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Sunday, September 5, 2010

Financial Accruals - Made Simple

Since I felt "ambitious", I decided to do some fun reading in an accounting textbook on accruals since this was something that I had seemed to miss in a lecture when I was in college. Finally, I understand the differences among the four types! Since I am so excited about it, I will share my new found knowledge here. (Prepare to be bored!)

There are two types of accruals-- cash movement prior to accounting recognition and cash movement after accounting recognition. Here, recognition just means recognizing the transaction on the financial statement, which in this case, really it's just the income statement. And since we are talking about the income statement, cash movement affects revenue and expense (since these are the top lines before one reaches net income-- remember that Net Income = Revenue - Expense). So, you see, there are four possible options here, just write out a 2 (cash movement: prior, after) x 2 (income statement: revenue, expense) matrix so you can organize your thoughts.

Box #1: Prior x Revenue
Unearned (Deferred) Revenue--
Originating entry-- record cash receipt and establish a liability (such as unearned revenue).
Adjusting entry-- reduce the liability while recording revenue

Box #2: Prior x Expense
Pre-paid Expense--
Originating entry-- record cash payment and establish an asset (such as prepaid expense)
Adjusting entry-- reduce the asset while recording expense

Box #3: After x Revenue
Unbilled (Accrued Revenue)--
Originating entry-- record revenue and establish an asset (such as unbilled revenue)
Adjusting entry-- when billing occurs, reduce unbilled revenue and increase accounts receivable. When cash is collected, eliminate the receivable.

Box #4: After x Expense
Accrued Expenses--
Originating entry-- establish a liability (such as accrued expenses) and record an expense
Adjusting entry-- reduce the liability as cash is paid

I guess I used to get confused by this topic because I always forget whether the originating entry is an asset or a liability. And now this chart makes it simple, because basically if the cash movement happened before accounting recognition, then it's recorded as an opposite to what the name suggests. For example, unearned revenue is a liability and a prepaid expense is an asset. On the other hand, if the cash movement happened after accounting recognition, then it follows what the name suggests. For example, unbilled revenue is an asset and accrued expense is an expense.

Do you get it?????

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