 Hello, in this discussion question we will discuss the question of does an accrual method overstate assets and revenue? This question and the discussion of this question will give us a better concept of what the accrual method is and the difference between an accrual method and a cash method because we often will have to contrast accrual method versus a cash method when discussing a question such as this. This is a question that often comes up when presenting topics of an accrual nature, both by students that are just learning accounting and often by students who have already had some accounting experience, often in small business experience where they would assume in many cases that a cash method would be better because the cash method would not recognize revenue until cash is received. In other words, an accrual method when presented to many people especially when discussing an accrual method related to an invoice when we do work in invoice a client recognizing revenue at the point of the invoice. There's often concern that we are recognizing revenue before the point in time that we actually receive the cash and are therefore overstating the revenue and that's something that we've heard many times and it's an interesting topic to take a look at. That's going to be one of the of course the accrual transactions. So in order to answer an essay question like this, we would first want to compare and contrast it to something. Clearly if we're saying that if we are asking the question of whether an accrual method overstates assets or revenue, we must compare or contrast that to something else. So although a cash method is not mentioned in a question like that, we're going to have to compare it to probably a cash method to some other method and look at the comparisons between those two methods. As we do that, as we think about the cash method and the accrual method, we have to think about where those two things differ, those two things differ in the timing statements. When we are going to record the timing statements, the income statement statements, those accounts of revenue and expenses, the two accrual principles that we'll be recognizing revenue and expenses will be revenue related, will be the revenue recognition principle and those related to the expenses are going to be either called the matching principle or the expense recognition principle. The revenue recognition principle will recognize revenue when we earn the revenue, not when we receive the cash. The expense recognition or matching principle will recognize the revenue when we consumed whatever we're going to consume in order to help generate revenue, revenue generation being the goal. A longer definition would be we either consumed an asset or we incurred a liability in order to help us generate revenue in the same time period. That's when an expense should be recognized under a cash method. It's of course a lot more simple in that we're just going to record revenue when we receive cash and we're going to record the expense when we pay the cash. That simplicity is one of the major advantages of the cash method. That's the whole goal of the cash method, it's going to be more simplistic. Now it's often thought however that a cash method can be more accurate in some ways by for example not recognizing revenue until we get the cash and that's often going to be the concern. That transaction when we're considering that transaction, that's usually a type of business that sells something or has a service company, they do the work, they invoice the client, they receive a check in the mail. That's usually the transaction that's going to cause the most concern with the accrual method meaning if we're a bookkeeper or a law firm or something like that we will also often do the work, we'll have to then count up the time that we did the work then we'll have to bill the client for the work that we did and then we're going to have to receive the check later in the mail. When we bill the client, when we create the invoice for the client, the journal entry related to that would be a debit to the accounts receivable and a credit to revenue and the concern is that we're recognizing revenue then at the point of time not when cash is received but before cash is received and we're recognizing an asset and I think the nature of this concern mainly is that revenue is often combined with cash in people's minds we tend to think of revenue and cash at the same time or as the same thing and we have to basically separate that in our minds the revenue is not the same thing as cash so although we're recognizing revenue before we receive the cash that's not the same thing as us recognizing cash before we receive the cash we're recognizing revenue at the point in time that we earned the revenue and we're recognizing another asset which we could think of as overstating the assets in some way in that we're recognizing an accounts receivable as an asset something that we haven't received something that's really intangible and that doesn't have any tangible value yet it's just an IOU for the future so if we look at both of those sides if we look at the balance sheet and the income statement from that transaction we can think about it and say well is the balance sheet overstated if we have this other asset this accounts receivable which isn't even cash it's just represents work that we did and people owe us money and we can think about that one from the standpoint of a creditor possibly someone that wants to use our end product that end product the financial statements if we were a creditor trying to decide if we want to give a loan for example to a business or if we were an investor in the business would we count that receivable as an asset would it be important to us to have the receivable on there as an asset and I would argue that it would because we're gonna want if it's by a creditable client that owes the company money then we want to know about that that's gonna be an important information for us to know about so although as a creditor I would look at that receivable and say hey that's not cash I know that the receivable is not as valuable as cash and I may want to go back into that receivable and say who is the customer you've got this receivable from you know I what work did you do in order to earn the receivable possibly and how reliable is the receivable to be received and talk about the value of that receivable or the likelihood of its payment and when it would be paid but it would clearly be something that I would be wanting to know about when deciding on whether I want to give a loan or an investment so therefore I think it'd be it's it could be argued of course that the receivable would be something that we would have to want as a creditor we would want to know about as a creditor so even though it's not cash and you could think we're overstating the asset until we get the cash it is a relevant information is something that we expect to see within the future and therefore you know it would be justifiable to be an asset at that time the revenue side we can think well what is it is it valid for us to recognize revenue before we get the cash we're increasing revenue even though we have not received payment and the same kind of kind of argument can be made on the revenue side and it's similar if we worked somewhere if we worked somewhere all week and we didn't get paid until Friday then we're gonna recognize the revenue during the week that we worked for example if we worked this week even if we were going to get you know laid off before the end of Friday we would still assume that we would get payment at the end of the week why because we earned it and there's a legal obligation for us to receive payment at the end of the week and many business transactions it might just be a handshake that we have in the transaction