When a firm prepares its financial statements it must indicate whether cash or accrual accounting methods are in use. Smaller businesses, especially sole proprietorships, are more likely to use the cash accounting method due to its simplicity. Larger corporations tend to use accrual accounting in order to reflect higher levels of accuracy when it comes to current revenue and liability reporting. Accounts payable is a liability account that business managers use to keep track of payments the organization owes.
The cash accounting method recognizes revenue when a company receives payment. Under cash accounting, expenses are also recognized when payments against liabilities are made. For example, if a firm receives a cash payment for merchandise sold, it will increase its cash account balance accordingly. If the firm sells merchandise on credit, it does not record the revenue until the period in which it receives cash payment for the sale. Likewise, a firm will record payments when they are sent, not in the period in which the expense is incurred.
Business managers that choose to record revenues and expenses under the accrual method recognize them when they occur. For example, if a firm makes a sale on credit, it records the revenue when the sale is made. It makes a corresponding entry under a liability account, which is cleared when it receives the actual payment. Likewise, when a company incurs an expense, it recognizes it right away instead of waiting until it sends payment. Expenses are recorded under liability accounts and then cleared once payments are made.
Service industries, such as airline travel, use accrual accounting principles to recognize revenue. Since an airline passenger typically purchases a plane ticket prior to traveling, the airline records the cash receipt in addition to making an entry under a liability account named unearned revenue. When the passenger receives the service he paid for, the airline then reduces the unearned revenue account in the amount of the airfaire. This accrual method helps avoid recognizing revenue prior to potential loss from refunds, exchanges or supplemental expenses due to concessionaries.
Under the generally accepted accounting principles (GAAP), the cash method is not accepted. This means that any company that has to officially file a report with the Securities and Exchange Commission (SEC) must use the accrual method. Accounts payable for a corporation should list all expense liabilities as they incur. For example, if a company signs a contract to purchase $1,000 worth of supplies in April, it must record it as an expense in April.
- Dummies.com: Understanding Accounting Methods
- Financial Accounting; Paul Kimmel, et al.