Tag: accounting lessons

Many small businesses use cash basis of accounting to record transactions, especially those who prepare the accounts once a year. Please refer to my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid for further illustrations.

Indications that cash basis of accounting is used includes the following:-

• No books of original entry such as sales day book and purchases day book used to record sales and purchases.
  
• No debtors ledger or creditors ledger maintained.
  
• All receipts and payments are recorded directly in cash book.
  

Cash basis of recording transactions and presenting the financial statements produced has long been deemed an inappropriate basis to use. Accrual basis of accounting is the accepted basis and this is stated in International Accounting Standard (IAS) 1: Presentation of Financial Statements.

It is good if a business entity is aware of the difference between cash basis and accrual basis of accounting and records its transactions using accrual basis. However, for those businesses who have recorded the transactions using cash basis do not need to discard those set of accounts produced and record all past transactions using accrual basis of accounting all over again. What need to be done is re-examine all the account items that have been produced using cash basis of accounting to determine as to whether any adjustment is required to adjust those items should accrual basis of accounting is used. Some examples: –

1. Sale of goods
   

   Under cash basis of accounting, all proceeds collected from sales are recorded in the accounting records upon receiving payments from customers. The balance sheets produced using cash basis of accounting do not show any trade debtor balances! Those sales figures shown in the income statements represent only cash sales. No credit sales are recorded.
   

   The solution is to identify all bills and invoices of those sales in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid sales invoices or bills and put through a journal adjustment to recognise the credit sales and trade debtors as follows: –

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Trade debtors	XXXX
   Sales				XXXX

   A point to note on the criteria used to determine the occurrence of transactions (sales recognition in this case) is usually based on delivery and acceptance of goods by customers. You may have come across the solution because I have discussed this in Step 4a, The Worst Case Scenario of my post: Preparing Accounts of Small Businesses Once A Year – Tips and Pitfalls To Avoid.

2. Purchase of goods
   

   This is the opposite of sales of goods discussed above. Similarly, the balance sheets produced under cash basis of accounting will not show any trade creditor balances. The purchases figures shown in the income statements represent only cash purchases. No credit purchases are recorded.
   

   The solution is the same as discussed in sale of goods above. You need to identify all unpaid bills and invoices in which the transactions have occurred as at the end of the financial year, but still unpaid, i.e. those unpaid purchase invoices or bills and put through a journal adjustment to recognise the credit purchases and trade creditors as follows: –

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Purchases			XXXX
   Trade Creditors		XXXX

3. Prepayments

Some expenses are paid now but part of them or the entire sums are meant for future period. This is the reason that they are called “Prepayments”. Under cash basis of accounting, prepayments are usually recorded as the respective expense accounts. What is required here is an adjustment to recognise the prepayments as current assets i.e. those portion of the payments that are meant for the next financial year.


The original double entry recording the transactions when payments are made: –

	Balance Sheet		Income Statement
	DR	CR	DR	CR
Expenses			XXXX
Cash at bank		XXXX

Adjustment for prepayments recognition:-

	Balance Sheet		Income Statement
	DR	CR	DR	CR
Prepayments	XXXX
Expenses				XXXX

Example

The financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 November 2007, ABC Co. Ltd. paid the insurance premium for its fire policy covering the period from 1 December 2007 to 30 November 2008. The amount paid was $2,400. The prepayment for insurance is therefore $2,200 ($2,400/12 months x 11 months for the period from 1 January 2008 to 30 November 2008).

The original double entry recording the transactions when payments are made: –

	Balance Sheet		Income Statement
	DR	CR	DR	CR
Insurance premium			2,400
Cash at bank		2,400

Adjustment for prepayment recognition:-

	Balance Sheet		Income Statement
	DR	CR	DR	CR
Prepayments	2,200
Insurance premium				2,200

The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for prepayment recognition are shown below to illustrate the impact of this adjustment: –

1. Interest income
   

   Business entities may place excess cash as term deposits with financial institutions to earn interest income. Under cash basis of accounting, there was no interest income recognised and recorded in the accounts until the business entities receive the interest upon maturity of the term deposits.
   

   However, under accrual basis of accounting, the amount of interest attributable to the relevant period of the deposits placement must be calculated and recognised accordingly. For examples, the financial period of ABC Co. Ltd. is from 1 January 2007 to 31 December 2007. On 1 July 2007, ABC Co. Ltd. placed $100,000 with its bank as term deposit for 1 year. The interest rate is 3.5% per annum. The interest earned from 1 July 2007 to 30 June 2008 is $350 ($100,000 x 3.5%). In respect for the accounts of ABC Co. Ltd. for the year ended 31 December 2007, the portion of the interest income to be recognised is $175 ($350 x 6months/12months for the period from 1 January 2007 to 31 December 2007).
   

   The journal adjustment to recognise this interest income is as follows: –

   	Balance Sheet		Income Statement
   	DR	CR	DR	CR
   Interest receivable	175
   Interest income				175

   The balance sheet and income statement of ABC Co. Ltd. before and after this adjustment for interest income recognition are shown below to illustrate the impact of this adjustment: –

On 30 June 2008, when the deposit matures and interest of $350 is received by ABC Co. Ltd., the double entry to record these transactions is as follows:-

The balance sheet and income statement of ABC Co. Ltd. for the year ended 31 December 2008 before and after this adjustment are shown below to illustrate the impact of this adjustment: –

Out of the $350 interest received, $175 was credited to the interest receivable account and $175 is credited to the interest income account for the year ended 31 December 2008 (for the interest earned for the period from 1 January 2008 to 31 December 2008.

The interest was calculated based on simple interest method. For illustrations on the difference between simple interest and compound interest, please refer to my post: Effective Interest? Simple Interest? Compound Interest? Nominal Interest?