FORM THREE BOOK KEEPING STUDY NOTES TOPIC 1-3.

TOPIC 1: GENERAL JOURNAL 
The Purpose of General Journal
Explain the purpose of the General journal
You are an accounting student; you do not need to be told just how difficult accounting can be. Accountants analyze business transactions and record them in journal entries using debit-credit rules as a guide. Usually, an accountant will use specialized journals for numerous journal entries of the same type – like cash journals, sales journals, and purchases journals. Large businesses usually use specialized journals. Smaller businesses tend to only use a general journal that includes all transactions. Recording journal entries is only the first step in the accounting cycle.
Relationship of the General Journal to the Ledger
Explain the relationship of the general journal to the ledger
Example 1
First Example
The company started business on June 6, 2013. The business was started with $300,000. The transactions they engaged in during their first month of business are below:
DateTransaction
June 8An amount of $50,000 was paid for six months of rent.
June 9Equipment costing $100,000 was purchased using $40,000 cash. The remaining amount of $60,000 is a one year note with an interest rate of 3.4%
June 10Office supplies were purchased totaling $25,000 on account.
June 16Received $39,400 in cash for services rendered to customers.
June 16Paid the account for office supplies purchased June 10.
June 20$63,900 worth of services were given to customers. Received cash amount of $43,700. Customers promised to pay remaining amount of $20,200.
June 21Paid employees’ wages for June 8-June 21. Wages totaled $23,500.
June 21Received $20,200 in cash for services rendered to customers on June 20.
June 22Received $6,300 in cash as advanced payment from customers.
June 27Office supplies were purchased totaling $3,500 on account.
June 28Electricity bill received totaling $1,850.
June 28Phone bill received totaling $2,650.
June 28Miscellaneous expenses totaled $4,320.
These events would then be recorded into the accounting journal. The table below records the journal entries for the events above.
DateAccountDebitCredit
June 6Cash300,000
June 8Prepaid rent50,000

Cash
50,000
June 9Equipment100,000

Cash
40,000

Notes Payable
60,000
June 10Office Supplies25,000

Accounts Payable
25,000
June 16Cash39,400

Service Revenue
39,400
June 16Accounts Payable25,000

Cash
25,000
June 20Cash43,700

Accounts Receivable20,200

Service Revenue
63,900
June 21Wages Expense23,500

Cash
23,500
June 21Cash20,200

Accounts Receivable
20,200
June 22Cash6,300

Unearned Revenue
6,300
June 27Office Supplies3,500

Accounts Payable
3,500
June 28Electricity Expense1,850

Utilities Payable
1,850
June 28Telephone Expense2,650

Utilities Payable
2,650
June 28Miscellaneous Expense4,320

Cash
4,320
The journal is then posted to the ledger accounts at the end of the period. Larger businesses separate their ledgers into different books, one being the general ledger and the other being a subsidiary ledger. The general ledger will include the main accounts and the following categories: assets, liabilities, owner’s equity, revenue, expense, gains, and losses. The subsidiary ledger includes detailed records of some accounts in the general ledger, the three main subsidiary ledgers being accounts receivable, inventory, and accounts payable.When recording the transactions, it is important to know how to record the debits and credits. When working with assets and expenses, an increase is recorded in debit, and a decrease is recorded in credit. When working with liabilities, equities, and revenues, a decrease is recorded in debit, and an increase is recorded in credit.
Preparation of Journal Entries to Record Common Business Transactions
Prepare journal entries to record common business transactions
Example 2
Second Example
This company was incorporated on March 1, 2013 with a starting of $1,500,000 and 10,000 common stock shares at $50 par value. These are the company’s transactions for the first month:
DateTransaction
March 3$300,000 were paid as advanced rent for six months.
March 4Office supplies were purchased on account totaling $35,000.
March 6Services were provided to customers, and the company received $54,000 in cash.
March 7The accounts payable for office supplies purchased on March 4 was paid.
March 7$200,000 in cash was used to purchase equipment costing $560,000. The remaining $360,000 became a one year note payable with interest rate of 4%.
March 9Office supplies were purchased on account totaling $13,500.
March 12Services were provided to customers, and the company received $43,500 in cash.
March 13The accounts payable for office supplies purchased on March 9 was paid.
March 14Employees were paid wages for March 3-March 14 totaling $356,000.
March 14Services were provided to customers totaling $256,720. Customers paid $143,650 with a promise to pay $113,070 remaining balance in the future.
March 20Office supplies were purchased on account totaling $5,400.
March 21Customers paid $100,000 toward the $113,070 remaining balance for services rendered March 14.
March 23The accounts payable for office supplies purchased on March 20 was paid.
March 25Customers paid $13,070 for services rendered March 14.
March 27Customers paid $23,000 in advance for services to be received.
March 28Employees were paid wages for the final weeks of March, totaling $453,600.
March 28Electricity bill was received totaling $6,750.
March 28Phone bill was received totaling $8,754.
March 31Miscellaneous expenses for the month were totaled at $15,450.
As in the example above, these transactions are then recorded into the accounting journal. Below is the table that records the accounting journal for March 2013.
DateAccountDebitCredit
March 1Cash1,500,000

