One of our readers reached out to us with a few queries, we thought these would help a lot of our readers, both the students, and also professionals (for refreshing concepts).
This was related to the following post:
The concept Query:
It’s great to see accounting concepts getting some airtime in this forum – keep up the great work!! I did have a few questions on the concept of accrual accounting and would welcome your feedback.
1. Is the key difference between cash and accrual accounting tied to the “Matching” principle (i.e. accrual accounting allows us to recognise revenue/expenses in the period it was earned/incurred v.s. cash accounting which recognises the above when the revenue/expenditure was received/paid)?
2. With the 10 year license fee example (under cash accounting), would the impact to P/L in year 1 represent 10 years of expenditure (i.e. debit license fee expense $xx, credit bank $xx) and in fact have no impact on P/L for the remaining 9 years? Under cash accounting this would represent an understatement of profit in Year 1 (by 9 years of licence fee), and an overstatement of profit by 1 year’s licence fee for each of the subsequent 9 years?
3. With the goods bought in CY example (under cash accounting) you note that because the creditor is not paid until next FY, we do not recognise the COGS upon sale. What would be the double entry accounts for the purchase of goods, sale of goods and payment of creditor transactions:
1. debit inventory, credit creditor – no P/L impact,
2. debit bank, credit sales – P/L impact,
3. debit COGS, credit inventory, P/L impact,
4. next FY debit creditor, credit bank no P/L impact)?
Must admit, it’s been about 7 or 8 years since I’ve posted a journal or looked at a T-ledger so please take the above with a grain of salt – looking forward to your feedback.
By Anthony Saffer
Hi Anthony, my responses on your questions are given below:
1) – Yes that is absolutely correct. You call it matching principle or items pertaining to the defined accounting period, an accrual system implies that income / expenses of the accounting period should reflect in the profit & loss of that period.
2) – In a cash system, your profits will be quite understated in year 1 and over stated in the balance 9 years. This is where we use the concept of deferred expenses (and not depreciation – which is a fund for asset replacement). An amount pertaining to balance 9 years will show in the balance sheet on the asset side in year 2, and reduced by 1/10 each year.
3) You should use the term inventory carefully, normally the accountants do not create an inventory account and inventory is a parallel system where you use quantities in place of values. Normally you would create the account with the inventory name. Normally these are termed as “Purchases – WiFi Keyboard model XYZ”
a) Purchase of goods:
Purchase account – Wifi KBD M-001 Dr. (100 units) $1000
To Seller account (or creditor A/c) $1000
(No P/L impact in cash system)
b) Sale of goods (credit sales):
Buyer account (or debtor a/c) Dr. $1100
To Sales account – Wifi KBD M-001 (100 units) $1100
(No P/L impact in cash system)
In both the above, if money has been paid / received, i.e. cash system,
The buyer / seller account will be replaced by bank / cash, and the recording will be there when funds exchange hands.
In an accrual / mercantile system, when payment is received / made, the following entries will be made.
a) Payment for goods:
Seller account (or creditor A/c) Dr. $1000
To Cash / Bank account (or creditor A/c) $1000
b) Receipt for Sales (credit sales):
Cash / Bank A/c Dr. $1100
To Buyer account (or debtor a/c) $1100
Where there are two financial years involved, a cash system will pose proper reflection challenges of the state of business for both P/L & B/S.
The entries will remain the same.