3.2: The Operating Cycle

Learning Objective

Explain how the timeliness, matching, and recognition GAAP require the recording of adjusting entries.

Financial transactions occur continuously during an accounting period as part of a sequence of operating activities. For Big Dog Carworks Corp., this sequence of operating activities takes the following form:

1. Operations begin with some cash on hand.
2. Cash is used to purchase supplies and to pay expenses.
3. Revenue is earned as repair services are completed for customers.
4. Cash is collected from customers.

This cash-to-cash sequence of transactions is commonly referred to as an operating cycle and is illustrated in Figure 3.1.1.

Figure \(\PageIndex{1}\): One Operating Cycle

Depending on the type of business, an operating cycle can vary in duration from short, such as one week (e.g., a grocery store) to much longer, such as one year (e.g., a car dealership). Therefore, an annual accounting period could involve multiple operating cycles as shown in Figure 3.1.2.

Figure \(\PageIndex{2}\): Operating Cycles Within an Annual Accounting Period

Notice that not all of the operating cycles in Figure 3.2 are completed within the accounting period. Since financial statements are prepared at specific time intervals to meet the GAAP requirement of timeliness, it is necessary to consider how to record and report transactions related to the accounting period's incomplete operating cycles. Two GAAP requirements — recognition and matching — provide guidance in this area, and are the topic of the next sections.

Recognition Principle in More Detail

GAAP provide guidance about when an economic activity should be recognized in financial statements. An economic activity is recognized when it meets two criteria:

1. it is probable that any future economic benefit associated with the item will flow to the business; and
2. it has a value that can be measured with reliability.

Revenue Recognition Illustrated

Revenue recognition is the process of recording revenue in the accounting period in which it was earned; this is not necessarily when cash is received. Most corporations assume that revenue has been earned at an objectively-determined point in the accounting cycle. For instance, it is often convenient to recognize revenue at the point when a sales invoice has been sent to a customer and the related goods have been received or services performed. This point can occur before receipt of cash from a customer, creating an asset called Accounts Receivable and resulting in the following entry:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Accounts Receivable		XX
	Revenue			XX
	To record revenue earned on account.

When cash payment is later received, the asset Accounts Receivable is exchanged for the asset Cash and the following entry is made:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Cash		XX
	Accounts Receivable			XX
	To record cash received from credit customer.

Revenue is recognized in the first entry (the credit to revenue), prior to the receipt of cash. The second entry has no effect on revenue.

When cash is received at the same time that revenue is recognized, the following entry is made:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Cash		XX
	Revenue			XX
	To record cash received from customer.

When a cash deposit or advance payment is obtained before revenue is earned, a liability called Unearned Revenue is recorded as follows:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Cash		XX
	Unearned Revenue			XX
	To record cash received from customer for work to be done in the future.

Revenue is not recognized until the services have been performed. At that time, the following entry is made:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Unearned Revenue		XX
	Revenue			XX
	To record the earned portion of Unearned Revenue.

The preceding entry reduces the unearned revenue account by the amount of revenue earned.

The matching of revenue to a particular time period, regardless of when cash is received, is an example of accrual accounting. Accrual accounting is the process of recognizing revenues when earned and expenses when incurred regardless of when cash is exchanged; it forms the basis of GAAP. Recognition of expenses is discussed in the next section.

Expense Recognition Illustrated

In a business, costs are incurred continuously. To review, a cost is recorded as an asset if it will be incurred in producing revenue in future accounting periods. A cost is recorded as an expense if it will be used or consumed during the current period to earn revenue. This distinction between types of cost outlays is illustrated in Figure 3.1.3.

Figure \(\PageIndex{3}\): The Interrelationship Between Assets and Expense

In the previous section regarding revenue recognition, journal entries illustrated three scenarios where revenue was recognized before, at the same time as, and after cash was received. Similarly, expenses can be incurred before, at the same time as, or after cash is paid out. An example of when expenses are incurred before cash is paid occurs when the utilities expense for January is not paid until February. In this case, an account payable is created in January as follows:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Utilities Expense		XX
	Accounts Payable (or Utilities Payable)			XX
	To record January utilities expense to be paid in February.

The utilities expense is reported in the January income statement.

When the January utilities are paid in February, the following is recorded:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Accounts Payable (or Utilities Payable)		XX
	Cash			XX
	To record payment in February of utilities used in January.

The preceding entry has no effect on expenses reported on the February income statement.

Expenses can also be recorded at the same time that cash is paid. For example, if salaries for January are paid on January 31, the entry on January 31 is:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Salaries Expense		XX
	Cash			XX
	To record payment of January salaries.

As a result of this entry, salaries expense is reported on the January income statement when cash is paid.

Finally, a cash payment can be made before the expense is incurred, such as insurance paid in advance. A prepayment of insurance creates an asset Prepaid Insurance and is recorded as:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Prepaid Insurance		XX
	Cash			XX
	To record payment of insurance in advance.

As the prepaid insurance is used, it is appropriate to report an expense on the income statement by recording the following entry:

General Journal
Date	Account/Explanation	F	Debit	Credit
	Insurance Expense		XX
	Prepaid Insurance			XX
	To record the use of Prepaid Insurance.

The preceding examples illustrate how to match expenses to the appropriate accounting period. The matching principle requires that expenses be reported in the same period as the revenues they helped generate. That is, expenses are reported on the income statement: a) when related revenue is recognized, or b) during the appropriate time period, regardless of when cash is paid.

To ensure the recognition and matching of revenues and expenses to the correct accounting period, account balances must be reviewed and adjusted prior to the preparation of financial statements. This is the topic of the next section.