Two overall accounting methods exist: the cash basis method and the accrual basis method. If using the cash basis method, revenue is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers and employees. When using the accrual basis, revenue is recorded when earned and expenses are recorded when consumed. Companies use the accrual method to report revenue and expenses in the proper accounting period, because many times, cash movement can occur before or after these events have been recognized on financial statements.
There are four main types of accrual entries; each of them involves an originating entry and at least one adjusting entry which are completed at a later date, or in some situations, dates. It is very important that candidates in the CFA program, especially those studying for the Level 1 exam, understand these four types of entries and the theory behind them. Remember, accrue means to receive, and defer means to put off to a later time.
Unearned revenue is when a company receives funds for a service that they have not yet provided. An example of this would be a magazine subscription company receiving money from a customer for an annual subscription: the customer has paid for a full year of magazines and the company now has to fulfill that obligation. The originating entry of this transaction would be to record a cash receipt and establish a liability. These two transactions would affect the asset side and the liability side of the accounting equation, keeping it in balance.
When the company starts delivering monthly magazines, they can begin to adjust that original liability entry by reducing it, and also record the revenue: the liability account is reduced, and the net income account (part of owner’s equity) is increased that same amount. The asset portion of the balance sheet is not affected in the adjusting entry, only the liability entry and net income because the payment has already been received.
Prepaid expenses arise when a company makes a payment before they are able to recognize the expense. These are very common and examples of this type of accrual are paying rent, as well as paying for insurance. Companies can pay for expenditures in one accounting period, but not consume it until a future period.
To record prepaid expenses, you will credit the cash account, and either debit an already existing account or create a new one (for the insurance example, the account name could be prepaid insurance). For the originating entry, the asset side is the only section of the accounting equation affected. The adjusting entry for this type of accrual will be a reduction of the asset created, and the recording of an expense. The asset side of the account equation will be reduced by the same amount the equity section (net income account) is, making the equation stay in balance.
Another term for accrued revenue is unbilled revenue, and this occurs when a company earns revenue prior to receiving cash for either the sale of a product or service. An example would be a company representing the sales of their products by using the accounts receivables account – the company has recognized the revenue but has not relieved the cash yet.
This type of accrual is more complicated than the rest because there are three sections, the originating entry, and two adjusting entries. First, you would record unbilled revenue by acknowledging the revenue and establishing an asset such as unbilled revenue. This would affect both the asset and equity section of the accounting equation, keeping it in balance. When billing occurs, you would reduce the unbilled revenue asset and increase accounts receivables. Finally, once payment starts to be received, you would recognize cash and credit accounts receivable.
Completely opposite from a prepaid expense, an accrued expense is an expense recognized in the books of a company before it is paid for. To record these, establish the liability and record the expense. Some examples of an accrued expense are wages, interest, and taxes.
To reflect incurred wage expenses at the end of an accounting period, a wage expense would be recognized and a liability, such as wages payable, would be created. To adjust this in the future, the liability will be credited as cash is paid out. This type of accrual affects the accounting equation in the following way: the liability and the wage expense only affect the liability and equity section of the balance sheet, and offset each other keeping the equation balanced. The adjusting entry will credit cash and the liability, affecting the asset and liability section of the balance sheet equally, keeping it in balance.
Accounts payable are similar to accrued expenses; however, they involve the receipt of inventory. Accounts payable should be recognized separately from other accrued expenses on the balance sheet because of their different nature.
Because of complex business practices, companies need to use the accrual method of accounting to accurately report revenue and expenses in the proper accounting period. It is extremely beneficial to understand the theory behind these four types of transactions, especially if you are preparing for the Level 1 CFA exam. The CFA curriculum will build upon these four concepts, so it is smart to understand them early.