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Accrual vs. Cash

For the non-accountant, accrual accounting can seem as mysterious as Egyptian hieroglyphics. When working with basic small business financial statements, the accrual concept is easy to understand. However, in more complex business environments accrual accounting can become as exacting and tedious in its application as deciphering hieroglyphics. Fortunately, we are going to be discussing the
former, not the latter.

Let’s say you are in the business of selling T-shirts. Today you sold four T-shirts for $10 each. Two of the T-shirts sold were paid for with cash,i.e., $20. The other two were sold “on account”. In other words, the customers said they would pay you later. These two transactions have to be recorded differently on your books. Here is the journal entry for the first transaction.

DESCRIPTION	DEBIT	CREDIT
Cash	20.00
T-Shirt Sales		20.00
To record Cash sales

Does this make sense? Check it against the Accounting Model. You increased Cash and you increased Sales, so are the amounts recorded properly in the debit and credit columns?

How about the “pay you later” transaction? We call that a “receivable” because money is owed to the business. Here is how it looks in journal entry form:

ESCRIPTION	DEBIT	CREDIT
Accounts Receivable	20.00
T-Shirt Sales		20.00
To record Accrual sales

Sales are said to be “accrued” when the payment for the goods or services is deferred to a later date. But, you might ask: Why are both the Cash and Accounts Receivable amounts listed in the debit column? It should be obvious that the General Ledger (GL) Sales account belongs in the Revenue section, but what section do the GL accounts, Cash and Accounts Receivable belong? They are Assets. Why? Because both of the items represent an economic resource that your company has possession and control over that will provide a future benefit. What happens when an Asset is increased? The Accounting Model tells us that
an increase of an Asset belongs on the “debit” side of the ledger.

Thirty days later your customers send you checks totaling $20 to pay for the T-Shirts. Here is how the transaction is booked:

DESCRIPTION	DEBIT	CREDIT
Cash	20.00
Accounts Receivable		20.00
To record Cash “received on account” (ROA).

What happened here? You received $20 Cash, put it in the bank, and you eliminated or canceled out the amount owed to you on the books.

Let’s look at Accounts Payable next. In this situation, we will assume that you bought some inventory (T-Shirts) for resale. You bought four T-Shirts altogether. You paid cash for two shirts and the other two you bought “on account”. Here is what it looks like in journal entry form:

DESCRIPTION	DEBIT	CREDIT
Inventory	20.00
Cash		20.00
To record cash purchase of T-Shirts

DESCRIPTION	DEBIT	CREDIT
Inventory	20.00
Accounts Payable		20.00

DESCRIPTION	DEBIT	CREDIT
Accounts Payable	20.00
Cash		20.00
To record payment “on account”.

You decreased the Liability and decreased Cash. These are examples of the difference between an Accrual transaction and a Cash transaction.

Which one is better? It is not a question of better, it is a question of accuracy. If you include all accrual transactions on your books, the reader will have a more complete understanding of what is going on in your business than if only Cash transactions are recorded. Think about it with our examples. The Accrual
transactions would show more Assets, more Liabilities and more Revenue than the strictly Cash transactions. This reflects all the activity going on instead of just a portion. This is why the Financial Accounting Standards Board (FASB) requires that financial statements that are prepared using Generally Accepted Accounting Principles (GAAP) use the Accrual method of accounting.

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Detail of the General Ledger Report

The Detail of the General Ledger Report:
Your most valuable analytic tool

How in the world could anyone working in accounting get along without a Detail of the General Ledger report? That would be like working with your hands tied and your eyes blindfolded. Without this report you would have a very difficult time determining how a final balance in a particular account was derived. Here is why:

Picture this: Back in the not-to-distant past (before computers really caught on) we accountants recorded each transaction of the business manually into a great big hard-bound, three-leaf binder book with yellow pre-printed ledger pages. Obviously, this was a very time-consuming, tedious process. Each page not only recorded the numbers associated with the transaction, it also recorded where the numbers came from, the date, and, when appropriate, a very brief note to the side describing additional detail. Here is an example of a general ledger account page:

Account 1010 – Cash-in-Bank

Date	Source	Debit	Credit	Balance
12/31	Balance Forward			3,450.21
01/05	General Journal pg 2	54.00		3,504.21
01/17	General Journal pg 4		27.00	3,477.21
01/31	Cash Receipts pg1	8,025.34		11,502.55
01/31	Cash Disbursements pg 4		7,945.87	3,556.68

