There are two commonly used methods of accounting - Cash Basis and the Accruals Basis. Understand the difference between accruals and reversals. Recap the earlier discussion we had on accruals and reversals and see the comparison between these two different but related accounting concepts. Understand how the action of accruing results in reversals subsequently in the accounting cycle.
There are two commonly used methods of accounting - Cash Basis and the Accruals Basis. In cash basis of accounting, income is recognized in books when it is received in cash, and expenses are offset when they are actually paid.
Contrary to Cash Basis Accounting, in Accrual Basis Accounting, financial items are accounted for when they are earned and deductions are claimed when expenses are incurred, irrespective of the actual cash flow. The Accrual accounting method measures the financial performance of a company by recognizing accounting events regardless of when corresponding cash transactions occur. Accrual follows the matching principle in which the revenues are matched (or offset) to expenses in the accounting period in which the transaction occurs rather than when payment is made (or received).
Accrual accounting is considered to be the standard accounting practice for most companies and is the most widely used accounting method in the automated accounting system. This method provides a more accurate picture of the company's current condition, but as all income and expenses need to be recognized based on their occurrence and matching, it is relatively complex when compared to cash accounting, which recognizes transactions only when there is an exchange of cash. The need for this method arose out of the increasing complexity of business transactions and investor demand for more timely and accurate financial information.
To help you understand this concept let’s look at an example. A company has sold merchandise on credit to a customer who is creditworthy and there is the absolute certainty that the payment will be received in the future. The company earns a profit of $500 on the total sales price of $2000. The accounting for this transaction will be different in the two methods. The revenue generated by the sale of the merchandise will only be recognized by the cash method when the money is received by the company which might happen next month or next year. However in the Accrual Method, the revenue will be recognized in the same period, an “Accounts Receivable” will be created to track future credit payments from the customer.
Based on the above discussion now let’s take a look at some accrual/deferral related concepts:
Accrued revenue is an asset, such as unpaid proceeds from a delivery of goods or services, when such income is earned and a related revenue item is recognized, while cash is to be received in a later period.
Accrued expense, in contrast, is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision.
As an accounting practice expense and revenue accruals are reversed in the next accounting period to prevent double-booking of expenses/revenues when they get settled in cash
At the beginning of each accounting period, there is an accounting practice to use reversing entries to cancel out the adjusting/accrual entries that were made to accrue revenues and expenses at the end of the previous accounting period. The use of Reversing Entries makes it easier to record subsequent transactions by eliminating the possibility of duplication.
Reversing entries are made on the first day of an accounting period in order to offset adjusting accrual/provision entries made in the previous accounting period.
Reversing entries are used to avoid the double booking of revenues or expenses when the accruals/provisions are settled in cash.
A reversing entry is linked to the original adjusting entry and is written by reversing the position of debits with credits and vice versa.
The net impact of Original Entry and Reversing Entry on the accounting books is always zero.
In Automated Accounting Systems, it is not possible to delete transactions once the posting has been made. In such systems reversals is the recommended way to correct the erroneous entries. An example is that one interface feed has been posted by mistake twice. This has inflated many income expense accounts. A reversing entry with opposite debit and credit amounts to all the impacted accounts will nullify the impact of the mistake.
There are five types of core accounts to capture any accounting transaction. Apart from these fundamental accounts, some other special-purpose accounts are used to ensure the integrity of financial transactions. Some examples of such accounts are clearing accounts, suspense accounts, contra accounts, and intercompany accounts. Understand the importance and usage of these accounts.
Legal Structures in Businesses
Businesses not only vary in size and industry but also in their ownership. Most businesses evolve from being owned by just one person to a small group of people and eventually being managed by a large numbers of shareholders. Different ownership structures overlap with different legal forms that a business can take. A business’s legal and ownership structure determines many of its legal responsibilities.
In most of the automated financial systems, you can define more than 12 accounting periods in a financial year. This article will explain the concept of the adjustment period and the benefits of having adjustment periods. Adjustment periods have their inherent challenges for the users of financial statements and there is a workaround for those who don’t want to use adjustment periods.
Trial Balance in General Ledger
One of the greatest benefits of using a double-entry accounting system is the capability to generate a trial balance. What do we mean by trial balance? As the name suggests a trial balance is a report that must have its debits equals to credits. Understand the importance of trial balance and why it is balanced. Learn how it is prepared and in which format.
Operational Structures in Business
Large organizations grow through subsidiaries, joint ventures, multiple divisions and departments along with mergers and acquisitions. Leaders of these organizations typically want to analyze the business based on operational structures such as industries, functions, consumers, or product lines.
Accrued expenses, sometimes referred to as accrued liabilities, are expenses that have been incurred but have not been recorded in the accounts. Discuss the need to record accrued liabilities and why they require an adjustment entry. Understand the treatment for these entries once the accounting period is closed and learn to differentiate when the commitments become liabilities.
In this article we will focus on and understand the accounting process which enables the accounting system to provide the necessary information to business stakeholders. We will deep dive into each of the steps of accounting and will understand how to identify accounting transactions and the process for recording accounting information and transactions.
After reading this article the learner should be able to understand the meaning of intercompany and different types of intercompany transactions that can occur. Understand why intercompany transactions are addressed when preparing consolidated financial statements, differentiate between upstream and downstream intercompany transactions, and understand the concept of intercompany reconciliations.
When the quantum of business is expected to be moderate and the entrepreneur desires that the risk involved in the operation be shared, he or she may prefer a partnership. A partnership comes into existence when two or more persons agree to share the profits of a business, which they run together.
Understand what we mean by GAAP to STAT adjustments. This article discusses the different standards that are used for multiple representations of the financial results for global organizations. Understand the meaning of US GAAP, Local GAAP, STAT, IFRS, and STAT. Finally, understand why accounting differences arise and how they are adjusted for different financial representations.