Common Stock
500,000
March 3Prepaid Rent300,000

Cash
300,000
March 4Office Supplies35,000

Accounts Payable
35,000
March 6Cash54,000

Service Revenue
54,000
March 7Accounts Payable35,000

Cash
35,000
March 7Equipment560,000

Cash
200,000

Notes Payable
360,000
March 9Office Supplies13,500

Accounts Payable
13,500
March 12Cash43,500

Services Revenue
43,500
March 13Accounts Payable13,500

Cash
13,500
March 14Wages Expense356,000

Cash
356,000
March 14Cash143,650

Accounts Receivable113,070

Services Revenue
256,720
March 20Office Supplies5,400

Accounts Payable
5,400
March 21Cash100,000

Accounts Receivable
100,000
March 23Accounts Payable5,400

Cash
5,400
March 25Cash13,070

Accounts Receivable
13,070
March 27Cash23,000

Unearned Revenue
23,000
March 28Wages Expense453,600

Cash
453,600
March 28Electricity Expense6,750

Utilities Payable
6,750
March 28Phone Expense8,754

Utilities Payable
8,754
March 31Miscellaneous Expense15,450

Cash
15,450
<!-- [if !supportLists]-->· <!--[endif]-->You can see why a larger company might have multiple journals instead of one general journal. This was only a short list of transactions that could occur in a large business, but there are usually many more. Looking at a table like this with sales and purchases mixed together could get confusing when there is so much of it going on. It is easier for accountants to record sales and purchases separately so they do not end up mixed.
Posting Information from the General Journal to the Ledger Accounts
Post information from the general journal to the ledger Accounts
Example 3
Third Example
For this last example, transactions will be recorded in three separate tables to represent four separate journals – purchases journal, sales journal, cash receipts journal, and cash disbursements journal. This example should give you a greater understanding of the debit-credit rules.
This company was incorporated January 1, 2014. They started out with a cash value of $2,350,000, and they have 25,000 stock at $200 par value. These are their transactions for the first month:
DateTransaction
January 2Rent was paid in advance for a full year totaling $750,000.
January 3Equipment costing $830,000 was purchased. $310,000 was paid in cash, and the remaining amount of $520,000 was a one year note payable with an interest rate of 4.6%.
January 3Office supplies were purchased on account totaling $340,000.
January 4Services were provided to customers, and the company received $570,000 in cash.
January 5Sales were made, and the company received $350,000 in cash.
January 6The accounts payable for office supplies purchased on January 3 was paid.
January 7Sales were made totaling $475,000. Customers paid $235,000 in cash and promised to pay the remaining $240,000 in the future.
January 8Services were provided to customers totaling $654,000. Customers paid $300,000 in cash and promised to pay the remaining $354,000 in the future.
January 9Office supplies were purchased on account totaling $115,000.
January 10Customers paid $25,000 for sales made on January 7 leaving a balance of $215,000.
January 11Employees were paid wages totaling $457,000 for the first two weeks of January 2014.
January 12The accounts payable for office supplies purchased on January 9 was paid.
January 13Customers paid $65,000 for services rendered on January 8 leaving a balance of $289,000.
January 14The company paid $35,000 to the note payable for equipment purchased January 3 leaving a balance of $485,000.
Janaury 15Customers paid $53,000 for sales made on January 7 leaving a balance of $162,000.
January 16Customers paid $43,000 for services rendered on January 8 leaving a balance of $246,000.
January 17Office supplies were purchased on account for $75,000.
January 18Customers paid $35,000 for services rendered on January 8 leaving a balance of $211,000.
January 19The company paid $75,000 for equipment purchased January 3 leaving a balance of $410,000.
January 20The accounts payable for office supplies purchased on January 17 was paid.
January 21Customers paid $100,000 for sales made on January 7 leaving a balance of $62,000.
January 22Sales were made, and the company received $235,000 in cash.
January 23Customers paid $211,000 for services rendered on January 8.
January 24Customers paid $65,000 in advance for services to be rendered.
January 25Employees were paid wages totaling $545,000 for the third and fourth weeks of January 2014.
January 26Customers paid $62,000 for sales made on January 7.
January 27Sales were made, and the company received $345,000 in cash.
January 28Office supplies were purchased on account totaling $215,000.
January 29The accounts payable for office supplies purchased on January 28 was paid.
January 30Services were provided to customers, and the company received $765,000 in cash.
January 31Dividends were paid totaling $1,000,000.
January 31Electricity bill totaling $15,450 was received.
January 31Phone bill totaling $17,850 was received.
January 31Miscellaneous expenses for the month totaled to $650,000.
<!-- [if !supportLists]-->· <!--[endif]-->Purchases Journal
DateAccountDebitCredit
January 3Equipment830,000

