4.1 Cash versus Accrual Accounting
Cash-basis accounting records revenues and expenses only when cash is received or distributed. Accrual-basis accounting, on the other hand, records revenues and expenses when they are earned or incurred rather than waiting until cash changes hands. Most publicly traded companies are required by the SEC to use accrual-basis accounting. Generally, smaller businesses that deal primarily in cash are the best candidates for using the cash basis since the accrual method more accurately depicts net income or net loss each period.
4.2 Economic Basis for Accrual Accounting
Double-entry accounting means that each time a transaction is recorded, there are at minimum two accounts impacted by the entry. Each entry’s debits must total its credits in order to support and maintain the balance in the accounting equation. The accounting equation is expressed as
4.3 How Does a Company Recognize a Sale and an Expense?
In accrual accounting, the timing of revenues (when to record them) is governed by the revenue recognition principle. The principle indicates that revenue is only recognized on the income statement once it is earned. This means goods or services must have been delivered or rendered. Expenses, on the other hand, are guided by the expense recognition principle, which dictates that expenses must be recorded in the period in which they are incurred.
4.4 When Should a Company Capitalize or Expense an Item?
Determining when an item is actually an expense depends on whether it is capitalized (a fixed asset) or not. Fixed assets are those that are of significant value and last longer than one year. The cost of fixed assets is capitalized (placed on the balance sheet as an asset) and expensed over the useful life of the asset by recording depreciation. Depreciation can be calculated using straight-line, double-declining-balance, or units-of-production methods.
4.5 What Is “Profit” versus “Loss” for the Company?
Profit or loss for a company is calculated by subtracting expenses from revenue. The result is a profit if revenues are larger than expenses. Profit (or loss) is the money earned from the day-to-day general business operations. Gains and losses, on the other hand, occur when the business does something they don’t normally do (like sell a piece of their equipment) and earns or loses money on the transaction. It’s key to note that the timing of cash flows can vary from the timing of recording revenues or expenses. Thus a revenue does not necessarily equal cash in, and an expense does not necessarily equal a cash flow out.