Background
We now know how to record transactions. The next question is when to record them...
Question
On Feb 1, a plumber goes to a customer's business to clear a clogged drain. The customer asks for a bill to be mailed. On Feb 2, the bill is mailed to the customer. On Feb 3, the bill arrives at the customer's business. On Feb 4, the customer mails a check. On Feb 5, the plumber receives the check.
For the plumber and the customer, walk through when transactions are recorded. Do two timelines for each - one for cash accounting and one for accrual accounting.
Answer
Plumber, cash method:
Feb 5, DR Cash, CR Income
Plumber, accrual method:
Feb 1, DR Accounts Receivable, CR Income
Feb 5, DR Cash, CR Accounts Receivable
Business, cash method:
Feb 4, DR Expense, CR Cash
Business, accrual method:
Feb 1, DR Expense, CR Accounts Payable
Feb 4, DR Accounts Payable, CR Cash
Analysis
Before we get into how to record transactions under different types of accounting schemes, let's talk about the two basic types and why we might use each.
Cash accounting is the easier to understand of the two systems. Essentially,
you record income transactions when you receive money and you record expense transactions when you pay money. Because the system is based on the receipt and payment of cash, knowing when to record transactions is simple and straightforward.
So
let's track the accounting of our question for the plumber on the cash method:
On Feb 1, the plumber does work but isn't paid. No transaction is recorded. In fact, all of that stuff with the bill being sent out has no effect on the plumber. We're waiting for the receipt of cash.
On Feb 5,
when the plumber receives the check from the customer, he has now received money and so records a transaction:
DR Cash
CR Income
(DR is short for Debit and CR is short for Credit)
Now let's do the same for the
business on the cash method:
On Feb 1, the business has work done but doesn't pay for it that day. Since money hasn't left the business yet, no transaction is recorded. In fact,
it's only when a check is sent to the plumber that an entry is made:
Feb 4
DR Expense
CR Cash
Now let's talk about
Accrual accounting. Essentially, you
record income transactions when income is earned and you record expenses when they are incurred.
How does this play out for the plumber and the business? Let's watch
the plumber first:
On Feb 1, the plumber does work. He has earned income. It doesn't matter that he hasn't received cash yet - he records income. We'll also record that he is owed money:
DR Accounts Receivable (i.e. he is owed money)
CR Income
On Feb 5 when he receives the check in the mail, he has now been paid. We reduce the account that says he is owed money and increase the account that says he has money:
DR Cash
CR Accounts Receivable
And now let's do the
business:
On Feb 1, the business called in the plumber. An expense has been incurred which will eventually need to be paid. We record the expense and we also record that money is owed to the plumber:
DR Expense
CR Accounts Payable (i.e. the business owes money to someone)
On Feb 4, the business sends payment to the plumber. The debt is paid and cash is decreased:
DR Accounts Payable
CR Cash
*****
So let's now talk about
why we might use the accrual method vs the cash method of accounting.
Clearly,
using the accrual method requires more work - it took twice as many entries to record the transactions under the accrual method than under the cash method. So whatever reasons there are to use accrual accounting, it has to be worth the extra work.
One reason the accrual method is preferred is that it follows something called the Revenue Recognition principle - which is what we described above when the plumber recorded income when it was earned and not when the bill was paid.
For accountants,
it's important that income transactions properly follow when income is earned. The payment of cash isn't always a good indicator of when income is earned. For instance, what if the plumber had had to wait 3 months for payment? It wouldn't be fair or right for the plumber to not record the income until he got paid.
Another reason is that the accrual method also follows something called the Matching Principle - which means that
expenses are recorded only when they can be properly matched to the income they were incurred to produce.
A prime example of this, which we'll discuss in a later entry, is depreciation. Depreciation is the recognition of wear and tear on machinery and other expensive assets in order to make income. For instance, let's say a business that will make widgets is getting started. The company has a large factory built. Should the company be able to record the building of the factory as an expense all at once? Or should it be reduced in value over time as the wear and tear of making widgets decreases its value? The Matching Principle says it should happen over time.
*****
One more note before closing this entry - the use of accounting method is independent of other businesses. The plumber could easily be using the cash method while the business is using accrual, and vice versa (the plumber could be using accrual accounting and the business using cash accounting).
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