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Methods of Accounting

•Cash Accounting•Accrual Accounting

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Cash Accounting

• Transactions recorded only when cash is received or paid– Credit sales and purchases recorded

only when cash received from customer or paid to supplier

• Does not adhere to matching principle

• Does not comply with ATO

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Accrual Accounting

Accrual accounting recognises transactions and events when revenues are earned and expenses are incurred.

Eg interest earned at the end of the accounting period will be recorded (though still not received) – application of the matching principle.

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Recognising revenue: although cash may not have been received, business records recognise that the revenue has been earned.

Realising revenue: occurs when cash is received and recorded by business for the revenue previously recognised.

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Balance Day Adjustments

• Allows matching principle to be carried out

• Adjustment entries facilitate a better matching of revenues and expenses

• Ensures a more accurate profit figure for the period

• Essential – final reports are a basis for future decisions

• Information in reports are of greater relevance and more reliable

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• Adjustments are carried out at balance day before revenues and expenses are closed to P&L summary a/c

Balance day adjustments are general journal entries made as at balance day in order to compare (match) the revenues and expenses accurately so that the profit (loss) can be determined.

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There are numerous balance day adjustments. Four will be covered in this unit:

• Prepaid expenses• Accrued expenses• Unearned revenues• Accrued revenues

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Prepaid Expenses

Prepaid expenses are the portion of an expense that has been paid by a business in one accounting period but will be incurred (used up) in a future accounting period.

eg– Insurance– Subscriptions

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The business paid $1 200 for a yearly subscription to a trade journal at the beginning of March. The Subscription a/c (an expense) would appear as:

General Ledger

Date Particulars Debit Credit Balance

Subscription a/c

Mar 1 Bank 1 200 1 200Dr

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• The subscription is for one year and will be renewed in March of 2008

• Balance day is 30 June 2007• Any part of the subscription past this date has

been prepaid and relates to the next accounting period

• The prepaid amount is $800 (8 months)• The account, on balance day, must recognise

this prepaid amount as belonging to the next accounting period– General journal entry is required:

General Journal

Date Particulars Debit Credit

Jun 30 Prepaid Expense 800

Subscription a/c 800

(Balance day adjustment)

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• This entry permits:– The necessary decrease in the

Subscription a/c by the prepaid amount and

– The temporary asset account Prepaid Expense is created to reflect the $800 paid in advance. (this is an asset because the business is owed the service of the subscription)

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General Ledger

Date Particulars Debit Credit Balance

Prepaid Expense a/c

Jun 30 Subscription 800 800Dr

Subscription a/c

Mar 1 Bank 1 200 1 200Dr

Jun 30 Prepaid Expense 800 400Dr

Balance Sheet

Closed to P&L Summary a/c

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• The very next day – July 1 a reversing entry is required to allow:– the reversal of the balance day adjustment

entries so that revenue and expenses are returned to the pre-adjusted state and

– the closure of the temporary asset or liability accounts that were created on balance day to adjust the revenue and expense accounts for accrual accounting purposes.

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General Journal

Date Particulars Debit Credit

Jul 1 Subscription 800

Prepaid Expense 800

(Reversing entry)

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General Ledger

Date Particulars Debit Credit Balance

Prepaid Expense a/c

Jun 30 Subscription 800 800Dr

Jul 1 Subscription 800 0

Subscription a/c

Mar 1 Bank 1 200 1 200Dr

Jun 30 Prepaid Expense 800 400Dr

P&L Summary 400 0

Jul 1 Prepaid Expense 800 800Dr

A/c now closed

$800 returned to a/c – represents the subscription amount which will be consumed in this current period.

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Accrued Expenses

Accrued expenses are costs incurred by a business in the current accounting period that have not yet been paid

eg– Rent– Wages

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During the 2006/2007 financial year the business has paid $25 500 in rent. On balance day rent is owing of $1 200 but will not be paid until the following week.

General Ledger

Date Particulars Debit Credit Balance

Rent Expense a/c

Jun 30 Entries to date 25 500 25 500Dr

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• On balance day rent is owing of $1 200 but will not be paid until the following week.

• According to the principles of accrual accounting, the expense of $1 200 for rent owing must be included in the profit calculation event though it has not been paid.

• Rent needs to be adjusted to show the total expense incurred for rent in the accounting period.

– General journal entry is required:

General Journal

Date Particulars Debit Credit

Jun 30 Rent Expense 1 200

Accrued Expense 1 200

(Balance day adjustment)

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• This entry permits:– The necessary increase in the Rent a/c

by $1 200 because the amount has been incurred in the current accounting period and

– The temporary liability account Accrued Expense is created to reflect the $1 200 that is owing by the business. (this is a liability because the business owes the amount for rent in this accounting period.)

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General Ledger

Date Particulars Debit Credit Balance

Accrued Expense a/c

Jun 30 Rent Expense 1 200 1 200Cr

Rent Expense a/c

Jun 30 Entries to date 25 500 25 500Dr

Accrued Expense 1 200 26 700Dr

Balance Sheet

Closed to P&L Summary a/c

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• The very next day – July 1 a reversing entry is required.

