Home News FORM THREE BOOK KEEPING STUDY NOTES TOPIC 1-3.

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:
Date Transaction
June 8 An amount of $50,000 was paid for six months of rent.
June 9 Equipment
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 10 Office supplies were purchased totaling $25,000 on account.
June 16 Received $39,400 in cash for services rendered to customers.
June 16 Paid 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 21 Paid employees’ wages for June 8-June 21. Wages totaled $23,500.
June 21 Received $20,200 in cash for services rendered to customers on June 20.
June 22 Received $6,300 in cash as advanced payment from customers.
June 27 Office supplies were purchased totaling $3,500 on account.
June 28 Electricity bill received totaling $1,850.
June 28 Phone bill received totaling $2,650.
June 28 Miscellaneous 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.
Date Account Debit Credit
June 6 Cash 300,000
June 8 Prepaid rent 50,000
Cash 50,000
June 9 Equipment 100,000
Cash 40,000
Notes Payable 60,000
June 10 Office Supplies 25,000
Accounts Payable 25,000
June 16 Cash 39,400
Service Revenue 39,400
June 16 Accounts Payable 25,000
Cash 25,000
June 20 Cash 43,700
Accounts Receivable 20,200
Service Revenue 63,900
June 21 Wages Expense 23,500
Cash 23,500
June 21 Cash 20,200
Accounts Receivable 20,200
June 22 Cash 6,300
Unearned Revenue 6,300
June 27 Office Supplies 3,500
Accounts Payable 3,500
June 28 Electricity Expense 1,850
Utilities Payable 1,850
June 28 Telephone Expense 2,650
Utilities Payable 2,650
June 28 Miscellaneous Expense 4,320
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:
Date Transaction
March 3 $300,000 were paid as advanced rent for six months.
March 4 Office supplies were purchased on account totaling $35,000.
March 6 Services were provided to customers, and the company received $54,000 in cash.
March 7 The 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 9 Office supplies were purchased on account totaling $13,500.
March 12 Services were provided to customers, and the company received $43,500 in cash.
March 13 The accounts payable for office supplies purchased on March 9 was paid.
March 14 Employees were paid wages for March 3-March 14 totaling $356,000.
March 14 Services
were provided to customers totaling $256,720. Customers paid $143,650
with a promise to pay $113,070 remaining balance in the future.
March 20 Office supplies were purchased on account totaling $5,400.
March 21 Customers paid $100,000 toward the $113,070 remaining balance for services rendered March 14.
March 23 The accounts payable for office supplies purchased on March 20 was paid.
March 25 Customers paid $13,070 for services rendered March 14.
March 27 Customers paid $23,000 in advance for services to be received.
March 28 Employees were paid wages for the final weeks of March, totaling $453,600.
March 28 Electricity bill was received totaling $6,750.
March 28 Phone bill was received totaling $8,754.
March 31 Miscellaneous 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.
Date Account Debit Credit
March 1 Cash 1,500,000
Common Stock 500,000
March 3 Prepaid Rent 300,000
Cash 300,000
March 4 Office Supplies 35,000
Accounts Payable 35,000
March 6 Cash 54,000
Service Revenue 54,000
March 7 Accounts Payable 35,000
Cash 35,000
March 7 Equipment 560,000
Cash 200,000
Notes Payable 360,000
March 9 Office Supplies 13,500
Accounts Payable 13,500
March 12 Cash 43,500
Services Revenue 43,500
March 13 Accounts Payable 13,500
Cash 13,500
March 14 Wages Expense 356,000
Cash 356,000
March 14 Cash 143,650
Accounts Receivable 113,070
Services Revenue 256,720
March 20 Office Supplies 5,400
Accounts Payable 5,400
March 21 Cash 100,000
Accounts Receivable 100,000
March 23 Accounts Payable 5,400
Cash 5,400
March 25 Cash 13,070
Accounts Receivable 13,070
March 27 Cash 23,000
Unearned Revenue 23,000
March 28 Wages Expense 453,600
Cash 453,600
March 28 Electricity Expense 6,750
Utilities Payable 6,750
March 28 Phone Expense 8,754
Utilities Payable 8,754
March 31 Miscellaneous Expense 15,450
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:
Date Transaction
January 2 Rent was paid in advance for a full year totaling $750,000.
January 3 Equipment
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 3 Office supplies were purchased on account totaling $340,000.
January 4 Services were provided to customers, and the company received $570,000 in cash.
January 5 Sales were made, and the company received $350,000 in cash.