Notes Payable
520,000
January 3Office Supplies340,000

Accounts Payable
340,000
January 9Office Supplies115,000

Accounts Payable
115,000
January 17Office Supplies75,000

Accounts Payable
75,000
January 27Office Supplies215,000

Accounts Payable
215,000
It is obvious that a journal written as such is a lot easier to read than a longer, larger general journal keeping track of everything. Notice that this table only recorded purchases on account, not payments for the purchases or cash payments for purchases.
Sales Journal
DateAccountDebitCredit
January 7Accounts Receivable240,000

Sales
240,000
January 8Accounts Receivable354,000

Service Revenue
354,000
Again, this journal does not record payments of sales or services purchased by customers on credit, and it does not record sales or services paid with cash. This only records the credit.
Cash Disbursements
Cash457,000
DateAccountDebitCredit
January 4Cash570,000

Service Revenue
570,000
January 5Cash350,000

Sales Revenue
350,000
January 7Cash235,000

Sales Revenue
235,000
January 8Cash300,000

Service Revenue
300,000
January 10Cash25,000

Accounts Receivable – Sales
25,000
January 13Cash65,000

Accounts Receivable – Service Revenue
65,000
January 15Cash53,000

Accounts Receivable – Sales
53,000
January 16Cash43,000

Accounts Receivable – Service Revenue
43,000
January 18Cash35,000

Accounts Receivable – Service Revenue
35,000
January 21Cash100,000

Accounts Receivable – Sales
100,000
January 22Cash235,000

Sales Revenue
235,000
January 23Cash211,000

Accounts Receivable – Service Revenue
211,000
January 24Cash65,000

Unearned Revenue
65,000
January 26Cash62,000

Accounts Receivable – Sales
62,000
January 27Cash345,000

Sales Revenue
345,000
January 30Cash765,000

Service Revenue
765,000
These are all payments made by customers with cash. This includes any advanced payments, listed as unearned revenue.
 
