Cash basis accounting produces a measure of performance called net operating cash flow. This measure is the difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers. On the other hand, the accrual accounting model measures an entity’s accomplishments (revenues) and resource sacrifices (expenses) during the period, regardless of when cash is received or paid.
In most cases, the accrual accounting model provides a better measure of performance because it attempts to measure the accomplishments and sacrifices that occurred during the year, which may not correspond to cash inflows and outflows.
Adjusting entries, for the most part, are conversions from cash to accrual. Prepayments and accruals occur when cash flow precedes or follows expense or revenue recognition.
Cash-basis net income $26,000
Add: 1. Unexpired (prepaid insurance) $12,000 x 8/12 8,000
2. Increase in accounts receivable ($6,500 – 5,000) 1,500
5. Increase in inventories ($35,000 – 32,000) 3,000
Deduct: 3. Increase in wages payable ($8,200 – 7,200) (1,000)
4. Increase in utilities payable ($1,200 – 900) (300)
6. Increase in amount owed to suppliers (4,000)
Accrual basis net income $33,200
Assets would be higher by $12,500 ($8,000 + 1,500 + 3,000) and liabilities would also be higher by $5,300 ($1,000 + 300 + 4,000). The difference, $7,200, is the difference between cash and accrual income. Therefore, equity would be higher by $7,200.
Prepaymentsoccur when the cash flow precedes either expense or revenue recognition. Accrualsoccur when the cash flow comes after either expense or revenue recognition.
The appropriate adjusting entry for a prepaid expense is a debit to expense and a credit to the prepaid asset. For unearned revenue, the appropriate adjusting entry is a debit to the unearned revenue liability account and a credit to revenue. Failure to record an adjusting entry for a prepaid expense will cause assets and shareholders’ equity to be overstated. Failure to record an adjusting entry for unearned revenue will cause liabilities to be overstated and shareholders’ equity to be understated.
The required adjusting entry for accrued liabilities is a debit to expense and a credit to a liability. For accrued receivables, the appropriate adjusting entry is a debit to a receivable and a credit to revenue. Failure to record an adjusting entry for an accrued liability will cause liabilities to be understated and shareholders’ equity to be overstated. Failure to record an adjusting entry for accrued receivables will cause assets and shareholders’ equity to be understated.