The ledger of Hammond Company

One of the factors considered in the timing issues of adjusting accounts is the Accrual- vs. Cash-Basis Accounting

Accrual- vs. Cash-Basis Accounting

Accrual and cash basis accounting considers the time to record transactions. Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when earned (rather than when they receive cash). It also means recognizing expenses when incurred (rather than when paid).

An alternative to the accrual basis is the cash basis. Under cash-basis accounting, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue that a company has earned but for which it has not received the cash. Also, it does not match expenses with earned revenues.

Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). Individuals and some small companies do use cash-basis accounting. The cash basis is justified for small businesses because they often have few receivables and payables. Medium and large companies use accrual-basis accounting.

Recognizing Revenues and Expenses

It can be difficult to determine the amount of revenues and expenses to report in a given accounting period. There are two principles that guide the reporting of revenues and expenses. They are:

• The revenue recognition principle
• Expense recognition principle.

REVENUE RECOGNITION PRINCIPLE

The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is considered to be earned at the time the service is performed.  If cash is yet to be collected for revenue earned at the time of preparing the financial report, it is recorded as a receivable on its balance sheet and revenue in its income statement.

EXPENSE RECOGNITION PRINCIPLE

Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. The matching principle is the practice of matching revenues with expenses.

 These principles of adjusting account is illustrated using the Hammond Company.

The ledger of Hammond Company, on March 31, 2012, includes these selected accounts before adjusting entries are prepared.

An analysis of the accounts shows the following.

1. Insurance expires at the rate of $100 per month.

2. Supplies on hand total $800.

3. The equipment depreciates $200 a month.

4. One-half of the unearned service revenue was earned in March.

Prepare the adjusting entries for the month of March.

Solution

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