TOPIC 2: CORRECTION OF ERRORS 
Wrong Entries
Identify wrong entries
An accounting error is a non-fraudulent discrepancy in financial documentation. The term is used in financial reporting.
Types of accounting errors include:
  • Error of omission -- a transaction that is not recorded.
  • Error of commission -- a transaction that is calculated incorrectly. One example of an error of commission is subtracting a figure that should have been added.
  • Error of principle -- a transaction that is not in accordance with generally accepted accounting principles ( GAAP). One example of an accounting error of principle is an expenditure that is placed in an inappropriate category.
Accounting errors can occur in double entry bookkeeping for a number of reasons. Accounting errors are not the same as fraud, errors happen unintentionally, whereas fraud is a deliberate and intentional attempt to falsify the bookkeeping entries.
An accounting error can cause the trial balance not to balance, which is easier to spot, or the error can be such that the trial balance will still balance due to compensating bookkeeping entries, which is more difficult to identify.
Preparation of a Corrected Trial Balance
Prepare a corrected Trial Balance
An adjusted trial balance is a listing of all company accounts that will appear on thefinancial statementsafter year-end adjusting journal entries have been made.
Preparing an adjusted trial balance is the fifth step in theaccounting cycleand is the last step beforefinancial statementscan be produced.
There are two main ways to prepare an adjusted trial balance. Both ways are useful depending on the site of the company and chart of accounts being used.
You could post accounts to the adjusted trial balance using the same method used in creating the unadjusted trial balance. The account balances are taken from the T-accounts or ledger accounts and listed on the trial balance. Essentially, you are just repeating this process again except now the ledger accounts include the year-end adjusting entries.
You could also take the unadjusted trial balance and simply add the adjustments to the accounts that have been changed. In many ways this is faster for smaller companies because very few accounts will need to be altered.
Note that only active accounts that will appear on the financial statements must to be listed on the trial balance. If an account has a zero balance, there is no need to list it on the trial balance.
Example 1
Using Paul'sunadjusted trial balanceand hisadjusted journal entries, we can prepare the adjusted trial balance.
Once all the accounts are posted, you have to check to see whether it is in balance. Remember that all trial balances' debit and credits must be equal.
Now that the trial balance is made, it can be posted to theaccounting worksheetand thefinancial statementscan be prepared.
Uses of the Trail Balance
Outline uses of the Trail Balance
Keeping in mind the definition of the trial balance we can define the following characteristics and use of the trial balance:-
  1. Trial balance is prepared in tabular form only. It contains debit column for debit balance of accounts and credit column for credit balances of accounts.
  2. Only the closing balances of the accounts are shown in trial balance.
  3. The closing balance of stock is never shown in trial balance. It is always shown as foot note.
  4. Other adjustments against which no entries are passed in the books also not shown in trial balance. They are also shown as footnotes.
  5. The trial balance is prepared on a particular date as required by the management or at the end of thefinancial year.
  6. Trial balance is not an account. It is a statement only.
  7. The balance of all accounts is shown at one place. Thus it is the summary of all accounts.
  8. It shows the arithmetical mistake of the entries.
  9. Trading,profit and loss accountand thebalance sheetare prepared with the help of trial balance only.
TOPIC 3: ADJUSTMENTS
Adjusting entries are accounting journal entries that convert a company's accounting records to theaccrual basis of accounting.An adjusting journal entry is typically made just prior to issuing a company'sfinancial statements.
The Reasons Why the Life of a Business is divided into Accounting Period
Explain why the life of a business is divided into accounting period
An accounting adjustment is a business transaction that has not yet been included in the accounting records of a business as of a specific date. Most transactions are eventually recorded through the recordation of (for example) a supplier invoice, a customer billing, or the receipt of cash. Such transactions are usually entered in a module of the accounting software that is specifically designed for it, and which generates an accounting entry on behalf of the user.
However, if such transactions have not yet been recorded as of the end of an accounting period, or if the entry incorrectly states the impact of the transaction, the accounting staff makes accounting adjustments in the form of adjusting entries. These adjustments are designed to bring the company's reported financial results into compliance with the dictates of the relevant accounting framework, such as Generally Accepted Accounting Principles or International Financial Reporting Standards. The adjustments are primarily used under the accrual basis of accounting. Examples of such accounting adjustments are:
