In accrual accounting, revenue is recorded when earned, and expenses recorded when incurred. A customer’s obligation to pay for goods and services provided is called accounts receivable. From the firm’s point of view, accounts receivable are assets. When a firm receives goods or services from another business before payment, the firm incurs a liability called accounts payable.
When a business extends credit to its customers, it records a revenue transaction at the time it provides its customer with goods or services. The transaction results in a revenue account increase and an increase in an asset account. Since no cash is received, the asset account that is increased is Accounts Receivable.
Example. When Joint Ventures made its December delivery the Columbian Grower’s Co-op did not pay the balance owed until January. When the delivery was completed the Co-op had an obligation to pay Joint Ventures for its services. Joint Ventures completed the $50,000 delivery on December 20. Recall that the Co-op had already paid $5,000 on the delivery, so on December 20 the following journal entry would be made:
Accounts Receivable is an asset account. Notice that no cash account was involved in the transaction, because no cash changed hands. An asset account was increased and equity (revenue) was increased. If on January 5 the Co-op paid the $45,000 owed, the transaction would be recorded in this way:
Notice that no revenue account was affected by the January payment. This is because the revenue was recorded in December 2004, when Joint Ventures actually earned it. In January, all that happened was that one asset account, Cash, increased, while another asset account, Accounts Receivable, decreased.
Just as a business extends credit to its customers, other firms may extend credit to it. When a business receives goods or services but does not pay immediately, it incurs a liability called accounts payable. Using an accrual basis of accounting, a business records the purchase of goods or services in the period when they are used, not necessarily when cash is paid.
Example. Say that Joint Ventures was granted credit by an office supply store to purchase $600 of office supplies at the end of December 2004. Joint Ventures received and used the office supplies in that month. Joint Ventures actually paid for the supplies in January 2005. The entry at the date of purchase is:
Office Supplies, an expense account, has increased while a liability account, Accounts Payable, has also increased. Remember, when an expense is incurred, equity decreases. What actually happens is that a liability account increases and an equity account decreases, so the fundamental accounting equation is maintained. When Joint Ventures pays cash for what it owes in January 2005, the following entry is made:
In this transaction a decrease in an asset (Cash), is offset by a decrease in a liability (Accounts Payable). No expense is recognized in 2005 because the supplies were used in 2004. The net effect of these two transactions is that Joint Ventures recognized the expense when it used the supplies, rather than when it actually paid for them.
If a business only has credit sales (i.e., it never receives cash when the sale is made), all cash collections from customers can be deemed to be credits to Accounts Receivable. Conversely, if a business has no credit sales (i.e., it never extends credit and receives cash whenever a sale is made), all cash received from customers can be credited to a revenue account.
A good number of businesses fall between these extremes. Sometimes they extend credit and sometimes they receive cash immediately. To avoid accounting confusion and accurately track accounts receivable, a business that extends credit to customers must maintain a special set of accounting records called subsidiary ledgers. An accounts receivable subsidiary ledger consists of the revenue and payment history of each customer to which a business extends credit.
Example. Assume that the Columbian Growers Co-op contracts with Joint Ventures for three deliveries and makes two payments in 2005. The accounts receivable subsidiary ledger on Joint Ventures would look like this:
In a manual accounting system, a business like Joint Ventures has to record all deliveries and payments twice: once in the general journal, and once again in the subsidiary ledger. Because two postings are required for each delivery and payment, transcription errors may cause the ending balance of the accounts receivable to disagree with the cumulative ending balances in the subsidiary ledgers. Finding such discrepancies can be a time consuming and expensive process.
When using computerized accounting software, all payments and deliveries are posted simultaneously to the subsidiary ledger and the general ledger accounts receivable account. In fact, in a computerized software system, even a cash sale is recorded in the general ledger and subsidiary ledger as if it were a credit transaction. In this case, the service or product delivery date is the same as the payment date.