Accounting – Accounting Concepts
We wrote about four basic concept of accounting, i.e. going concern, business entity, money measurement, cost concept, the dual-entry concept and the realization concept.
https://faoblog.com/accounting-accounting-concepts-2/
https://faoblog.com/accounting-accounting-concepts-3/
https://faoblog.com/accounting-accounting-concepts-4/
https://faoblog.com/accounting-accounting-concepts-5/
https://faoblog.com/accounting-accounting-concepts-6/
https://faoblog.com/accounting-accounting-concepts-7/
The seventh concept is the Accrual – If money has not been realized, it should be capable of being accrued as payable / receivable
This by far is one critical concept of accounting. What is accounting supposed to provide? A true and fair view of the business for a certain period, clearly reflecting the profit or loss for that period and the net worth of the business as at the end of that period.
Now imagine you did accounting purely based on cash, i.e. record a transaction only when cash was exchanged. Now for some license, you pay a fee, which will remain valid for a period of ten years. So, on a cash basis, you would deflate the profit for the year in which this amount was paid and inflate the same for the next nine years. Thus this accrual concept becomes important.
Another example can be that you bought goods in the current year, which you have an agreement with the seller that you will pay for them in the next financial year. But you sold the goods in the current year and received the money for sales. The profit will be distorted as the cost of purchase will not be accounted for in the current year.
Hence, it will make sense to ensure that the transaction is reflected in the books, using the accrual concept.
Next post I will talk about the prevalent systems of accounting…
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Hi Mohit
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.
Best regards
Anthony
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.
Hope that helps. I will post this as a post as well, so that other readers benefit as well.