- Understand the difference between cash-basis and accrual accounting.
- Understand the purpose of a statement of cash flows and describe its format.
In this section, we’re going to take a step further into the world of accounting by examining the principles of accrual accounting. In our Stress-Buster illustration, we’ve assumed that all your transactions have been made in cash: You paid cash for your inputs (plastic treasure chests and toys) and for your other expenses, and your customers paid cash when they bought Stress-Buster packs. In the real world, of course, things are rarely that simple. In the following cases, timing plays a role in making and receiving payments:
- Customers don’t always pay in cash; they often buy something and pay later. When this happens, the seller is owed money and has an account receivable (it will receive something later).
- Companies don’t generally pay cash for materials and other expenses—they often pay later. If this is the case, the buyer has an account payable (it will pay something later).
- Many companies manufacture or buy goods and hold them in inventory before selling them. Under these circumstances, they don’t report payment for the goods until they’ve been sold.
- Companies buy long-term assets (also called fixed assets), such as cars, buildings, and equipment, which they plan to use over an extended period (as a rule, for more than one year).
What Is Accrual Accounting?
In situations such as these, firms use accrual accounting: a system in which the accountant records a transaction when it occurs, without waiting until cash is paid out or received. Here are a few basic principles of accrual accounting:
- A sale is recognized on the income statement when it takes place, regardless of when cash is collected.
- An expense is recognized on the income statement when it’s incurred, regardless of when payment is made.
- An item manufactured for later sale or bought for resale becomes part of inventory and appears on the balance sheet until it’s actually sold; at that point, it goes on the income statement under cost of goods sold.
- A long-term asset that will be used for several years—for example, a vehicle, machine, or building—appears on the balance sheet. Its cost is spread over its useful life—the number of years that it will be used. Its annual allocated cost appears on the income statement as a depreciation expense.
Going to School on a New Business Idea
As we saw in our Stress-Buster illustration, it’s easier to make sense of accounting concepts when you see some real—or at least realistic—numbers being put to realistic use. So let’s now assume that you successfully operated the Stress-Buster Company while you were in college. Now fast-forward to graduation, and rather than work for someone else, you’ve decided to set up a more ambitious business—some kind of retail outlet—close to the college. During your four years in school, you noticed that there was no store near campus that met the wide range of students’ specific needs. Thus the mission of your proposed retail business: to provide products that satisfy the specific needs of college students.