General Journal

Date Particulars Debit Credit

Jul 1 Accrued Expense 1 200

Rent Expense 1 200

(Reversing entry)

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General Ledger

Date Particulars Debit Credit Balance

Accrued Expense a/c

Jun 30 Rent Expense 1 200 1 200Cr

Rent Expense 1 200 0

Rent Expense a/c

Jun 30 Entries to date 25 500 25 500Dr

Accrued Expense 1 200 26 700Dr

P&L Summary 26 700 0

Jul 1 Accrued Expense 1 200 1 200Cr

A/c now closed

$1 200 returned to a/c – represents the rent amount which will be paid in this current period but was owed in the previous period.

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Unearned Revenues

Unearned Revenues are income that has been received by a business and recorded in the current accounting period but will not be earned until a future accounting period.

eg– Rent Revenue

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The business received 3 months rent on 30 April 2007 of $3 000.

General Ledger

Date Particulars Debit Credit Balance

Rent Revenue a/c

Apr 30 Bank 3 000 3 000Cr

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• On balance day, 30 June 2007, the business must account for the rent that was received in advance.

• This amount relates to the next accounting period.• Rent Revenue a/c needs to be adjusted to demonstrate

that the one month’s rent for July (paid in April) represents a revenue that will be earned in the next accounting period.

• One month’s rent is $1 000– General journal entry is required:General Journal

Date Particulars Debit Credit

Jun 30 Rent Revenue 1 000

Unearned Revenue 1 000

(Balance day adjustment)

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• This entry permits:– The decrease in the rent revenue account of $1

000 because only $2 000 has been earned in the current accounting period

– The temporary liability account Unearned Revenue is created to reflect the $1 000 that has been received but not yet earned. (this is a liability because the business owes the tenant the use of the premises.)

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General Ledger

Date Particulars Debit Credit Balance

Unearned Revenue a/c

Jun 30 Rent Revenue 1 000 1 000Cr

Rent Revenue a/c

Apr 1 Bank 3 000 3 000Cr

Unearned Revenue 1 000 2 000Cr

Balance Sheet

Closed to P&L Summary a/c

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• The very next day – July 1 a reversing entry is required.

General Journal

Date Particulars Debit Credit

Jul 1 Unearned Revenue 1 000

Rent Revenue 1 000

(Reversing entry)

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General Ledger

Date Particulars Debit Credit Balance

Unearned Revenue a/c

Jun 30 Rent Revenue 1 000 1 000Cr

Jul 1 Rent Revenue 1 000 0

Rent Revenue a/c

Apr 1 Bank 3 000 3 000Cr

Jun 30 Unearned Revenue 1 000 2 000Cr

P&L Summary 2 000 0

Jul 1 Unearned Revenue 1 000 1 000Cr

A/c now closed

$1 000 returned to a/c – represents the rent revenue amount which will be earned in this current period but was received in the previous period.

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Accrued Revenues

Accrued Revenues are revenues that have been earned in the current financial period but not yet received

eg– Commission Revenue– Interest Revenue– Rent Revenue

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The business has earned a 5% commission on sales amounting to $1000. On 30 June the commission had still to be received

General Ledger

Date Particulars Debit Credit Balance

Commission Revenue a/c

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• On balance day commission is still to be received and will likely be received in the next accounting period.

• According to the principles of accrual accounting, the revenue of $50 for commission revenue must be included in the profit calculation even though it has not been received.

• The Commission Revenue a/c needs to be adjusted to show the total revenue earned in the accounting period.– General journal entry is required:

General Journal

Date Particulars Debit Credit

Jun 30 Accrued Revenue 50

Commission Revenue 50

(Balance day adjustment)

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• This entry permits:– The necessary increase in the

Commission Revenue a/c by $50 because the amount has been earned in the current accounting period and

– The temporary asset account Accrued Revenue is created to reflect the $50 owing to the business.

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General Ledger

Date Particulars Debit Credit Balance

Accrued Revenue a/c

Jun 30 Commission Revenue 50 50Dr

Commission Revenue a/c

Jun 30 Accrued Revenue 50 50Cr

Balance Sheet

Closed to P&L Summary a/c

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• The very next day – July 1 a reversing entry is required.

General Journal

Date Particulars Debit Credit

Jul 1 Commission Revenue 50

Accrued Revenue 50

(Reversing entry)

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General Ledger

Date Particulars Debit Credit Balance

Accrued Revenue a/c

Jun 30 Commission Revenue 50 50Dr

Commission Revenue 50 0

Commission Revenue a/c

Jun 30 Accrued Revenue 50 50Cr

P&L Summary 50 0

Jul 1 Accrued Revenue 50 50Dr

A/c now closed

$50 returned to a/c – represents the commission amount which will be received in this current period but was earned in the previous period.