Cash VS Accrual Accounting

Lecture Aid 1
Accrual Accounting and Income Determination
(Sources: Financial Reporting & Analysis By Revsine, Collins, Johnson and
Mittelstaedt and Intermediate Accounting by Kieso Weygandt and Warfield)

Learning Objectives
 What is revenue recognition principle under
the accrual-basis accounting?
 How to apply the matching principle to
expense recognition under the accrual-basis?
.
 How is income measured under the accrual-
basis?
 What is the cash-basis accounting?

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Learning Objectives (Contd.)
 What are the distinctions between cash-
basis and accrual-basis earnings?
 Why is accrual-basis income generally a
better measure of operating performance?
 Income statement format and
classification.
 How to report a change in accounting
principle, accounting estimate, and
accounting entity.
 What is comprehensive income?
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Learning Objectives :

• What is the revenue recognition principle

under the accrual-basis accounting?
• How to apply the matching principle to
expense recognition under the accrual-
basis? .
• How is income measured under the
accrual-basis?

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 Measuring Profit ( Net income) Performance:
When to recognize revenues and expenses under
the GAAP (the accrual-basis)?
Operating Cycle

Market
 Step 1: Revenuer ecognition the
product
 Step 2: Expense matching Receive
 Step 3: Income Recognition Collect cash order

Deliver Negotiate
product production
Net income = contract

Revenues - Expenses Manufacture

product
Order
material

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Accrual Basis Accounting – Income Measurement
 Step1: Revenues are “recognized”
(recorded) when:
 Earned: The seller has performed a service or
conveyed an asset to the buyer; and
 Measurable (Realizable): The value to be
received for that service or asset can be
measured with a high degree of reliability and
the collection is reasonably assured.

 Step 2: Expenses are “matched” to revenues.

 Step 3: Net income = Revenues - Expenses

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Step 1: Determine the amount of revenue to be
recorded (revenue recognition).

Time of sale is used in

most industries

Condition 1: The critical event in the process of earning the

revenue has taken place. (Earned)

Condition 2: The amount of revenue that will be collected is

reasonably assured and is measurable with a
reasonable degree of reliability. (Measurability)

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Step 2: Matching expenses with revenues

 Matching Principle: if revenues are

recognized in x1 period, all related
expenses (including both traceable and
period costs) should be recognized in the
same period.

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Step 2: Matching expenses with revenues
(contd.)
 Traceable costs : The costs which can be
easily traced to the revenues. These traceable
costs also called product costs (i.e., the
cost of goods sold).

 Period costs: These costs are more difficult

to quantify their contribution to revenues of a
particular period.
Thus, period costs are expensed in the
period when they occur or consume (e.g.,
advertising costs, salary costs).

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Matching Traceable costs (expenses)
with Revenues: (Cory TV and Appliance )

This example illustrates how product (traceable) costs are matched with 10
revenues.
 Expense Period costs when they are
consumed
Suppose Cory TV also buys radio advertising for a monthly cost of
$120 beginning in February. This is a period cost (not product
cost).

Period costs are expensed in the period when they are consumed.
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Learning Objective :
• What is the cash-basis accounting?

• What are the distinctions between

cash-basis and accrual-basis income?

• Why is accrual-basis income

generally a better measure of
operating performance?

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Cash Basis Income Measurement

 Revenues are recognized upon the

receipts of cash.
 Expenses are recognized when they are
paid in cash.
 Cash flow inflows and outflows do not
reflect the true economic benefits (i.e.,
revenues) or efforts (i.e., expenses).

 Revenues and expenses do Not match.

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 Summary of Accrual vs. Cash Basis
Accounting
 Accrual-basis accounting: Revenues are
recognized when they earned and realizable,
not wait until cash is collected. Expenses are
recognized when they occur or are
consumed, not wait until they are paid for.
 Cash-basis accounting: The accountant does
not record a transaction until cash is received
or disbursed.

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Cash Versus Accrual Accounting
 Carter Company has sales on account totaling
$100,000 per year for three years. Carter
collected $50,000 in the first year and $125,000
in the second and third years. The company
prepaid $60,000 for three years’ rent in the first
year. Utilities are $10,000 per year, but in the
first year only $5,000 was paid. In the second
year, the total of $15,000 was paid for the
utilities. Payments to employees are $50,000
per year.

Let’s look at the cash flows. 15

Cash BasisCash
Accounting
flows in any one year may not be a
predictor of future cash flows.
Summary of Cash Flows
Year 1 Year 2 Year 3 Total
Cash receipts from
customers $ 50,000 $ 125,000 $ 125,000 $ 300,000
Payment of 3
years' rent (60,000) - - (60,000)
Salaries to
employees (50,000) (50,000) (50,000) (150,000)
Payments for
utilities (5,000) (15,000) (10,000) (30,000)
Net cash flow $ (65,000) $ 60,000 $ 65,000 $ 60,000

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Accrual Accounting
Summary of Operations
Year 1 Year 2 Year 3 Total

Revenue $ 100,000 $ 100,000 $ 100,000 $ 300,000

Rent expense (20,000) (20,000) (20,000) (60,000)

Salary expense (50,000) (50,000) (50,000) (150,000)

Utility expense (10,000) (10,000) (10,000) (30,000)

Income $ 20,000 $ 20,000 $ 20,000 $ 60,000

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Cash Basis vs. Accrual Basis Accounting
 Looking at the cash-basis and the
accrual-basis results for Carter Company,
which method would you want to use if
you were asked to make predictions about
future years’ operating performance?

 Accrual-basis earnings is a more

accurate measure of performance than
is cash- basis earnings.

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Cash Basis vs. Accrual Basis Accounting
 Information about enterprise
earnings and its components
measured by accrual accounting
generally provides a better
indication of enterprise performance
than does information about current
cash receipts and payments.
( SFAC No. 1)

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Example: Whole Foods Market Inc.
Discrepancies between earnings (net income) and cash flows
Year Net Income Total Accruals Cash Flows
1996 -17.23 17.58 0.35
1997 26.64 11.60 38.24
1998 45.40 30.94 76.33
1999 42.16 59.78 101.93
2000 28.93 57.44 86.36
2001 51.65 97.96 149.61
2002 84.49 89.32 173.81
2003 103.69 122.85 226.53
2004 132.66 145.19 277.85
2005 136.35 150.23 286.58
2006 203.83 208.94 412.76
Note: Amounts are in millions. 20