Transactions may come from a variety of journals, but they all pyramid into the General Ledger. I use the word “pyramid” because it is helpful to visualize the shape of a pyramid with all the source documents spread out at the base. The information is being summarized from each document and “migrates” upward to the General Ledger and eventually to the financial statements, which are at the top of the pyramid:

Fin State
Trial Balance
General Ledger
Gen Jour, Cash Rec, Cash Disb, Acct Rec, Acct Pay
Sales Invoices, Purchase Invoices, Bank Rec, Check Register

If I wanted to find out how a particular balance came to be, all I had to do was look at the detail on the general ledger page. That detail would then tell me which source documents contained the numbers that contributed to the final balance. I did not have search all over kingdom come to find what I was looking for.

Nowadays, your computer accounting software should give you a report of the detail in your General Ledger that is laid out as cleanly and clearly as presented above. Just like you would find in a manual general ledger. The report should not be encumbered with all kinds of other information that makes it hard to decipher. Some software programs don’t call this report a Detail of the General Ledger, they call it a transaction report or something similar.

Furthermore, you should be able to print a report for any period your heart desires, for instance: a year-to-date report; from February to July; for just one month; or whatever. You need that flexibility. If you need to see all twelve months of activity for a particular account, then you need to see all twelve months. You should not have to print out each month separately and then manually piece them together. And, if you only need to look at one month, you don’t want to have to print out the entire year.

A good report will enable you to use it as an analytic tool to find mistakes. Let’s assume that after printing your financial statements you looked at the Cash-in-Bank account and it said the balance was $3,556.38. Being the good accountant that you are, you verified that balance with the bank reconciliation balance and found that it said the balance should be $3,583.38. The difference between the two totals is $27.00. Your first step should be to run a Detail of the General Ledger report for the month, which you do and it is our example above. The first thing you notice is a $27.00 credit entry. This is suspicious and worth investigating. You can see that this entry came from the General Journal so you turn to page 4. Let’s hypothesize and assume that you really meant for this credit entry to go to Employee Advance, which is 1110. You simply wrote the wrong GL Account number.

We used to call this procedure “smoking out the error”. Sometimes the errors are easy to find, sometimes not so easy. The process consists of verifying the final balances that are on the financial statements. What is in the General Ledger should be what is on the financial statements. Therefore, you must use another document as a means of verifying the account balance. In our example above, we used the Bank Reconciliation. Other documents used to verify balances could be the Accounts Payable Ledger, Accounts Receivable Ledger, Sales Tax Report, Payroll History Report, Inventory Control Report, Notes Payable Amortization Schedule, and so on.

 

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Equity Accounts – It’s Your Money

Equity is the difference between assets and liabilities as shown on a balance sheet. In other words, equity represents the portion of assets that are fully owned by the owners (stockholders, partners, or proprietor) of a business.

When I prepare financial statements, I always review the general ledger (GL) account numbers that the client has coded on the check register. Whenever I see a balance sheet GL account number, I automatically double-check it. The reason I do this is that the balance sheet is the least understood part of the financial statements for most clients. This is especially true regarding the equity section. In a way, this is rather strange, since the equity section represents the owner’s share of the business. I would want to keep a very close eye on my investment and, to do that effectively, I would need to know the nature of each equity account and how to interpret the changes in those accounts as they occur.

If I am a sole proprietor, it’s not as crucial because everything in the equity section is mine. That’s not to diminish the importance of knowing what the accounts mean, as there are other good reasons to track the increases and decreases that occur within them. However, if I am a partner in a partnership or a stockholder in a corporation, it is my responsibility to protect my investment interest from mistakes and/or deliberate misstatements. This can be a challenge and accounting knowledge is required.

Sole Proprietor

The equity section title in a sole proprietorship is most commonly called “Owner’s Equity”. The accounts within this section are usually laid out in this fashion:

Owner’s Equity
Current Year Capital Contributions
Owner’s Draw
Net Profit or Loss

Look at the accounting model chart and find the equity section. An increase to the equity section requires a “credit” entry, while a decrease requires a “debit” entry. Following this “accounting logic”,
it makes sense that a contribution of personal money to the business requires a debit entry to Cash and a credit entry to Current Year Capital Contributions. On the other hand, if cash is removed from the business for personal reasons, a debit entry to Owner’s Draw and a credit entry to Cash would be required.

