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CHAPTER TEN

Learn about the accrual basis and cash basis of accounting for professional service businesses. Understand the advantages and disadvantages of each method and how they impact revenue and expense recognition.

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CHAPTER TEN

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  1. CHAPTER TEN ACCOUNTING FOR A PROFESSIONAL SERVICE BUSINESS: THE COMBINATION JOURNAL

  2. ACCRUAL BASIS OF ACCOUNTING • Offers the best matching of revenues and expenses • Required under Generally Accepted Accounting Principles: • Important when major businesses want to raise large amounts of money • Smaller service organizations often use the Cash or Modified Cash Basis

  3. CASH BASIS OF ACCOUNTING • Revenues are recorded when cash is RECEIVED • Expenses are recorded when cash is PAID • Similar to Accrual Basis if: • There are few receivables, payables, and assets • Can vary significantly if: • Business has many receivables, payables, and assets

  4. CASH BASIS OF ACCOUNTING Since this method records revenues only when the cash is received: There is no Accounts Receivable account

  5. CASH BASIS OF ACCOUNTING Since this method records expenses only when cash is paid: There is no Accounts Payable account

  6. CASH BASIS OF ACCOUNTING All cash spent is recorded as an expense, therefore: There are no Long-term Assets and no Prepaid Assets

  7. ACCRUAL BASIS vs CASH BASIS Let’s look at some transactions and see how they are recorded under each of the methods.

  8. Accrual Basis Cash Basis Expense Revenue Expense Revenue Transaction (a) Provided services on account $600 $600 The Accrual Basis would say this is revenue, since services were provided to a client.

  9. Accrual Basis Cash Basis Transaction Revenue Expense Expense Revenue (a) Provided services on account $600 $600 But the Cash Basis does NOT recognize the revenue, since cash was not received.

  10. Accrual Basis Cash Basis Transaction Expense Revenue Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 The Accrual Basis considers the payment of wages an expense, since services were received.

  11. Accrual Basis Cash Basis Transaction Expense Expense Revenue Revenue (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 The Cash Basis also considers the payment of wages an expense, since cash was received.

  12. Accrual Basis Cash Basis Revenue Expense Revenue Expense Transaction (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 Under the Accrual Basis, revenue would have been recognized last month (the month it was earned).

  13. Accrual Basis Cash Basis Transaction Expense Revenue Expense Revenue (a) Provided services on account $600 $600 $300 (b) Paid wages $300 $300 (c) Received cash for services performed on account last month $200 $200 The Cash Basis, however, would recognize the revenue this month (the month the cash was received).

  14. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 Accrual Basis says Services Received = Expense

  15. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 Cash Basis says: No Cash…. No Expense

  16. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 Accrual Basis would have shown the expense last month (when advertising occurred).

  17. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 Cash Basis says: Cash Paid = Expense

  18. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 (f) Purchase of supplies $50 Accrual Basis says: Supplies are an asset, not an Expense.

  19. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 Cash Basis says: Cash spent = Expense

  20. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 (g) Supplies used during month, $40 $40 Accrual Basis says: Asset consumed = Expense

  21. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 (g) Supplies used during month, $40 $40 Cash Basis says: No Cash spent, No Expense.

  22. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 (g) Supplies used during month, $40 $40 Let’s look at the Net Income under each method.

  23. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 (g) Supplies used during month, $40 $40 $590 $600 Net Income (Loss) $10

  24. Accrual Basis Cash Basis Transaction Revenue Expense Revenue Expense (a) Provided services on account $600 $600 (b) Paid wages $300 $300 $300 (c) Received cash for services performed on account last month $200 Net Incomes (Losses) are very different!! $200 (d) Received cleaning bill for month $250 $250 (e) Paid on account for last month’s advertising $100 $100 $50 (f) Purchase of supplies $50 (g) Supplies used during month, $40 $40 $590 $200 $600 $450 ($250) $10 Net Income (Loss)

  25. MODIFIED CASH BASIS • Combines aspects of the Cash and Accrual methods • Revenues and Expenses: • Cash Basis • Except for assets with a useful life > 1 accounting period • Recorded as assets (e.g., Prepaid Insurance, Supplies, Equipment, Building, etc.)

  26. MODIFIED CASH BASIS Unlike the Cash Basis, the Modified Cash Basis uses the following accounts: Accounts Payable (for asset purchases only) Long-Term Assets Prepaid Assets

  27. COMPARISON OF METHODS Revenue example: Performed services for cash

  28. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Cash Profess. Fees Cash Basis would consider this revenue because cash was received.

  29. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Cash Cash Profess. Fees Profess. Fees Modified Cash Basis uses the same criteria for determining revenues…. Cash Received = Revenue

  30. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Cash Cash Cash Profess. Fees Profess. Fees Profess. Fees Accrual Basis records this as a revenue…. Services Performed = Revenue

  31. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Cash Cash Cash Profess. Fees Profess. Fees Profess. Fees SAME ENTRY For all 3 methods

  32. REVENUE EXAMPLE Performed services on account

  33. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS No Entry Cash Basis would NOT consider this revenue because cash was not received.

  34. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS No Entry No Entry Modified Cash Basis also would NOT consider this revenue because cash was not received.

  35. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS No Entry Accts. Rec. No Entry Profess. Fees Accrual Basis DOES consider this revenue. Services Performed = Revenue

  36. EXPENSE EXAMPLE Pay cash for operating expenses (e.g., Wages, Advertising, Rent, Telephone, etc.)

  37. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Cash Cash Basis would consider this an expense since cash was spent.

  38. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Expense Cash Cash Modified Cash Basis would also consider this an expense since cash was spent.

  39. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Expense Expense Cash Cash Cash Accrual Basis would also consider this an expense because services were received.

  40. EXPENSE/ASSET EXAMPLE Pay cash for prepaid items (e.g., Insurance, Supplies, etc.)

  41. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Cash Cash Basis would consider this an expense since cash was spent.

  42. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Prepaid Asset Cash Cash Modified Cash Basis: Sets up an asset account for items that will last more than one accounting period.

  43. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Prepaid Asset Prepaid Asset Cash Cash Cash Accrual Basis: An asset account is debited for items that will benefit more than one accounting period.

  44. EXPENSE/ASSET EXAMPLE Pay cash for property, plant, and equipment

  45. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense Cash Cash Basis would still consider this an expense, causing a large reduction in profits this year.

  46. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense PP&E Asset Cash Cash Modified Cash Basis: Follows the Accrual Basis and sets up an asset account for items that will last more than one accounting period.

  47. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS Expense PP&E Asset PP&E Asset Cash Cash Cash Accrual Basis records Property, Plant, & Equipment as assets so their cost can be expensed (depreciated) over their useful lives.

  48. EXPENSE/ASSET EXAMPLE Received a bill for services received

  49. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS No Entry No Entry is made since No Cash was exchanged.

  50. JOURNAL ENTRY COMPARISON MODIFIED CASH BASIS ACCRUAL BASIS CASH BASIS No Entry No Entry Modified Cash Basis also would NOT journalize this event. No Cash was received or spent.

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