Let’s consider the following example:
VTC completes a safari trek for a customer on December 15 and the customer agrees to make the payment of 200,000 on January 15.
Under cash accounting, when will VTC recognize the transaction?
Under accrual accounting, when will VTC recognize the transaction?
VTC completes a safari trek for a customer on December 15 and the customer agrees to make the payment of 200,000 on January 15.
Take a few minutes to think about this
Cash accounting:
VTC would recognize the transaction on January 15 when the customer pays because under cash accounting we only recognize transactions when cash is exchanged
VTC would record the following journal entry:
Debit – Cash 200,000
Credit – Tour revenue 200,000
Qs: Under cash accounting when will VTC recognize the transaction?
The transaction will be recorded on January 15 because that is when cash is exchanged (VTC receives cash for the services provided on December 15)
Qs: And what is the journal entry to post?
Accrual accounting:
VTC would recognize the transaction on December 15 when the safari trek is complete because on that date:
The event occurred (VTC delivered the service to the customer)
The amount can be measured reliably (the value of the service was 200,000)
Qs: Under accrual accounting when will VTC recognize the transaction?
Looking back at the criteria:
- The event occurred
- The amount can be measured reliably
In fact, in this situation, there are 2 transactions. Qs: Can you tell me what the two transactions or two journal entries are?
VTC would record the following journal entries:
December 15:
Debit – Accounts receivable 200,000
Credit – Tour revenue 200,000
January 15:
Debit – Cash 200,000
Credit – Accounts receivable 200,000
Qs: What are accounts receivable?
– Assets
When is the revenue recorded?
Cash accounting: JANUARY
Accrual accounting: DECEMBER
When was the service delivered?
DECEMBER
What do we see here? Under accrual accounting, the revenue is matched to period when the service is delivered
Cash accounting is NOT appropriate because it fails to capture the economic substance of the events
In the prior example, on December 15, did VTC earn revenue?
Under cash accounting, we are not reflecting the economic benefit that flows to VTC from completing the safari trek (the accounts receivable from the customer, which is an asset)
We are both understating assets (accounts receivable) and revenue in December because we do not record until January
Let’s consider another example:
VTC receives a bill on January 31 for 20,000 from WASAC for water consumed in the month. On February 15, VTC pays 20,000 to WASAC.
Under cash accounting, when will VTC recognize the transaction?
Under accrual accounting, when will VTC recognize the transaction?
Take a few minutes to note down your answers in your workbook.
NOTE: Student version is a different. We removed “receive bill on February 10”
VTC’s office consumes 20,000 worth of water in the month of January. On February 15, VTC pays the amount to WASAC.
Qs: I will give you a few minutes to think about this. Jot down both the cash accounting journal entries and the accrual accounting entries. Remember under accrual accounting, think about when we expect a change in the future cash flows of the company and what are the appropriate journal entries and one which date to capture those changes.
Cash accounting:
VTC would recognize the transaction on February 15 when it pays WASAC 20,000 because under cash accounting we only recognize the transaction when cash is exchanged
VTC would record the following journal entry:
Debit – Water expense 20,000
Credit – Cash 20,000
Qs: Can you tell me what your answer was?
Accrual accounting:
VTC would recognize the transaction at the end of January because at the end of January:
The event occurred (VTC consumed the water in January)
The amount can be measured reliably (the value of the water was 20,000)
In other words, VTC has consumed the water without paying for it. It has an obligation (liability) to pay WASAC.
Qs: When will VTC record the transactions and why?
At the end of January, VTC is now obligated to pay WASAC for the water consumed. So we expect the company’s future cash flows to change.
VTC would record the following journal entries:
January 31:
Debit – Water expense 20,000
Credit – Accrued liabilities 20,000
February 15:
Debit – Accrued liabilities 20,000
Credit – Cash 20,000
Qs: What were your journal entries?
- Could also record an account payable on January 31. Accounts payable are recorded when bills are received. So if a bill was received from WASAC on January 31, we would record an accounts payable
The purpose of this example was just to illustrate the difference between cash and accrual accounting, we will go in more detail later in the lesson
When is the expense recorded?
Cash accounting: FEBRUARY
Accrual accounting: JANUARY
When was the expense incurred?
JANUARY