  • Altering the amount in a reserve account, such as the allowance for doubtful accounts or the inventory obsolescence reserve.
  • Recognizing revenue that has not yet been billed.
  • Deferring the recognition of revenue that has been billed but has not yet been earned.
  • Recognizing expenses for supplier invoices that have not yet been received.
  • Deferring the recognition of expenses that have been billed to the company, but for which the company has not yet expended the asset.
  • Recognizing prepaid expenses as expenses.
The Reasons Why the Accounts must be Adjusted at the End of Each Accounting Period
State why the accounts must be adjusted at the end of each accounting period
Some of these accounting adjustments are intended to be reversing entries - that is, they are to be reversed as of the beginning of the next accounting period. In particular, accrued revenue and expenses should be reversed. Otherwise, inattention by the accounting staff may leave these adjustments on the books in perpetuity, which may cause future financial statements to be incorrect. Reversing entries can be set to automatically reverse in a future period, thereby eliminating this risk.
Accounting adjustments can also apply to prior periods when the company has adopted a change in accounting principle. When there is such a change, it is carried back through earlier accounting periods, so that the financial results for multiple periods will be comparable
How Adjusting Entries are Related to the Concept of Accrual Accounting and Matching Principle
Explain how adjusting entries are related to the concept of accrual accounting and matching principle
An adjusting entry to accrue expenses is necessary when there are unrecorded expenses and liabilities that apply to a given accounting period. These expenses may include wages for work performed in the current accounting period but not paid until the following accounting period and also the accumulation of interest on notes payable and other debts.
Suppose a company owes its employees $2,000 in unpaid wages at the end of an accounting period. The company makes an adjusting entry to accrue the expense by increasing (debiting) wages expense for $2,000 and by increasing (crediting) wages payable for $2,000.
If a long-term note payable of $10,000 carries an annual interest rate of 12%, then $1,200 in interest expense accrues each year. At the close of each month, therefore, the company makes an adjusting entry to increase (debit) interest expense for $100 and to increase (credit) interest payable for $100.
Accounting records that do not include adjusting entries for accrued expenses understate total liabilities and total expenses and overstate net income.
The Four Basic Adjusting Entries
Describe the four basic adjusting retries
Basic types of adjusting journal entries:
  • Accrued revenues(also called accrued assets) are revenues already earned but not yet paid by the customer or posted to the general ledger. An example of accrued revenue would be for a custom ordered machine that has been shipped FOB shipping point on the day the accounts receivable module is closed and the approval to bill the customer has not been received by the billing clerk. An adjusting entry would be recorded to recognize the revenue in the correct period. This entry will reverse when the customer is appropriately invoiced. Accrued Revenue 14,00; Revenue 14,000
  • Unearned revenues(or deferred revenues) are revenues received in cash and recorded as liabilities prior to being earned. Unearned revenue is a liability to the entity until the revenue is earned. An example of unearned revenue would be if the customer paid a deposit for a custom ordered machine that has not been delivered, the deposit would be recorded as unearned revenue. This type of adjusting entry will be adjusted by another entry. Revenue 14,000; Deferred Revenue 14,000
  • Accrued expenses(also called accrued liabilities) are expenses already incurred but not yet paid or recorded. Examples of these types of adjusting entries could be for payroll that has been earned by employees on the last day of the period but not paid until the next payroll date. These types of entries generally reverse the next month. Salaries Expense 89,000; Salaries Payable 89,000
  • Prepaid expenses(or deferred expenses) are expenses paid in cash and recorded as assets prior to being used. The most common form of an adjusting entry for prepaid expense would be for the used portion of an insurance premium. These types of adjusting entries are usually permanent. Insurance Expense 1,000; Prepaid Insurance 1,000
  • Other adjusting entries includedepreciationof fixed assets, allowancesfor bad debts, and inventory adjustments. Bad Debt Expense 50; Allowance for Bad debt 50 (Adjusting EN, 2010)
At the end of each closing period, usually monthly, a thorough analysis of the trial balance is preformed. This analysis includes performance budget to actual and month to month to ensure all of the accounts are correctly stated. When an adjusting entry is identified, a journal entry input form is prepared. This form should be supported with source documents that justify the entry and reviewed and approved by the appropriate level of accounting management. Once the approval has been obtained, the journal entry is keyed into the general ledger system as either a standard or self reversing journal entry. The journal entry is then posted to the general ledger.
