ACCT1 C3 BASIS OF ACCT By Aregawi Gebru(MA).ppt

FUNDAMENTAL
ACCT I (ACFN2011)
CHAPTER 3: BASIS OF ACCT
2
By: Aregawi Gebru
Tell: 0909919122

3
By: Aregawi Gebru, MA, 2011
E.C
(Instructor)
Tell: 0909919122
 The revenues earned and expanse incurred by business
enterprise are periodically assembled and reported in
income statements.
 Such statements cover a definite period of time such as
specific month ,quarterly, half year or year.
 The periodic matching of revenues and expenses not
only yields the amount of net income or net loss but also
yields the amounts for assets, liabilities, and capital to be
reported in the balance sheet.
Introduction

4
E.C
(Instructor)
Tell: 0909919122
3.1. Matching Principle
Matching principle:
 The matching principle dictates that efforts
(expenses) be matched with accomplishments
(revenues) in the accounting period.
 The need for proper matching of revenues and
expenses arises because of the existence of
accounting periods and of payments and receipts that
apply for different accounting periods.

3.2. Nature of Acct Basis
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E.C
(Instructor)
Tell: 0909919122
Revenues and expenses recording
business transactions are reported on the
income statement by either;
1. Cash Basis Accounting
2. Accrual Basis Accounting

3.2.1. Cash Basis Acct
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E.C
(Instructor)
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 It is an accounting method in which income is
recorded when cash is received, and expenses are
recorded when cash is paid out.
 It is, however, simpler than the accrual basis
accounting and quite suitable for small organizations
that transact business mainly in cash.
 Net in come is the difference between the cash receipts
(Revenues) and cash payments (expenses).
 This method will be used by organizations that have very few
receivables and payables.

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E.C
(Instructor)
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 A method of reporting revenues and expenses in the
income statement in the period in which cash is
received and paid, respectively.
 Revenue is recorded when cash is received (no
matter when it is "earned"), and expenses are
recognized when paid (no matter when "incurred").
 State that ‘’Revenues are reported in the period in
which cash is received and expenses are reported in
the period in which cash is paid.
 Revenues& expense are recorded when cash is
received & cash is paid respectively.

8
E.C
(Instructor)
Tell: 0909919122
 The cash basis is not compliant with GAAP basically
it violates the matching principle.
 Cash basis accounting does not follow with the
provisions of GAAP and is not considered a good
management tool because it leaves a time gap
between recording the cause of an action (sale or
purchase) and its result (payment or receipt of
money).

9
E.C
(Instructor)
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 The credit transactions are not recorded at all, till
actual cash is received or paid.
 Thus, if purchases are made in the year 2010 on credit
& payment for purchases is made in the year 2011,
such purchases shall be considered to be an expense of
the year 2011 & shall not be recorded in the year 2010.

10
E.C
(Instructor)
Tell: 0909919122
• Mostly followed by non-trading organizations,
professionals like lawyers, doctors, chartered accountants,
etc.
• Because the cash basis of accounting doesn’t match
expenses incurred & revenues earned, it is generally
unacceptable.
• Companies using the cash basis do not have to prepare
any adjusting entries unless they discover they have made
a mistake in preparing an entry during the accounting
period.

11
E.C
(Instructor)
Tell: 0909919122
 Accrual Accounting is a method for measuring the
performance and position of the company by identifying
economic events regardless of when cash transaction
happened.
 In this method, revenue is compared with the expenditures, at
the time in which the transaction happens rather than when
the payment is made.
• Transactions recorded in the periods in which the events
occur.
• In accrual basis accounting, income is reported in the
fiscal period it is earned, regardless of when it is
received, and expenses are deducted in the fiscal period
they are incurred, whether they are paid or not.
3.2.2. Accrual Basis Acct

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E.C
(Instructor)
Tell: 0909919122
recognize revenues when they perform services
(rather than when they receive cash). Expenses
are recognized when incurred (rather than when
paid).

13
E.C
(Instructor)
Tell: 0909919122
• Fiscal Year is a the maximum length of an accounting
period is usually one year (12 months). The annual
accounting period adopted by an enterprise is known as
fiscal year.
 state that ‘’Revenues are reported in the period
they are earned, and expenses are reported in
the period incurred regardless of the time of
cash receipt or payment
 In other words, using accrual basis accounting,
you record both revenues and expenses when
they occur.

