Overview of Accrual Basis and Cash Basis Accounting
The Accounting Period
If a business such as Global Air were to use accrual basis accounting, it would recognize the revenue in May, when the flight actually takes place and the services are rendered to the customer. By recognizing the flight revenue in May, Global Air follows the revenue recognition principle under GAAP, which is the principle on which the adjusting process is based. It recognizes or records revenue in the time period when earned, regardless of when cash is received.
Global Air receives $2,000 in January for a flight to take place in May.
Matching Expense with Revenue
|Cash basis||Revenue recognized = cash received $2,000||$0 revenue recognized||Does not follow GAAP, as revenue is recognized in the incorrect accounting period (January, instead of May)|
|Accrual basis||Cash received $2,000;
$0 revenue, carried as unearned revenue (liability)
|Revenue recognized when earned; $2,000||Under the revenue recognition principle, revenue is recognized in the correct accounting period to follow GAAP rules (May).|
|Result if cash basis is used||Revenue overstated for the month, not necessarily for the period||Revenue understated|
To apply accrual basis accounting further, Global Air purchases and uses $500 in fuel to fly the aircraft from Toronto to Reykjavík in May and pays the invoice in June. Global Air will use the matching principle, which is applied in the adjusting process to report or match expenses in the same accounting period as the revenue earned. Global Air reports or matches expenses, such as fuel expense, in the same accounting period as the flight revenue they helped to generate, namely, in the month of May, even though the payment does not occur until June. The business income for Global Air reported for the month of May would then be correct by matching the expense with the revenue that the expense helped to generate, again using the accrual basis accounting.
Global Air orders and uses $500 in fuel for the May flight but pays for the fuel in June.
Matching Expense with Revenue Generated by Expense
|Cash basis||$0 fuel expense||Fuel expense = cash payment $500||Does not follow GAAP, as the expense is recognized in the incorrect accounting period (June, instead of May)|
|Accrual basis||Fuel expense recognized to match the revenue earned; $500||$0 fuel expense; cash payment $500||Under the matching principle, the expense is recognized in the correct accounting period (May).|
|Result if cash basis is used||Expense understated||Expense overstated|
Accrual Basis versus Cash Basis
|Global Air: Transaction Impact||Accrual Basis Accounting||Cash Basis Accounting|
The Adjusting Process
Using accrual basis accounting, adjusting entries are required to properly account for revenue and expense recognition in accordance with GAAP. Accrual basis accounting is based on the principles of revenue recognition, the matching principle, and the time period concept, which is the division of a business's activities into specific time periods, such as a month, quarter, or year. The matching principle requires reporting or matching expenses in the same accounting period as when the revenue was earned. Adjusting entries are made for unearned revenue, which is a liability, a payment (cash) received before the goods or services are provided. Adjusting entries are also made for a prepaid expense, which is an expense that has been paid for in advance of receiving goods or services purchased.
At the end of each accounting period, or specific time period, certain accounts will need to be adjusted to bring an asset or liability account balance to an accurate amount. In doing so, revenues or expenses will also be impacted. Therefore, every adjusting entry affects both an income statement account (revenue or expense) and a balance sheet account (asset or liability). Adjusting entries are recorded at the period end, typically, at month-end or at year-end. This is the adjusting process.For example, the adjusting process plays a part in the proper reporting of financial results for an airline company, Global Air. Using the accrual basis accounting method, adjusting entries are recorded at the company's period end, which is month-end July 31. Global Air receives $5,000 cash in ticket sales on July 1 as unearned or deferred revenue. Half of the company's flights then occur in July, and the other half occur in August. Thus, the required adjusting entry on July 31 (month-end) is half of the cash, $2,500. Also, Global Air pays $6,000 as a prepaid expense for insurance coverage for 6 months (July through December) on July 1. At the end of the month, July 31, the adjusting entry for the prepaid expense will be for one month's insurance.