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Tuesday 8 January 2008

Cash Basis Vs Accrual Basis of Accounting

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. Please refer to: Various Types of Transactions – Part 3, Collection from Sales or Services Rendered for further illustrations. 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: -

  4. Example of Income Statement and Balance Sheet of ABC Co. Ltd.

    Income Statement for the year ended 31 December 2007

    BEFORE

    Adjustment

    AFTER

    DR

    CR

    $

    $

    Sales

    159,270

    159,270

    Cost of Sales

    - 90,875

    - 90,875

    Gross profit

    68,395

    68,395

    Other income: -


    Interest income

    2,356

    2,356

    Operating expenses: -


    Accountancy fee

    -800

    - 800

    Depreciation of property, plant and equipment

    -2,500

    - 2,500

    Donation

    -500

    - 500

    Electricity & water

    -3,340

    - 3,340

    Insurance premium

    -2,400

    2,200

    - 200

    Printing & stationery

    - 1,697

    - 1,697

    Rental of premises

    -12,000

    - 12,000

    Salaries

    -35,579

    - 35,579

    Upkeep of office

    -3,547

    - 3,547

    Telephone charges

    -1,285

    - 1,285

    Travelling, petrol & toll charges

    -2,648

    - 2,648

    -66,296

    - 64,096

    Net profit for the year

    4,455

    6,655

    Retained profits B/F

    27,654

    27,654

    Retained profits C/F

    32,109

    34,309

    Balance Sheet as at 31 December 2007

    $

    $

    Non-current assets

    Property, plant and equipment

    15,000

    15,000

    Current assets

    Inventories

    5,200

    5,200

    Trade receivables

    6,000

    6,000

    Other receivables, deposits & prepayments:

    -

    Sundry receivables

    1,058

    1,058

    Deposits

    2,000

    2,000

    Prepayments

    -

    2,200

    2,200

    Amount due by shareholders

    13,375

    13,375

    Cash and bank balances

    10,639

    10,639

    38,272

    40,472

    Current liabilities

    Trade payables

    -3,588

    - 3,588

    Other payables and accruals

    -2,575

    - 2,575

    -6,163

    - 6,163

    Net current assets

    32,109

    34,309

    47,109

    49,309

    Financed by: -

    Share capital

    15,000

    15,000

    Retained profits

    32,109

    34,309

    47,109

    49,309


  5. 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: -

  6. Example of Income Statement and Balance Sheet of ABC Co. Ltd.

    Income Statement for the year ended 31 December 2007

    BEFORE

    Adjustment

    AFTER

    DR

    CR

    $

    $

    Sales

    159,270

    159,270

    Cost of Sales

    90,875

    - 90,875

    Gross profit

    68,395

    68,395

    Other income: -

    Interest income

    -

    175

    175

    Operating expenses: -

    Accountancy fee

    -800

    - 800

    Depreciation of property, plant and equipment

    -2,500

    - 2,500

    Donation

    -500

    - 500

    Electricity & water

    -3,340

    - 3,340

    Insurance premium

    -200

    - 200

    Printing & stationery

    - 1,697

    - 1,697

    Rental of premises

    -12,000

    - 12,000

    Salaries

    -35,579

    - 35,579

    Upkeep of office

    -3,547

    - 3,547

    Telephone charges

    -1,285

    - 1,285

    Travelling, petrol & toll charges

    -2,648

    - 2,648

    -64,096

    - 64,096

    Net profit for the year

    4,299

    4,474

    Retained profits B/F

    27,654

    27,654

    Retained profits C/F

    31,953

    32,128

    Balance Sheet as at 31 December 2007

    $

    $

    Non-current assets

    Property, plant and equipment

    15,000

    15,000

    Current assets

    Inventories

    5,200

    5,200

    Trade receivables

    6,000

    6,000

    Other receivables, deposits & prepayments:

    Interest receivable

    -

    175

    175

    Deposits

    14,077

    14,077

    Prepayments

    2,200

    2,200

    Fixed deposit with licensed bank

    100,000

    100,000

    Cash and bank balances

    10,639

    10,639

    138,116

    138,291

    Current liabilities

    Trade payables

    -3,588

    - 3,588

    Other payables and accruals

    -102,575

    - 102,575

    - 106,163

    - 106,163

    Net current assets

    31,953

    32,128

    46,953

    47,128

    Financed by: -

    Share capital

    15,000

    15,000

    Retained profits

    31,953

    32,128

    46,953

    47,128


    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:-

    Balance Sheet

    Income Statement

    DR

    CR

    DR

    CR

    Cash at bank

    100,350

    Fixed deposit with licensed bank



    100,000

    Interest receivable


    175

    Interest income

    175


    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: -

    Example of Income Statement and Balance Sheet of ABC Co. Ltd.

    Income Statement for the year ended 31 December 2008

    BEFORE

    Adjustment

    AFTER

    DR

    CR

    $

    $

    Sales

    109,270

    109,270

    Cost of Sales

    - 40,875

    - 40,875

    Gross profit

    68,395

    68,395

    Other income: -

    Interest income

    -

    175

    175

    Operating expenses: -

    Accountancy fee

    - 800

    - 800

    Depreciation of property, plant and equipment

    - 2,500

    - 2,500

    Donation

    - 500

    - 500

    Electricity & water

    - 3,340

    - 3,340

    Insurance premium

    - 200

    - 200

    Printing & stationery

    - 1,697

    - 1,697

    Rental of premises

    - 12,000

    - 12,000

    Salaries

    - 27,865

    - 27,865

    Upkeep of office

    - 3,547

    - 3,547

    Telephone charges

    - 1,285

    - 1,285

    Travelling, petrol & toll charges

    - 2,648

    - 2,648

    - 56,382

    - 56,382

    Net profit for the year

    12,013

    12,188

    Retained profits B/F

    27,654

    27,654

    Retained profits C/F

    39,667

    39,842

    Balance Sheet as at 31 December 2007

    $

    $

    Non-current assets

    Property, plant and equipment

    10,000

    10,000

    Current assets

    Inventories

    5,000

    5,000

    Trade receivables

    17,030

    17,030

    Other receivables, deposits & prepayments:

    Interest receivable

    175

    175

    -

    Deposits

    14,077

    14,077

    Prepayments

    2,200

    2,200

    Fixed deposit with licensed bank

    100,000

    100,000

    -

    Cash and bank balances

    12,348

    100,350

    112,698

    150,830

    151,005

    Current liabilities

    Trade payables

    -3,588

    - 3,588

    Other payables and accruals

    -102,575

    - 102,575

    -106,163

    - 106,163

    Net current assets

    44,667

    44,842

    54,667

    54,842

    Financed by: -

    Share capital

    15,000

    15,000

    Retained profits

    39,667

    39,842

    54,667

    54,842

    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?


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