14
E.C
(Instructor)
Tell: 0909919122
• A method of reporting revenues and expenses in the
income statement in the period in which they are earned
and incurred, respectively.
• Accruals occur when no cash has been received or paid, but the
company has undertaken activities that result in earning revenues or
incurring expenses.
• Unlike deferrals, no original entry has been recorded.
• Here: Revenues Earned when: service /product are sold to
customers.
 Expenses are incurred when some assets are consumed or
when the services of some Employees or party is used rather
than when cash is paid.

15
E.C
(Instructor)
Tell: 0909919122
• Concerned to all the business transactions
pertaining to the specific period, whether of cash or
credit nature, are recorded in the books.
• Revenues are recognized when sales are made or
services are performed, regardless of when cash is
received.
• Expenses are recognized as incurred, whether or not
cash has been paid out.

16
E.C
(Instructor)
Tell: 0909919122
• Actual movement of cash is irrelevant.
• Widely followed by the industrial and commercial
undertakings because it takes into account the effects of all
transactions already entered into.
• Adjusting entries are needed to bring the account up to date
for unrecorded economic activity that has taken place.
• Used for recording sales and expenses on an accrual
basis for long-term assets and a cash basis for short-
term assets.

17
By: Aregawi Gebru, MA,(Instructor)
Tell: 0909919122
Revenue is recorded in the
period it is earned
regardless of collection
In December 2019 ABC
Co. rendered Service :
 on cash: Br 100,000
 on account/on credit: Br
200,000 (it was collected
in Feb. 2020)
Total Revenue of Br
300,000 is reported in
December 2019
period of cash collection.
 In December 2019 ABC
 on cash: Br 100,000
200,000 (it was collected in
Feb. 2020)
Only Revenue of Br 100,000 is
reported in December 2019
and Br 200,000 is reported in
2020
 Accrual Basis of Accounting  Cash Basis of Accounting
Accrual Vs Cash Basis of Accounting
Companies prepare financial statements based on Accrual Basis
3.3. Accrual Vs Cash Basis Acct

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Tell: 0909919122
Expense is recorded in the
period it is incurred
regardless of payment
 In December2019 ABC
Co. incurred Expenses as
follows:
 paid in cash: Br 50,000
 incurred but not paid Br
80,000 (it was paid in Jan.
2020)
Total expense of Br 130,000
is reported in December
2019
Expense is recorded in the
period of cash payment.
 In December2019 ABC Co.
incurred Expenses as follows:
 paid in cash: Br 50,000
 incurred but not paid Br 80,000
(it was paid in Jan. 2020)
Only Expense of Br 50,000 is
reported in December 2019 and
Br 80,000 is reported in 2020

19
Tell: 0909919122
period it is earned
regardless of collection
In December 2019 ABC
 on cash: Br 100,000
200,000 (it was collected
in Feb. 2020)
Total Revenue of Br
300,000 is reported in
December 2019
period of cash collection.
 In December 2019 ABC
 on cash: Br 100,000
200,000 (it was collected in
Feb. 2020)
Only Revenue of Br 100,000 is
reported in December 2019
and Br 200,000 is reported in
2020

20
E.C
(Instructor)
Tell: 0909919122
Recognition Type Cash Basis Accrual Basis
Revenue As cash is
Received
As earned (goods are
delivered or services are
performed)
Expenses As cash is
Paid
As incurred to produce
revenues.

 Meaning Adjusting Entries
 Are entries made at the end of the period to
bring the balances of accounts that do not show
their true balance to the true balance to be
reported on the financial reports
 Are journal entries that are required at the end
of an accounting period to bring the ledger up to
date.
 Prepare & post accrued and deferred items to
journals and ledger accounts
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3.4. Nature of Adjustments

 Meaning Adjusting Entries
 Determine the correct amount of assets, liabilities,
owner’s equity, revenues , and expenses to be reported
on the financial statements
 Result of accrual basis of accounting, i.e. recording
revenues when earned and expenses when incurred
instead of cash basis of accounting
 Periodicity assumption: business life is divisible into
equal intervals of time called accounting periods for
reporting purpose
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Tell: 0909919122

23
E.C
(Instructor)
Tell: 0909919122
• Is the process of updating the outdated
accounts. Or
• Is the activity of assuring proper matching of
revenues and expenses within given Acct period
• Is the entries required at the end of an
accounting period to bring the accounts up-to-
date .
• entries required to up-date some accounts
before preparing financial statements.

