Accrual Basis Accounting

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.
b. Revenue is realized or realizable.
Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).
Revenue is earned when products are delivered or services are provided.
Realized means cash is received.
Realizable means it is reasonable to expect that cash will be received in the future.


Cash Basis Accounting

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.

Timing differences in recognizing revenues and expenses
There are potential timing differences in recognizing revenues and expenses between accrual basis and cash basis accounting.

Four types of timing differences
If a company uses accrual basis accounting, there are four cases where revenue and expense recognition may not coincide with cash transactions.

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.
Example: Products are sold at $5,000 on May 1, 1999 and cash is received on May 10, 1999.

May 1, 1999 May 10, 1999
Revenue is recognized. Cash is received.
[Journal entry on May 1, 1999]

Debit Credit
Accounts receivable 5,000
Sales 5,000
[Journal entry on May 10, 1999]

Debit Credit
Cash 5,000
Accounts receivable 5,000

Case 2: Expense is recognized before cash is paid.
Example: On May 1, 1999, Company A borrowed $100,000 from a bank and promised to pay 12% interest at the end of each quarter.

May 31, 1999 June 30, 1999
Interest expense is recognized for May. Cash is paid at the end of the quarter.
[Journal entry on May 1, 1999]

Debit Credit
Cash 100,000
Borrowings from bank 100,000
[Journal entry on May 31, 1999]

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, 1999]

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.
Example: On May 1, 1999, Company A had a new lease contract with a tenant and received $6,000 for two month rent.

May 1, 1999 May 31 and June 30 1999
Cash is received. 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, 1999]

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, 1999]

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, 1999]

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.
Example: Company A purchased an insurance for a period from May 1, 1999 to July 31, 1999 and paid $6,000 cash for three month insurance premium.

May 1, 1999 May 31, June 30, July 31, 1999
Cash is paid. Expense is recognized at the end of May, June and July.
[Journal entry on May 1, 1999]

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, 1999]

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, 1999]

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, 1999]

Debit Credit
Insurance expense 2,000
Prepaid insurance 2,000
Credit side of prepaid insurance (an asset account) represents a decrease.