Preparation of Adjusting Entries for Prepaid Expenses, Unearned Revenue, Accrued Revenues and Depreciation
Prepare adjusting entries for prepaid expenses, unearned revenue, accrued Revenues and depreciation
Prepaid expenses are assets that become expenses as they expire or get used up. For example, office supplies are considered an asset until they are used in the course of doing business, at which time they become an expense. At the end of each accounting period, adjusting entries are necessary to recognize the portion of prepaid expenses that have become actual expenses through use or the passage of time.
Consider the previous example from the point of view of the customer who pays $1,800 for six months of insurance coverage. Initially, she records the transaction by increasing one asset account (prepaid insurance) with a debit and by decreasing another asset account (cash) with a credit. After one month, she makes an adjusting entry to increase (debit) insurance expense for $300 and to decrease (credit) prepaid insurance for $300.
Prepaid expenses in one company's accounting records are often—but not always— unearned revenues in another company's accounting records. Office supplies provide an example of a prepaid expense that does not appear on another company's books as unearned revenue.
Accounting records that do not include adjusting entries to show the expiration or consumption of prepaid expenses overstate assets and net income and understate expenses.
Preparation of Entries to Dispose of Accrued Revenue and Expense Items in Three New Accounting Period
Prepare entries to dispose of accrued revenue and expense items in thee new accounting period
Accrued income is an amount earned but not actually received during the accounting period or till the date of preparation of Final Accounts for the period concerned. Such an income receivable is also called income earned but not received or income accrued or income due and outstanding.
For instance, interest on investments, rent from sub-letting, commission on sales etc., earned by the business during a particular accounting period but might not have been received so far. Thus such outstanding income needs adjustment when Final Accounts are prepared. For instance, commission has been earned but not received Rs 100.
The double effect of accrued income is:
  1. It is credited to the Profit & Loss Account
  2. It is shown in the asset side of the Balance Sheet. Income Received in Advance: Adjustment Entries in Final Accounts!
Income received during a particular trading period for the work to be done in future is termed as unearned income. When income is received in advance, for the work not done yet, the trader is liable that is such income though received is not the income for the current trading period, but services will be rendered in the next year.
The unearned income is deducted from the concerned income, in the credit side of Profit and Loss Account and also shown in the liability side of the Balance Sheet. For insurance, a trade received rent @ Rs 200 per month for a full year ending on 31st March 2005 but his Final Accounts are prepared for the year ending on 31st December 2004.
Then, the entries are:
The double effect in the Final Account is:
  1. The unearned income is deducted from Rent Received Account.
  2. The deducted amount is shown in the liability side of the Balance Sheet
Example 1
Ashok and Tanaji are Partners sharing Profit and Losses in the ratio 2:3 respectively. Their Trial Balance as on 31st March, 2007 is given below. You are required to prepare Trading and Profit and Loss Account for the year ended 31stMarch, 2007 and Balance Sheet as on that date after taking into account given adjustments.
Particulars Amt. (Rs.)ParticularsAmt. (Rs.)
PurchasesPatents RightBuilding98,0004,0001,00,000Capital: Ashok Tanaji30,00040,000
Stock (1.04.2006)15,000Provident Fund7,000
Printing and Stationery1,750Creditors45,000
Sundry Debtors Wages and Salaries35,00011,00010% Bank Loan taken on 1st April 200612,000
Audit Fees700Sales1,58,000
Sundry Expenses3,500Reserve for Doubtful Debts250
Furniture8,000Purchase Returns3,500
Investment10,000
Cash4,000
Provident Fund Contribution800
Carriage Inwards1,300
Travelling Expenses2,700
2,95,7502,95,750
Adjustments:
Activity 1
  1. Closing stock is valued at the cost of Rs. 15,000 while its market price is Rs.18,000.
  2. On 31st March, 2007 the stock of stationery was Rs. 500.
  3. Provide reserve for bad and doubtful debts at 5% on debtors.
  4. Depreciate building at 5% and patent rights at 10%. p.a.
  5. Interest on capitals is to be provided at 5%
Difference between the Cash and Accrual Basis of Accounting
Explain the difference between the cash and accrual basis of accounting
Under the cash basis of accounting
  1. Revenuesare reported on theincome statementin the period in which the cash is received from customers.
  2. Expensesare reported on the income statement when the cash is paid out.
Under theaccrual basis of accounting.
  1. Revenues are reported on the income statement when they areearned—which often occurs before the cash is received from the customers.
  2. Expenses are reported on the income statement in the period when they occur or when they expire—which is often in a period different from when the payment is made.