24
E.C
(Instructor)
Tell: 0909919122
• Purpose of adjusting Entries:
 To measure all assets and Liabilities correctly
 To measure net income correctly by matching expired
costs (Expenses) with realized/Recognised revenue.
 To report all revenues earned during the accounting
period.
 To report all expenses incurred to produce the revenues
earned in the same accounting period.
 To accurately report the assets & liabilities on the
balance sheet date. Some assets may have been used
up during the accounting period & Expenses may have
been incurred, but not yet paid.

3.5. Types of Adjustments
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E.C
(Instructor)
Tell: 0909919122
 Generally, there are two types of Adjusting
entries:
1. Deferrals (Deferred expense & deferred revenue)
2. Accrual (Accrued expense & accrued revenue)
Adjustments are entered here. Two possibilities:
1. Deferrals – Existing balances are Changed.
2. Accruals – New information is entered.

26 By: Aregawi Gebru, MA, (Instructor) Tell: 0909919122

27 By: Aregawi Gebru, MA,(Instructor)Tell: 0909919122

28 By: Aregawi Gebru, MA,(Instructor)Tell: 0909919122

 The word “
defer means to delay or post
pone.
 Deferrals are the delay (or post ponment) in
the recognition of an expense already paid
or revenue already received.
 Deferrals are expenses or revenues that are
recognized at a date later than the point
when cash was originally exchanged.
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3.5. Deferrals

 Depreciation is an example of a deferred
expense.
 There are two types of deferrals:
Deferred/Prepaid Expenses and Unearned/Pre
collected Revenues.
 Deferred items consist of adjusting entries
involving data previously recorded in accounts.
 These entries involve the transfer of data
already recorded in asset and liability accounts
to expense and revenues accounts.
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Tell: 0909919122
3.5. Deferrals

31
E.C
(Instructor)
Tell: 0909919122
• Prepaid expenses are expenses paid in cash and recorded
as assets before they are used or consumed.
• Prepaid expenses expire with the passage of time or
through use and consumption.
• An asset-expense account relationship exists with prepaid
expenses.
• Prior to adjustment, assets are overstated and expenses
are understated.
• The adjusting entry results in a debit to an expense
account and a credit to an asset account.
• Concerned with Converting assets to Expenses
/Prepaid Expense Adjustments:
3.5.1. Deferred /Prepaid Expense

32
E.C
(Instructor)
Tell: 0909919122
 Pre-payments are initially recorded in asset account:

33
By: Aregawi Gebru, MA,(Instructor) Tell: 0909919122
1. purchased supplies costing 2,500 on October 5. Pioneer
recorded the purchase by increasing (debiting) the asset
Supplies. This account shows a balance of 2,500 in the
October 31. An inventory count at the close of business on
October 31 reveals that 1,000 of supplies are still on hand.
2. On October 4, Pioneer Advertising Inc. paid 600 for a one
year fire insurance policy. Coverage began on October 1.
Pioneer recorded the payment by increasing (debiting)
Prepaid Insurance. This account shows a balance of 600 in
the Oct. 31 TB.
 Required: prepared adjusting entry.
Examples.3.5.1

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Date Accounts Debit Credit
Oct. 31/2014 Supplies expense(2500-1000) 1500
Supplies 1500
To Record Supplies Used
Insurance Expense 50 (600 ÷ 12) 50
Prepaid Insurance
(Insurance of 50 (600 ÷ 12) expires each
month)
50
To Record Monthly Insurance
Expense
Solution 3.5.1.

35
By: Aregawi Gebru, MA, (Instructor) Tell:
0909919122
3.5.1. Deferred Prepaid/Expense
 Accumulated Depreciation is called a Contra Asset
Account.
 Book Value is the difference between the cost of
any depreciable asset and its accumulated
depreciation.

36
By: Aregawi Gebru, MA, (Instructor) Tell:
0909919122
3.5.1. Deferred Prepaid/Expense
Examples.3.5.1
 For Pioneer Advertising, assume that depreciation on
the equipment is 480 a year, or 40 per month.
 Required: prepared adjusting entry at the end of the
Month.
Solution 3.5.1
Oct. 31/2014 Depreciation Expense(480/12) 40
Accumulated Depreciation 40
To Record Monthly Depreciation

37
E.C
(Instructor)
Tell: 0909919122
• Deferred Revenue When a business enterprise
receives payment for goods and services before
goods are delivered or the services are performed, a
liability exists until performance takes place.
• Under this approach adjusting Entry reduce the
liability account and increase the Revenue account
for the earned portion of revenue during the period.
3.5.2. Deferred/Unearned /Pre collected Revenue