Furthermore, if the business showed a profit, that would indicate an increase in equity (credit), or if it showed a loss, that would indicate a decrease (debit) in equity.

Since the Owner’s Equity account (a credit balance account) is an “accumulation account”, all the other accounts are closed out at the end of the year into the Owner’s Equity account. This makes perfect sense when you follow the journal entries required to close out the accounts. For Instance:

Net Profit or Loss is automatically closed into Owner’s Equity at the end of the year by your computer. If a journal entry were written, it would look like this:

DESCRIPTION	DEBIT	CREDIT
Net Profit	50,000
Owner’s Equity		50,000

Or

DESCRIPTION	DEBIT	CREDIT
Owner’s Equity	5,000
Net Loss		5,000

DESCRIPTION	DEBIT	CREDIT
Owner’s Equity	20,000
Owner’s Draw		20,000

DESCRIPTION	DEBIT	CREDIT
Captial Contribution	2,000
Owner’s Equity		2,000

As you can see the function of the sole proprietor equity accounts is not complicated or difficult to understand.

Partnership

Depending on how many partners there are, partnership equity accounts usually are organized as follows under the title, “Partner’s Equity”:

Partner A, Capital Account
Partner B, Capital Account
Partner C. Capital Account
Net Profit or Loss

All the increases or decreases occur within the partner’s capital accounts. In other words, the partner capital accounts are the equity accounts. If a partner makes a capital contribution, then his/her capital account is increased (credit). If the partner takes a distribution, then the capital account is decreased (debit). If the business has a profit or a loss at the end of the year, then that profit
or loss is distributed among the partners at whatever ownership interest or other arrangement is appropriate.

General partners who work in the business are paid a management fee called a “guaranteed payment”. This fee is a legitimate business expense and therefore acts to lower the net profit of the business. This fee is similar to a salary paid to a working stockholder in a corporation, except, according
to U.S. tax law, a fee paid to a working partner cannot be run through payroll. It is treated as a draw, subject to self-employment taxes. Both the general partner’s guaranteed payment and share of the profits are taxable and subject to self-employment taxes.

Sometimes a business may not have enough cash to make a distribution to the partners even though the business realized a profit. Partners may have a rude awakening to discover that they still have to pay taxes on those profits regardless of whether they received any money.

Another scenario to be aware of if you are a non-working general partner or a limited partner is this one: You and your partner contributed an equal amount of cash for working capital. The reason for investing your money is because you expect to share in the profits. Your partner is a working partner and is entitled to receive a management fee for services rendered. You need to keep an eye on the books because there may never be a profit to share in if your partner simply continues to increase his/her management fee. It can be a sticky situation because the working partner may feel he/she is never making enough money to justify all the work he/she has to do. It is best to define what the management fee is going to be in the partnership agreement beforehand.

Corporation (Primarily closely held corporations)

Closely held (private) corporation equity accounts are a little more complicated than a sole proprietorship or partnership. These are the typical accounts found in the corporation equity section under the title, “Stockholder’s Equity”:

Retained Earnings
Paid-in-Capital
Dividends Paid
Common and/or Preferred Stock
Net Profit or Loss

Retained Earnings is similar to the Owner’s Equity account in that the Net Profit or Loss is closed into that account at the end of each accounting year. Paid-in-Capital is the account used to record capital contributions made by stockholders. Keep in mind, as in the examples above, that increases to an equity account are credits. For example:

DESCRIPTION	DEBIT	CREDIT
Cash	5,000
Paid-in-Capital		5,000

If dividends were paid the journal entry would look like this:

DESCRIPTION	DEBIT	CREDIT
Dividends Paid	10,000
Cash		10,000

When common stock is sold or issued to raise money or acquire property:

DESCRIPTION	DEBIT	CREDIT
Cash	100,000
Common Stock		100,000

When Net Profit is closed out for the year:

DESCRIPTION	DEBIT	CREDIT
Net Profit	20,000
Retained Earnings		20,000

These accounts are also found on public corporations, however they may have additional equity accounts that are necessary to explain more complex activities.

You can see that the equity accounts in all three business entities function in a similar manner. From year to year, there should be continuity. This means there should be a logical explanation for any increases or decreases in theequity accounts. As an investor or owner, you have a right to know the reasons for any changes. If there has been a mistake, willful or otherwise, it is most likely going to show up in the equity section. Stay vigilant and protect your investment.