a negotiation between two parties to do work if we did the work though we would assume and have a rightful assumption to payment being received sometime in the future and that's the justification for having that revenue recognition at that point it's also important to note that we all we typically focus in on that one transaction when we when we think about this idea when people have this idea that the the cash method is going to overstate revenue we always think of that invoicing transaction invoicing transaction before we get payment meaning we're recognizing revenue and the receivable before we get cash but note the opposite could happen too so it is possible for the opposite thing to happen meaning it's possible for us to receive payment before we do work and that's one way that the the cash method kind of manipulates things on on the reverse side in that case meaning if we were to receive payment if we were asking a client for some reason say pay us upfront and then we'll give you services later on and this is typical in something like a service company in in that if we have newspaper services we we have a subscription so they're going to buy the subscription we give them the newspapers if we record revenue at the point in time we got money in that case that we would be overstated that would be an overstatement of revenue because we're recording the revenue at the point in time that we got cash even though we might be working for a whole year in the future in order to to earn that money we received today so that would we would think be a distortion of the revenue recognition principle that doesn't happen quite as often but that's that's just an example of why the accrual method tends to be more accurate and therefore we would think that the accrual method would actually be a typically more accurate overall method of recording both assets and revenue and recording them on a more fair basis than the cash method we can also think about the accrual method versus the cash method as the accrual method being more like a GPS system that's kind of trying to pinpoint an exact location that exact location being the exact location that we earned revenue and we incurred expenses and the cash method is really kind of a shortcut method it's not really there as a principle saying hey cash is the best point in time in order to recognize revenue and expenses that's not typically what the cash flow statement is saying although the cash flow tracks well in the cash flow method what the cash flow method is really basically saying is it's really easy for us to to recognize revenue when cash is received because we can see exactly when cash is received we know exactly when that point in time is happening and if the point in time when revenue is recognized or when the revenue is earned is somewhere close to that same point in time that cash is received why not just use cash then because it will be easier for us to do it's easy for it's an easy point in time for us to identify and if it's close enough to the actual point in time we earned revenue let's use it that would be more of a justification for the cash method on the expense side we would say hey the cash method isn't exactly when we consumed the expense but it's pretty close I mean if I paid the utility bill at the end of the month I use the utilities during the month it's pretty close I can be on a cash method it'd be pretty close to the actual point in time the utilities were consumed now there's many points in time even when we are on a cash method when we were deviate from the cash method recognizing the fact that it doesn't work it's not close enough at the point in time and even under a cash method we have to deviate meaning if we bought for example equipment we know that that equipment if it's a building even if we bought a building we're pretty sure that even if we paid cash for that building that we haven't yet consumed it so we just have an intuitive sense that when we buy a building even if for cash we're not going to record building expense okay because we already we already purchased it for cash what we're going to do is we're going to put it on as an asset and we're going to depreciate it over time whether we paid cash for it or not so that's going to be you know one of the arguments for the reasons for an accrual method versus cash method most of the time if we have a type of company where we're basically doing work for cash at a given time meaning we have like a food truck or something like that we're receiving cash at that point in time at the same point that we deliver the service if if that's the case then the two methods will typically be the same under that method and and this is often a question as well the question being why would we be on an accrual method I would put in a policy possibly a business owner might say that I would put in a policy just to run a cash method arguing that a cash method means that we only do work at the same point in time that we receive payment and that's not exactly that's a good policy possibly not exactly the same thing however as a cash method versus accrual method if we put in a policy as a food truck to only give food for money that we receive at the same point in time that just means that we're going to record revenue at the same point in time whether we use an accrual method or a cash method it does not define that we're going to use a cash method under that case what really drives whether or not we need an accrual method and the revenue recognition side other than if we're publicly traded is this timing issue note that if we are the type of company that we have to build the client before we receive payment then we have to really use an accrual method for the receivables why because we need to track who owes us money the account that tracks who owes us money is going to be that that accounts receivable account so if we do work invoice the client such as a law firm or a cpa firm and we need to track which of these clients still owes us money we do that in the in the accounts receivable account and accrual account and therefore that type of industry is pretty much required to have an accrual method at least on that component so that we have something to track who owes us money so therefore with the discussion question of doesn't accrual method overstate assets and revenue i would say that no it doesn't overstate assets and revenue typically it should state those at more of an accurate level there is concern of course with the receivable being overstated if we are over if we are invoicing clients and recording the asset and the revenue at that point in time later on of course we will talk about an allowance method and that allowance method will be an estimate in order to to to mitigate that problem if we believe that the accounts receivable is overstated meaning we have clients that aren't going to pay us then we're going to have to come up with an estimate and try to think about how much of those receivables are not going to be paid but note although that takes more work to do to try to figure out what the receivables are how much is not going to be paid what we think the net receivables are that's more accurate that's more useful to creditors investors end users in management of the financial statements then it would be for us to just wait until we actually receive payments to report that amount on the financial statements we want to track who owes us money and that would be the proper way to do it we want to make sure that we are not overstating in that we are estimating and trying to see how much is actually due how much we will actually receive based on prior year and future estimates but we want to have that receivable on there in some way that's going to be the most useful thing to both us as management and to the users of the financial statements