38
E.C
(Instructor)
Tell: 0909919122
 Deferred Revenue

39
 Pioneer Advertising Inc. received 1,200 on October 2
from R. Knox for advertising services expected to be
completed by December 31. Unearned Service
Revenue shows a balance of 1,200 in the October 31
trial balance.
 Required: Analyze & prepared adjusting entry at the end
of the October 31.
•
• Analysis reveals that the company performed 400 of
services in October.(Oct. Nov. Dec. 31)
Example:3.5.2

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 Analysis indicates that the company received 1,200
on October 2 from R. Knox for advertising services
expected to be completed by December 31.(Oct. Nov.
Dec. 31)
 . Unearned Service Revenue = 1200/3 = 400 in Oct.31.
the Adjusted Journal entry also
Solution:3.5.2
Oct. 31/2014 Service Revenue 400
Unearned Service Revenue 400
To Record Monthly Service Revenue
Performed

41
E.C
(Instructor)
Tell: 0909919122
 Deferred Revenue

 Accruals occur when no cash has been
received or paid, but the company has
undertaken activities that result in earning
revenues or incurring expenses.
 Unlike deferrals, no original entry has been
recorded.
42
Tell: 0909919122
3.5.3. Accruals

 Accrued Expenses or accrued liabilities are expenses
that have been incurred but have not been
recorded in the accounts.

43
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3.5.3. Accrued Expense

 Examples 3.5.3.
1. Queens College signed a three-month note payable in
the amount of 5,000 on October 1. The note requires
Queens to pay interest at an annual rate of 12%.
2. Queens College paid salaries & wages on October 26;
the next payment of salaries will not occur until
November 9. The employees receive total salaries of
2,000 for a five-day work week, or 400 per day.
Required: Make necessary adjusting entry
44
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3.5.3. Accrued Expenses

 Solution 3.5.3:
1. The interest expense on this note until 3 month
October 1. is calculated using the following formula:

 Interest = 5,000 * 12% per year. * 1/12 Months = Br. 50.
45
Tell: 0909919122
Oct. 31/2008 Interest Expense 50
Interest Payable 50
To record Monthly interest on Notes payable

2. The employees receive total salaries of 2,000 for a five-
day work week, or 400(2000/5) per day. Thus, accrued
salaries at October 31 are 1,200 (400 x 3 days).The
accrued salaries at October 31 are 1,200 (400 x 3 days)
46
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Solution:3.5.2

47
Tell: 0909919122
Oct. 31/2008 Salaries & Wages Expense 1200
Salaries & Wages Payable 1200
To record Accrued Salaries & Wages
Solution:3.5.3

48
Tell: 0909919122
3.5.4. Accrual of Unrecorded Revenue

 Is revenue that has been realized but not recorded
that must be recognized at the end of an accounting
period. Examples include:
 Unbilled commissions by travel agent,
 Accrued interest on notes receivable
 Accrued rent on property rented to others
49
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Example:3.5.4
1. Pioneer Advertising Inc. signed an annually note
payable in the amount of 5,000 on October 1. The note
requires Pioneer to pay interest at an annual rate of
12%. Determine the adjusting entry to record the interest
expense incurred in October 31 is:
2. In October, Pioneer Advertising Inc. performed
services worth 200 that were not billed to clients in
October.
 Required: Make necessary adjusting entry:
50
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3.5.4. Accrued/Unrecorded Revenue

 Solution 3.5.4
1. The interest revenue earned For Oct 31, is
calculated using the following formula:
 Interest = 5000 * 12% per year. * 1/12 Months = Br. 50
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 Solution 3.5.4
52
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Dec. 31 Interest Receivable 50
Interest Income 50
To record the Monthly interest
on Notes payable
Oct. 31 Accounts Receivable 200
Service Revenue 200
To record Revenue for the
interest on Notes payable

53
By: Aregawi Gebru, MA,(Instructor)Tell: 0909919122

54
Summary of Basic Adjustments

55
Summary of Basic Adjustments

uestion
&
nswer
By: Aregawi Gebru,
MA,(Instructor)
Tell: 0909919122

Example
of a
Statement
of Cash
Flows
Exhibit
4.1

ACCT1 C3 BASIS OF ACCT By Aregawi Gebru(MA).ppt

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