The accrual basis of accounting provides a better picture of a company's profits during anaccounting period. The reason is that the income statement prepared under the accrual basis will report all of the revenues actuallyearnedduring the period and all of the expenses incurred in order to earn the revenues.
The accrual basis of accounting also provides a better picture of a company's financial position at a moment or point in time. The reason is that all assets that were earned are reported and allliabilitiesthat were incurred will be reported.
The accrual basis of accounting is required because of the matching principle.
Importance of Comparability in the Financial Statements of a Business, Period after Period
Explain the importance of comparability in the financial statements of a business, period after period
Comparability is one of the key qualities which accounting information must possess. Accounting information is comparable when accounting standards and policies are applied consistently from one period to another and from one region to another. The characteristic of comparability offinancial statementsis important because it allows us to compare a set of financial statements with those of prior periods and those of other companies.
For example
  1. We can compare 20X2 financial statements of ExxonMobil with its 20X1 financial statements to know whether performance and position improved or deteriorated.
  2. We can compare the ExxonMobil financial statements with that of BP if both are prepared in accordance with same set of accounting standards, such as IFRS or US GAAP, etc.
  3. When preparing 20X3 financial statements we are required to present with each of the 20X3 figure the corresponding 20X2 figures. This is done to add the characteristic of comparability to the financial statements.
Accounting standards are intended to outline the best accounting treatment so that companies follow them and hence accounting information isunderstandable,relevant and reliableand comparable.Consistencymeans that the accounting policies should be changed only when there are valid grounds for such a change.
How the Realization Principle and the Matching Principle Attribute to Comparability
Explain how the realization principle and the matching principle attribute to comparability
Realization concept in accounting, also known as revenue recognition principle, refers to the application of accruals concept towards the recognition of revenue (income).Under this principle, revenue is recognized by the seller when it is earned irrespective of whether cash from the transaction has been received or not.
In case of sale of goods, revenue must be recognized when the seller transfers the risks and rewards associated with the ownership of the goods to the buyer. This is generally deemed to occur when the goods are actually transferred to the buyer. Where goods are sold on credit terms, revenue is recognized along with a corresponding receivable which is subsequently settled upon the receipt of the due amount from the customer.
Example 2
Motors PLC is a car dealer. It receives orders from customers in advance against 20% down payment. Motors PLC delivers the cars to the respective customers within 30 days upon which it receives the remaining 80% of the list price
In accordance with the revenue realization principle, Motors PLC must not recognize any revenue until the cars are delivered to the respective customers as that is the point when the risks and rewards incidental to the ownership of the cars are transferred to the buyers.
Application of the realization principle ensures that the reported performance of an entity, as evidenced from the income statement, reflects the true extent of revenue earned during a period rather than the cash inflows generated during a period which can otherwise be gauged from the cash flow statement. Recognition of revenue on cash basis may not present a consistent basis for evaluating the performance of a company over several accounting periods due to the potential volatility in cash flows.
Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned.
Prior to the application of the matching principle, expenses were charged to the income statement in the accounting period in which they were paid irrespective of whether they relate to the revenue earned during that period. This resulted in non recognition of expenses incurred but not paid for during an accounting period (i.e. accrued expenses) and the charge to income statement of expenses paid in respect of future periods (i.e. prepaid expenses). Application of matching principle results in the deferral of prepaid expenses in order to match them with the revenue earned in future periods. Similarly, accrued expenses are charged in the income statement in which they are incurred to match them with the current period's revenue.
A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets. Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over several accounting periods spanning the asset's useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of fixed assets is not charged to the profit & loss at once but is 'matched' against economic benefits (revenue or cost savings) earned from the asset's use over several accounting periods.
Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an organization than would result from the use of cash basis of accounting.

 

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