January 6 The accounts payable for office supplies purchased on January 3 was paid.
January 7 Sales were made totaling $475,000. Customers paid $235,000 in cash and promised to pay the remaining $240,000 in the future.
January 8 Services
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 9 Office supplies were purchased on account totaling $115,000.
January 10 Customers paid $25,000 for sales made on January 7 leaving a balance of $215,000.
January 11 Employees were paid wages totaling $457,000 for the first two weeks of January 2014.
January 12 The accounts payable for office supplies purchased on January 9 was paid.
January 13 Customers paid $65,000 for services rendered on January 8 leaving a balance of $289,000.
January 14 The company paid $35,000 to the note payable for equipment purchased January 3 leaving a balance of $485,000.
Janaury 15 Customers paid $53,000 for sales made on January 7 leaving a balance of $162,000.
January 16 Customers paid $43,000 for services rendered on January 8 leaving a balance of $246,000.
January 17 Office supplies were purchased on account for $75,000.
January 18 Customers paid $35,000 for services rendered on January 8 leaving a balance of $211,000.
January 19 The company paid $75,000 for equipment purchased January 3 leaving a balance of $410,000.
January 20 The accounts payable for office supplies purchased on January 17 was paid.
January 21 Customers paid $100,000 for sales made on January 7 leaving a balance of $62,000.
January 22 Sales were made, and the company received $235,000 in cash.
January 23 Customers paid $211,000 for services rendered on January 8.
January 24 Customers paid $65,000 in advance for services to be rendered.
January 25 Employees were paid wages totaling $545,000 for the third and fourth weeks of January 2014.
January 26 Customers paid $62,000 for sales made on January 7.
January 27 Sales were made, and the company received $345,000 in cash.
January 28 Office supplies were purchased on account totaling $215,000.
January 29 The accounts payable for office supplies purchased on January 28 was paid.
January 30 Services were provided to customers, and the company received $765,000 in cash.
January 31 Dividends were paid totaling $1,000,000.
January 31 Electricity bill totaling $15,450 was received.
January 31 Phone bill totaling $17,850 was received.
January 31 Miscellaneous expenses for the month totaled to $650,000.
<!– [if !supportLists]–>· <!–[endif]–>Purchases Journal
Date Account Debit Credit
January 3 Equipment 830,000
Notes Payable 520,000
January 3 Office Supplies 340,000
Accounts Payable 340,000
January 9 Office Supplies 115,000
Accounts Payable 115,000
January 17 Office Supplies 75,000
Accounts Payable 75,000
January 27 Office Supplies 215,000
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
Date Account Debit Credit
January 7 Accounts Receivable 240,000
Sales 240,000
January 8 Accounts Receivable 354,000
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
Date Account Debit Credit
January 4 Cash 570,000
Service Revenue 570,000
January 5 Cash 350,000
Sales Revenue 350,000
January 7 Cash 235,000
Sales Revenue 235,000
January 8 Cash 300,000
Service Revenue 300,000
January 10 Cash 25,000
Accounts Receivable – Sales 25,000
January 13 Cash 65,000
Accounts Receivable – Service Revenue 65,000
January 15 Cash 53,000
Accounts Receivable – Sales 53,000
January 16 Cash 43,000
Accounts Receivable – Service Revenue 43,000
January 18 Cash 35,000
Accounts Receivable – Service Revenue 35,000
January 21 Cash 100,000
Accounts Receivable – Sales 100,000
January 22 Cash 235,000
Sales Revenue 235,000
January 23 Cash 211,000
Accounts Receivable – Service Revenue 211,000
January 24 Cash 65,000
Unearned Revenue 65,000
January 26 Cash 62,000
Accounts Receivable – Sales 62,000
January 27 Cash 345,000
Sales Revenue 345,000
January 30 Cash 765,000
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.) Particulars Amt. (Rs.)
PurchasesPatents RightBuilding 98,0004,0001,00,000 Capital: Ashok Tanaji 30,00040,000
Stock (1.04.2006) 15,000 Provident Fund 7,000
Printing and Stationery 1,750 Creditors 45,000
Sundry Debtors Wages and Salaries 35,00011,000 10% Bank Loan taken on 1st April 2006 12,000
Audit Fees 700 Sales 1,58,000
Sundry Expenses 3,500 Reserve for Doubtful Debts 250
Furniture 8,000 Purchase Returns 3,500
Investment 10,000
Cash 4,000
Provident Fund Contribution 800
Carriage Inwards 1,300
Travelling Expenses 2,700
2,95,750 2,95,750
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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