Page 45 - Finance for Non-Financial Managers

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Finance for Non-Financial Managers
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basis accounting is not considered indicative of economic reali-
ties, thus the requirement for accrual accounting except for cer-
tain kinds of companies, such as very small businesses and
some not-for-profit organizations.
When the Sales Department obtains an order from one of
your customers and the product is shipped to the customer, a
sale has been consummated and it is recorded. This transaction
will appear on the income statement even though not a single
dollar may have passed from the customer to your company,
because the customer has an open account with the company.
The transaction is recorded by increasing Sales and by increas-
ing Accounts Receivable, the amount due from your customer.
Later on, perhaps the following month, your customer pays
his or her bill and your company receives the cash. That trans-
action will not appear on the income statement. It was already
recorded as income when the sale was made and, under accru-
al accounting rules, only the sale itself is considered an income-
producing event, not the act of collecting the money.
This example demonstrates the essence of accrual basis
accounting. Transactions are recorded when an economic event
is deemed to have occurred. A sale is an economic event
because a binding agreement has been reached: your customer
agreed to accept the merchandise and pay for it in due course
and your company shipped the merchandise on your cus-
tomer’s promise to pay. That is an economic event, an offer
made and accepted.
The customer’s payment is another economic event. It is
related to the first, but it is nevertheless a new event. The cus-
tomer might have chosen to delay his or her payment or return
the merchandise, but chose instead to pay for it. The second
economic event doesn’t affect Sales. However, it affects the bal-
ance in the customer’s account and it increases your company’s
cash receipts. So when this transaction is recorded, Accounts
Receivable and Cash are the accounts that are affected. This
transaction, although not shown on the income statement, will
be included in the statement of cash flow, which documents