Why the bank wants accrual

Two ways to measure December

Northlake's owner looks at the bank balance on 31 December, sees it lower than on 1 December, and says December lost money. Whether that is true depends on what "lost money" means.

Worked example — Northlake's December, twice

Cash basis. Count operating cash in and operating cash out (the 50,000 share issue is financing, and neither method calls it income):

Cash in:   season passes 24,000 + day passes 16,400 + school board 4,000  = 44,400
Cash out:  ski fleet 12,000 + insurance 6,000 + groomer payable 30,000
           + wages 11,300                                                = 59,300
Cash-basis result                                                        = (14,900)

A loss of 14,900. Every number is real, and every number is in the wrong month. The 24,000 of passes is for a season that has barely begun; the 6,000 of insurance covers a year; the 30,000 paid for the groomer bought in November; and the 12,000 is a down-payment on skis that will earn rentals for years.

Accrual basis. Count revenue earned in December and expenses incurred in December, whenever the cash moved:

Revenue earned:   day passes 16,400 + school board lessons 7,200
                  + one month of the 54,000 of passes 13,500          = 37,100
Expenses incurred: wages paid 11,300 + wages earned but unpaid 4,700
                  + hydro 1,950 + one month of insurance 500          = 18,450
Accrual result, before the remaining adjustments                     = 18,650

The month that "lost" 14,900 earned 18,650 — and the remaining year-end adjustments of this module (supplies used, interest, amortization) reduce that figure without reversing it. The bank, which is deciding whether to lend against next season, wants the second number: it measures what December's operations produced, not when the cheques happened to clear. The owner's cash concern is real, and it is answered by a different statement — the cash flow statement (Module 13) — not by a different income figure.

The three ideas behind the second number

Periodicity. A business's life is cut into equal periods — a year, and for Northlake's bank a quarter — and a statement set is prepared for each, even though the season passes, the insurance and the groomer all straddle the cut. Cutting the life into periods is what makes adjustments necessary: something is always in progress at the year end.

Revenue recognition (the introductory rule; Module 7 gives ASPE's criteria). Revenue is recorded in the period it is earned — when the service is performed — not when the invoice is sent and not when the cash arrives. The school board's 7,200 is December revenue although only 4,000 was collected; the 24,000 of passes is not, although all of it was collected.

Matching. An expense is recorded in the period whose revenue it helped to earn. December's hydro is a December expense though the bill is paid in January; the four days of wages earned by 31 December are December's though the payroll runs on 7 January; and one-twelfth of the insurance belongs to December, the rest to the eleven months it still covers. Matching does not mean expenses equal revenues — it means they go in the same period.

Classifying eight events for December