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Business transactions are recorded when they occur and not when the related payments are received or made. This concept is called accrual basis of accounting and it is fundamental to the usefulness of financial accounting information. Examples: 1. An airline sells its tickets days or even weeks before the flight is made, but it does not record the payments as revenue because the flight, the event on which the revenue is based has not occurred yet. 2. An accounting firm obtained its office on rent and paid $120,000 on January 1. It does not record the payment as an expense because the building is not yet used. While preparing its quarterly report on March 31, the firm expensed out three months worth of rent i.e. 30,00 [$120,000/12*3] because 3 months equivalent of time has expired. 3. A business records its utility bills as soon as it receives them and not when they are paid, because the service has already been used. The company ignored the date when the payment will be made. Accounting standards strictly require accounting on accrual basis. However, there is an alternative called cash basis of accounting. Under the cash basis events are recorded based on their underlying cash inflows or outflows. Cash basis is normally used while preparing financial statements for tax purposes, etc.
There are certain other frameworks for reporting business performance such as triple bottom line which focuses on "people, planet profit" the three pillars; corporate social responsibility reporting, etc. Accounting focuses on the financial aspects of the business and that too for matters which can be expressed in terms of currencies.
Examples
1. A telecommunication company sells talk time through scratch cards. No revenue is recognized when the scratch card is sold, but it is recognized when the subscriber makes a call and consumes the talk time. 2. A monthly magazine receives 1,000 subscriptions of $240 to be paid at the beginning of the year. Each month it recognizes revenue worth $20,000 [$240/12*1,000]. 3. A media company recognizes revenue when the ads are aired even if the payment is not received or where payment is received in advance. In case where payment is received before the event triggering recognition of revenue happens, the debit goes to cash and credit to unearned revenue. In case the event triggering revenue recognition occurs before payment is received, the debit goes to accounts receivable and credit to revenue.
Revenue is the item which is the easiest to misstate, hence more stringent rules and guidance is required in this area. IAS 18 Revenue deals with recognition of revenue.
Examples
1. Accounting policies need to be disclosed because they help understand the basis of accounting. 2. Details of contingent liabilities, contingent assets, legal proceedings, etc. are also relevant to the decision making of users and hence need to be disclosed. 3. Significant events occurring after the date of the financial statements but before the issue of financial statements (i.e. events after the balance sheet date) need to be disclosed. 4. Details of property, plant and equipment cannot be presented on the face of balance sheet, but a detailed schedule outlining movement in cost and accumulated depreciation should be presented in the notes. 5. Tax rate is expected to change in near future. This information needs to be disclosed. 6. The draft for a new legislation is presented in the legislative of the country in which the company operates. If passed, the law would subject the company to significant cleanup costs. The company has to disclose the information in the notes. 7. The company sold one of its subsidiaries to the spouse of one of its directors. The information is material and needs disclosure.
Examples
1. 100 units of an item were purchased one month back for $10 per unit. The price today is $11 per unit. The inventory shall appear on balance sheet at $1,000 and not at $1,100. 2. The company built its ERP in 2008 at a cost of $40 million. In 2010 it is estimated that the present value of the future benefits attributable to the ERP is $1 billion. The ERP shall stand on balance sheet at its historical costs less accumulated depreciation. The concept of historical cost is important because market values change so often that allowing reporting of assets and liabilities at current values would distort the whole fabric of accounting, impair comparability and makes accounting information unreliable.
Matching Principle
In order to reach accurate net income figure the expenses incurred in earnings revenues recognized in a time period should be recognized in that time period and not in the next or previous. This is called matching principle.
Examples
1. $2,000,000 worth of sales are made in 2010. Total purchases of inventory were $1,000,000 of which $100,000 remained on hand at the end of 2010. The cost of earnings is $2,000,000 revenue is $900,000 [$1,000,000 minus $100,000] and this should be recognized in 2010 thereby yielding a gross profit of $1,100,000. 2. A hospital pays $20,000 per month to 5 of its doctors. Monthly sales are $500,000. $100,000 worth of monthly salaries should be matched with $500,000 of revenue generated. Matching principle is relevant to the time period assumption, the revenue recognition principle and is at the heart of accrual basis of accounting.
Examples
1. After the balance sheet date but before the date of issue a company wants to dispose of one of its subsidiaries and is in final stages of reaching a deal but the outcome is still uncertain. If the company waits they are expected to find more reliable information but that would cost them relevance. The information would be outdated and no longer very relevant. 2. After the balance sheet date during the time when audit is carried out, it becomes clear which debts were realized and where were not hence it improves the reliability of allowance for bad debts estimate but the information loses its relevance due to too much time being taken. Timeliness is key to relevance.
