Question

Explain the difference between accrual based accounting and cash basis accounting.

-What is the revenue recognition principle?

-What is an accrual?

-What is an unearned revenue?

-What is the trial balance used for?

Answer 1

2.5 Basis of Accounting : There are two important basis for recognising revenue in accounting from the view point of the timing of recognition of income and expenditure. These approaches are Cash basis and Accrual basis. Cash Basis : On the cash basis, incomes and expenses are identified only on the date of receipt or payment of cash, but not on the date of transaction. The realisation in cash of a transaction is only considered. The cash basis is adopted when there is doubt regarding the realisation of payment from the party. In case of sales on Hire Purchase and Instalments, payment is made in certain instalments, split over a period of certain years. Accounts of professionals and government concerns are made on this basis. Outstanding expenses like salary or rent of last month of the year paid in subsequent month of next year, or incomes receivable are not included. Credit sales or credit purchases are also excluded from this purview. Hence, this system considers just cash realisation of the transaction but not the related period of the transaction. Accrual Basis: According to accrual basis revenue and expenses are recognised when they occur rather than when they are actually received or paid in cash. Revenue and expenses are supposed to be generated when legal right to receive payments and legal obligation to make payments are established. Under this system, the revenue is recognised in the period of its occurrence and not in the period of its actual receipts or payments in cash. Example, Credit sale

fice for the month of December 2010, realised in March, 2011, will be recorded in the e books, as December 2010 only. In the same way outstanding rent payable for the month of December 2010 will be recorded in the books, during December 2010 only, and we shall not be waiting for the actual date of payment. It is a widely accepted method as it considers the date on which transaction occurs. As such, it facilitates matching revenue and expense of the period and determines the profit earned during the period. Differences between Cash Basis and Accrual Basis: Points of Difference Cash Basis Accrual Basis Basis of transactions | It is based on cash transactions. It is based on cash and credit transactions. Adjustments Accounting is simple as it does not Accounting involves the involve the adjustments. adjustments while preparing financial statements. It is not reliable, because it Itis more reliable and accurate considers only the cash transactions. as it considers both cash and credit transactions. Reliability Results Financial Statements would not Financial Statements would reveal accurate profit & results. reveal accurate results. Users Professionals, small concerns, non- | All business organisations. trading concerns, Government departments.

Revenue recognition (realisation) concept : This concept states that, revenue is earned from the sale of goods or from provision of services to customers and revenue is said to be recognised or considered to be realised only when goods or services are transferred to a customer and the customer becomes legally liable to pay for them. So, when an order is received from a customer, it does not mean that, revenue is realised or earned even if, an advance payment is received from a customer.

For example, Mr. Peter receives an order for goods on April 2011 and he sells the goods on May 2011 but receives the amount for them in July 2011. In this case, revenue will be recognised on May 2011 i.e., when Mr. Peter sells the goods.

6.2 : Objectives of preparing the Trial Balance. To ascertain the arithmetical accuracy of ledger accounts. 1. As stated earlier, the purpose of preparing a trial balance is to ascertain whether all debits and credits are properly recorded in the ledger or not and that all accounts have been correctly balanced. As a summary of the ledger, it is a list of the accounts and their balances. When the totals of all the debit balances and credit balances in the trial balance are equal, it is assumed that the posting and balancing of accounts is arithmetically correct. However, the tallying of the trial balance is not a conclusive proof of the accuracy of the accounts. It only ensures that all debits and the corresponding credits have been properly recorded in the ledger. To help in locating errors : When a trial balance does not tally (i.e., when the total of debit column is not equal to the total of credit column) we can conclude that some errors have crept in the books of account. The errors might have occurred in any one of the following accounting stages mentioned below; 1. Totalling of subsidiary books. 2. Posting of journal entries in to the ledger. 3. Balancing of ledger accounts. 4. Carrying ledger account balances to the trial balance and 5. Totalling the trial balance columns. Thus, a trial balance helps us to verify the correctness of entries in the books of account. However, it should be noted that the mere agreement of the trial balance is not a conclusive evidence of the correctness of the books of account. Sometimes, a trial balance may agree even if some errors still exists in the books of account such errors not disclosed by the trial balance are called two-sided errors. For example errors of commission, errors of complete m Delehona omission, errors of principle compensating errors, etc. The errors disclosed by trial balance are called one-sided errors (Refer 6.4)

3. To help in the preparation of the Financial Statements. Trial balance is considered as the connecting link between accounting records and the preparation of financial statements (Trading A/c, Profit & Loss A/c and Balance sheet). For preparing the financial statements one need not refer to the ledger. In fact the availability of a tallied trial balance is the first step in the preparation of financial statements. All revenues and expenses accounts appearing in the trial balance are transferred to the trading and profit and loss account and all liabilities, capital and assets accounts are transferred to the balance sheet. (Preparation of financial statements is explained in chapter - 8) To help in the making of adjustments while preparing final accounts: Trial balance helps us to find out the transactions that requires the passing of adjusting entries. Trial balance contains only those items which have been already recorded in the books of accounts but at the same time it may not contain certain items of incomes and expenses, gains and losses which belong to the year to which the final accounts are to be prepared. Unless such outstanding items are not properly adjusted it is difficult to ascertain the correct trading results and financial position of the business. Therefore, adjustments in respect of items like closing stock, prepaid expenses, outstanding expenses and incomes, incomes received in advance, bad debts, provision for doubtful debts, depreciation, interests, etc. are essential for the preparation of final accounts.

Accrual Concept: The accrual concept states that, the future consequence of a transaction arises, when a transaction is entered into books of accounts. So, all transactions must be brought into record, whether they are settled in cash or not. It suggests that, all the items of revenues will be treated as such for which there is a legal right to receive them even though cash might not have been received for the same. Similarly, the items of expenses are treated as such for which there is a legal obligation to pay them, even though cash might not have been paid for the same. This concept has given rise to the introduction of the accrual system of accounting as against cash system of accounting. So, interest on capital, interest on drawings, depreciation, provisions and reserves etc., which are not paid or received in cash, and are taken into account while preparing the financial statements of every year.

Unearned revenue means the income which is not yet earned , in the sense that the advance money is received but the goods or service against such money is not yet rendered .

The journal entry to record unearned revenue is :

Cash A/c   

Unearned revenue A/c

And when the goods or service are rendered the journal entry is :

Sales A/c

Unearned revenue A/c

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