Accounting Basics 1

accrual basis of accounting

The accounting method under which revenues are recognized on the income statement when they are
earned (rather than when the cash is received). The balance sheet is also affected at the time of the
revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts
Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service
was performed after the customer had paid in advance for the service).

Under the accrual basis of accounting, expenses are matched with revenues on the income statement
when the expenses expire or title has transferred to the buyer, rather than at the time when expenses
are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the
expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense
will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).

revenue recognition principle

The accounting guideline requiring that revenues be shown on the income statement in the period in
which they are earned, not in the period when the cash is collected. This is part of the accrual basis of
accounting (as opposed to the cash basis of accounting).

accounts receivable

A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a)
net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.

matching principle

The principle that requires a company to match expenses with related revenues in order to report a
company's profitability during a specified time interval. Ideally, the matching is based on a cause and
effect relationship: sales causes the cost of goods sold expense and the sales commissions expense. If no
cause and effect relationship exists, accountants will show an expense in the accounting period when a
cost is used up or has expired. Lastly, if a cost cannot be linked to revenues or to an accounting period,
the expense will be recorded immediately. An example of this is Advertising Expense and Research and
Development Expense.

interest expense

This account is a non-operating or "other" expense for the cost of borrowed money or other credit. The
amount of interest expense appearing on the income statement is the cost of the money that was used
during the time interval shown in the heading of the income statement, not the amount of interest paid
during that period.

accounts receivable

A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a)
net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.
prepaid expense

A current asset representing amounts paid in advance for future expenses. As the expenses are used or
expire, expense is increased and prepaid expense is decreased.

insurance expense

The amount of insurance that was incurred/used up/expired during the period appearing in the heading
of the income statement. The amount of insurance premiums that have not yet expired should be
reported in the current asset account Prepaid Insurance.

prepaid insurance

A current asset which indicates the cost of the insurance contract (premiums) that have been paid in
advance. It represents the amount that has been paid but has not yet expired as of the balance sheet
date.

A related account is Insurance Expense, which appears on the income statement. The amount in the
Insurance Expense account should report the amount of insurance expense expiring during the period
indicated in the heading of the income statement.

cost principle

The accounting guideline requiring amounts in the accounts and on the financial statements to be the
actual cost rather than the current value. Accountants can show an amount less than cost due to
conservatism, but accountants are generally prohibited from showing amounts greater than cost.
(Certain investments will be shown at fair value instead of cost.)

conservatism

This accounting guideline states that if doubt exists between two acceptable alternatives (in other words
the accountant needs to break a tie), the accountant should choose the alternative that will result in a
lesser asset amount and/or a lesser profit. A classic example is inventory where the net realizable value
(NRV) is less than the actual cost. The accountant must decide whether to leave the inventory at cost or
to reduce the inventory amount to its NRV. Conservatism directs the accountant to reduce the inventory
to the lower amount (NRV). This results in a lower asset amount and a debit to an income statement
account, such as Loss from Reducing Inventory to NRV.

net realizable value (NRV)

In the context of inventory, net realizable value or NRV is the expected selling price in the ordinary
course of business minus the costs of completion, disposal, and transportation.

In the context of accounts receivable, it is the amount of accounts receivable that is expected to be
collected. This should be the debit balance in Accounts Receivable minus the credit balance in Allowance
for Doubtful Accounts.

You could think of NRV as the cash realizable value.

matching principle

The principle that requires a company to match expenses with related revenues in order to report a
company's profitability during a specified time interval. Ideally, the matching is based on a cause and
effect relationship: sales causes the cost of goods sold expense and the sales commissions expense. If no
cause and effect relationship exists, accountants will show an expense in the accounting period when a
cost is used up or has expired. Lastly, if a cost cannot be linked to revenues or to an accounting period,
the expense will be recorded immediately. An example of this is Advertising Expense and Research and
Development Expense.

depreciation expense

The income statement account which contains a portion of the cost of plant and equipment that is being
matched to the time interval shown in the heading of the income statement. (There is no depreciation
expense for land.)
liabilities

Obligations of a company or organization. Amounts owed to lenders and suppliers. Liabilities often have
the word "payable" in the account title. Liabilities also include amounts received in advance for a future
sale or for a future service to be performed. To learn more, see Explanation of Balance Sheet.

unearned revenue(s)

A liability account that reports amounts received in advance of providing goods or services. When the
goods or services are provided, this account balance is decreased and a revenue account is increased. To
learn more, see Explanation of Adjusting Entries.

service revenues

Under the accrual basis of accounting, the Service Revenues account reports the fees earned by a
company during the time indicated in the heading of the income statement. Service Revenues include
work completed whether it was billed. Service Revenues is an operating revenue account and will
appear at the beginning of the company's income statement.

chart of accounts

A listing of the accounts available in the accounting system in which to record entries. The chart of
accounts consists of balance sheet accounts (assets, liabilities, stockholders' equity) and income
statement accounts (revenues, expenses, gains, losses). The chart of accounts can be expanded and
tailored to reflect the operations of the company.

A general ledger account is an account or record used to sort and store balance sheet and income
statement transactions. Examples of general ledger accounts include the asset accounts such as Cash,
Accounts Receivable, Inventory, Investments, Land, and Equipment.

Petty cash is a small amount of cash on hand that is used for paying small amounts owed, rather than
writing a check. Petty cash is also referred to as a petty cash fund. The person responsible for the petty
cash is known as the petty cash custodian.