Materiality Concept
Financial statements are prepared to help the users with their decisions. Hence, all such information which has the ability to affect the decisions of the users of financial statements is material and this property of information is called materiality. In deciding whether a piece of information is material or not requires considerable judgment. Information is material either due to the amount involved or due to the importance of the event.
Examples
1. The government of the country in which the company operates in working on a new legislation which would seriously impair the company's operations in future. Although there are no figures involved but the impact is so large that disclosure is imminent. 2. The remuneration paid to the executives and the directors is material. 3. The accounting policies are material because they help the users understand the figures. Materiality might be based on a percentage of sales such as 0.5% of sales or on total assets. Materiality is helpful in determining which figures are to be reported on income statement and balance sheet and which one in the notes. It is also helpful in helping decide which items should appear as line items and which ones are aggregated with others.
Examples
1. A lease might not transfer ownership to the leasee but the leasee has to record the leased items as an asset if it intends to use it for major portion of its useful life or where the present value of lease payment is fairly equal to the fair value of the asset, etc. Although legally the leasee is not the owner, so the leased item is not his asset, but from the perspective of the underlying economics the leasee is entitled to the benefits embedded in the use of the item and hence it has to be recorded as an asset. 2. A company is short of cash, so it sells its machinery to the bank and obtains it back on a lease. It is called sale and leaseback. Although the legal ownership has transferred but the underlying economics remain the same and hence under the substance over form principle the sale and subsequent leaseback are considered one transaction. 3. If two companies swap their inventories they will not be allowed to record sales because not sales has occurred even if they have entered into valid enforceable contracts.
Prudence Concept
Accounting transactions and other events are sometimes uncertain but in order to be relevant we have to report them in time. We have to make estimates requiring judgment to counter the uncertainty. While making judgment we need to be cautious and prudent. Prudence is a key accounting principle which makes sure that assets and income are not overstated and liabilities and expenses are not understated.
Explanation
1. Bad debts are probable in many businesses, so they create a special contra-account to accounts receivable called allowance for bad debts which brings the accounts receivable balance to the amount which is expected to be realized and hence prevents overstatement of assets. An expense called bad debts expense is also booked to stop net income from being overstated. 2. Some liabilities are contingent upon future occurrence or non-occurrence of an event such a law suit, etc. We judge the probability of occurrence of that event and if it is more than 50% we record a liability and corresponding expense at the most likely amount. Hence, we stop liability and expense from being understated. 3. Periodic evaluations of assets are made to make sure their carrying value does not exceed the benefits expected to be derived from the asset, and if it the carrying amount is reduced by recording impairment expense.
Comparability Principle
Comparability is one of the key qualities which accounting information must have. Comparable accounting information is useful because it tells us the story of the business so we can compare it with prior periods and with other companies in the industry, the country, the region or even the whole world.
Examples
1. We can compare 2010 financial statements of ExxonMobil with its 2009 financial statements to tell 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 GAAP, such as IFRS or US GAAP, etc. 3. If we are making 2010 financial statements we are required to present with each of the 2010 figure the corresponding 2009 figures. This is to add comparability to the financial statements. Comparability is achieved by applying the GAAP (such as US GAAP or the IFRS) and by being consistent in such application. GAAP are intended to outline the best accounting treatment so that companies follow them and hence accounting information is understandable, relevant, reliable ad comparable. Consistency means that the accounting policies should be changed only when there are valid grounds for such a change.
1. 2. 3. 4. 5. 6. 7. 8.
Analyzing and Recording Transactions via Journal Entries Posting Transactions to Ledger Accounts Preparing Unadjusted Trial Balance Preparing Adjusting Entries at the end of the Period Preparing Adjusted Trial Balance Preparing Financial Statements Closing Temporary Accounts via Closing Entries Preparing Post Closing Trial Balance
Journal Entries
Analyzing transactions and recording them as journal entries is the first step in the accounting cycle. It begins at the start of the accounting period and continues during the whole period. Transaction analysis is the process of determining whether a particular business event will effect the assets, liabilities or equity of
the business and the magnitude of its effect (i.e. its currency value). When analyzing transactions, accountants also classify them appropriately and record them according to the debit-credit rules. Business transactions are those events which cause change in the value of its assets, liabilities or equities. The following example illustrates the first step of accounting cy