. Income  earned in one period is accurately matched against the expenses that correspond to that period, so you get a better picture of your net profits for each period.

Under the accrual basis accounting, revenues and expenses are recognized as follows:

* Revenue recognition: Revenue is recognized when both of the following   conditions are met:

a. Revenue is earned

i.e. When products are delivered or services are provided.

b. Revenue is realized or realizable.

i.e. Either cash is received or it is reasonable to expect that cash  will be received in the future.

* Expense recognition: Expense is recognized in the period in which  related revenue is recognized (Matching Principle).

Timing differences in recognizing revenues and expenses

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There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting. If a company uses accrual basis accounting, there are four cases where revenue and expense recognition may not coincide with cash transactions. The following are four types of  timing differences

a. Revenue is recognized ‘before’ cash is received       Accrued Revenue

b. Expense is recognized ‘before’ cash is paid           Accrued Expense

c. Revenue is recognized ‘after’  cash is received       Deferred Revenue

d. Expense is recognized ‘after’  cash is paid           Deferred Expense

Case 1: Revenue is recognized before cash is received.

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Example: Products are sold at $5,000 on May 1, 2000 and cash is received on

May 10, 2000.

i.e. On May  1, 2000 Revenue is recognized.

On May 10, 2000 Cash is received.

[Journal entry on May 1, 2000]

Debit   Credit

Accounts receivable                  5,000

Sales                          5,000

[Journal entry on May 10, 2000]

Debit   Credit

Cash                           5,000

Accounts receivable                   5,000

Case 2: Expense is recognized before cash is paid.

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Example: On May 1, 2000, Company A borrowed $100,000 from a bank and promised to pay 12% interest at the end of each quarter.

i.e. On May  31, 2000 Interest expense is recognized for May.

On June 30, 2000 Cash is paid at the end of the quarter.

[Journal entry on May 1, 2000]

Debit   Credit

Cash                                  100,000

Borrowings from bank                100,000

[Journal entry on May 31, 2000]

Debit   Credit

Interest expense                      1,000

Interest payable                     1,000

- $100,000 x 12% x 1/12 = $1,000 for each month.

- Interest payable is a liability account.

- Credit side of interest payable (a liability account) represents  an increase.

[Journal entry on June 30, 2000]

Debit   Credit

Interest expense                     1,000

Interest payable                    1,000

- Credit side of interest payable (a liability account) represents an increase.

Debit   Credit

Interest payable                     2,000

Cash                                2,000

- Company pays $2,000 as interests for May and June.

- Debit side of interest payable (a liability account) represents a decrease.

Case 3: Revenue is recognized after cash is received.

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Example: On May 1, 2000, Company A had a new lease contract with a tenant and received $6,000 for two month rent.

i.e. On May  1, 2000 Cash is received.

On May 31 and June 30, 2000 Revenue is recognized at the end of

May and June.

Revenue is recognized when Company A provides service. In this example, service is provided when time passes.

[Journal entry on May 1, 2000]

Debit   Credit

Cash                              3,000

Unearned rent revenue                 3,000

- Unearned rent revenue is a liability account.

- Credit side of unearned rent revenue (a liability account) represents an increase.

- “Unearned revenue” accounts represent the amount of cash received before services are provided. Since services have not been provided yet, it is not revenue. “Unearned revenue” accounts are liabilities of the company, because they should be paid back to the other party if service is not provided in the future.

[Journal entry on May 31, 2000]

Debit   Credit

Unearned rent revenue                3,000

Rent revenue                        3,000

- Debit side of unearned rent revenue (a liability account) represents a decrease.

- Credit side of rent revenue (a revenue account) represents an increase.

[Journal entry on June 30, 2000]

Debit   Credit

Unearned rent revenue                3,000

Rent revenue                        3,000

- Debit side of unearned rent revenue (a liability account) represents a decrease.

- Credit side of rent revenue (a revenue account) represents an increase.

Case 4: Expense is recognized after cash is paid.

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Example: Company A purchased an insurance for a period from May 1, 2000 to  July 31, 2000 and paid $6,000 cash for three month insurance premium.

i.e. On May 1, 2000 Cash is paid.

On May 31, June 30, July 31, 2000 Expense is recognized at the end of May, June and July.

[Journal entry on May 1, 2000]

Debit   Credit

Prepaid insurance                    6,000

Cash                                 6,000

- Prepaid insurance is an asset account.

- Debit side of prepaid insurance (an asset account) represents an increase.

[Journal entry on May 31, 2000]

Debit   Credit

Insurance expense                    2,000

Prepaid insurance                     2,000

- Credit side of prepaid insurance (an asset account) represents  a decrease.

[Journal entry on June 30, 2000]

Debit   Credit

Insurance expense                    2,000

Prepaid insurance                     2,000

- Credit side of prepaid insurance (an asset account) represents a decrease.

[Journal entry on July 31, 2000]

Debit   Credit

Insurance expense                    2,000

Prepaid insurance                     2,000

- Credit side of prepaid insurance (an asset account) represents  a decrease.

Accounting Method Pros and cons

The cash method is easier to maintain because you don’t record income until you receive the cash, and you don’t record an expense until the cash is paid. With the accrual method, you will typically record more transactions. For example, if you make a sale on account (or, on credit), you would record the transaction at the time of the sale, with an entry to the receivables account. Then, when the customer pays their bill, you will record the receipt on account as another transaction.

With the cash method, the only transaction that is recorded is when the customer pays the bill. If you are using computer software to do your accounting, this is probably not a big concern, since the application automates much of the extra effort required by the accrual method.

Generally Accepted Accounting Principles (GAAP) requires companies to use the accrual basis for financial reporting purposes; it is considered a more accurate depiction of a company’s income and expenses. However, different companies may account for transactions using different accounting methods based on their own countries’ laws and regulations. Oracle Financials have been developed to meet GAAP requirements as well as the special needs of different countries. For example, in Oracle Payables you can choose whether to record journal entries for invoices and payments on an accrual basis, a cash basis, or a combined basis where accrual journal entries are posted to one Ledgers and cash basis journal entries are sent to a second Ledgers.