Professional Documents
Culture Documents
Types of Accounting
Accounting is a vast and dynamic profession and is constantly adapting itself to
the specific and varying needs of its users. Over the past few decades,
accountancy has branched out into specialized areas to cater for the different
needs of the users.
Main types of accounting are as follows:
Financial Accounting, or financial reporting, is the process of producing
information for external use usually in the form of financial statements.
Financial Statements reflect an entity's past performance and current position
based on a set of standards and guidelines known as GAAP (Generally Accepted
Accounting Principles). GAAP refers to the standard framework of guideline for
financial accounting used in any given jurisdiction. This generally includes
accounting standards (e.g. International Financial Reporting Standards),
accounting conventions, and rules and regulations that accountants must follow
in the preparation of the financial statements.
Equity: What the business owes to its owners. This represents the amount
of capital that is left in the business after its assets are used to pay off its
outstanding liabilities.
120,000
Equity
Share Capital
80,000
Retained Reserves
Total Equity
20,000
100,000
100,000
Liabilities
Payables 5,000
Bank Loan15,000
Total Liability
20,000
Assets of an entity may be financed from internal sources (i.e. share capital and
profits) or from external credit (e.g. bank loan, trade creditors, etc.). Since the
total assets of a business must be equal to the amount of capital invested by the
owners (i.e. in the form of share capital and profits not withdrawn) and any
borrowings, its no surprise that in the above example total Assets worth
$120,000 equal to the sum of Equity ($100,000) and Liabilities ($20,000).
Accounting Concepts and Principles are a set of broad conventions that have
been devised to provide a basic framework for financial reporting. As financial
reporting involves significant professional judgments by accountants, these
concepts and principles ensure that the users of financial information are not
mislead by the adoption of accounting policies and practices that go against the
spirit of the accountancy profession. Accountants must therefore actively
consider whether the accounting treatments adopted are consistent with the
accounting concepts and principles.
In order to ensure application of the accounting concepts and principles, major
accounting standard-setting bodies have incorporated them into their reporting
frameworks such as the IASB Framework.
Following is a list of the major accounting concepts and principles:
Relevance
Reliability
Neutrality
Faithful Representation
Substance over Form
Prudence
Completeness
Comparability/Consistency
Understandability
Materiality
Going Concern
Accruals
Business Entity
In case where application of one accounting concept or principle leads to a
conflict with another accounting concept or principle, accountants must consider
what is best for the users of the financial information. An example of such a case
would be the trade off between relevance and reliability. Information is more
relevant if it is disclosed timely. However, it may take more time to gather
reliable information. Whether reliability of information may be compromised to
ensure relevance of information is a matter of judgment that ought to be
considered in the interest of the users of the financial information.
Relevance:
Information should be relevant to the decision making needs of the user.
Information is relevant if it helps users of the financial statements in predicting
future trends of the business (Predictive Value) or confirming or correcting any
past predictions they have made (Confirmatory Value). Same piece of
information which assists users in confirming their past predictions may also be
helpful in forming future forecasts.
Example:
A company discloses an increase in Earnings Per Share (EPS) from $5 to $6
since the last reporting period. The information is relevant to investors as it may
assist them in confirming their past predictions regarding the profitability of the
company and will also help them in forecasting future trend in the earnings of
the company.
Relevance is affected by the materiality of information contained in the financial
statements because only material information influences the economic decisions
of its users.
Example:
A default by a customer who owes $1000 to a company having net assets of
worth $10 million is not relevant to the decision making needs of users of the
financial statements.
However, if the amount of default is, say, $2 million, the information becomes
relevant to the users as it may affect their view regarding the financial
performance and position of the company.
Reliability
Information is reliable if a user can depend upon it to be materially accurate and
if it faithfully represents the information that it purports to present. Significant
misstatements or omissions in financial statements reduce the reliability of
information contained in them.
Example:
A company is being sued for damages by a rival firm, settlement of which could
threaten the financial stability of the company. Non-disclosure of this
information would render the financial statements unreliable for its users.
Reliability of financial information is enhanced by the use of following
accounting concepts and principles:
Meaning
Substance over form is an accounting concept which means that the economic
substance of transactions and events must be recorded in the financial
statements rather than just their legal form in order to present a true and fair
view of the affairs of the entity.
Substance over form concept entails the use of judgment on the part of the
preparers of the financial statements in order for them to derive the business
sense from the transactions and events and to present them in a manner that best
reflects their true essence. Whereas legal aspects of transactions and events are
of great importance, they may have to be disregarded at times in order to
provide more useful and relevant information to the users of financial
statements.
Example:
There is widespread use of substance over form concept in accounting.
Following are examples of the application of the concept in the International
Financial Reporting Standards (IFRS).
IAS 17 Leases requires the preparers of financial statements to consider
the substance of lease arrangements when determining the type of lease for
accounting
purposes.
For example, an asset may be leased to a lessee without the transfer of
legal title at the end of the lease term. Such a lease may, in substance, be
considered as a finance lease if for instance the lease term is substantially
for entire useful life of the asset or the lease agreement entitles the lessee
to purchase the asset at the end of the lease term at a very nominal price
and it is very likely that such option will be exercised by the lessee in the
given circumstances.
IAS 18 Revenue requires accountants to consider the economic substance
of the sale agreements while determining whether a sale has occurred or
not.
For example, an entity may agree to sell inventory to someone and buy
back the same inventory after a specified time at an inflated price that is
planned to compensate the seller for the time value of money. On paper,
the sale and buy back may be deemed as two different transactions which
should be dealt with as such for accounting purposes i.e. recording the sale
and (subsequently) purchase. However, the economic reality of the
transactions is that no sale has in fact occurred. The sale and buy back,
when considered in the context of both transactions, is actually a financing
arrangement in which the seller has obtained a loan which is to be repaid
with interest (via inflated price). Inventory acts as the security for the loan
which will be returned to the 'seller' upon repayment. So instead of
recognizing sale, the entity should recognize a liability for loan obtained
which shall be reversed when the loan is repaid. The excess of loan
received and the amount that is to be paid (i.e. inflated price) is recognized
as finance cost in the income statement.
Importance
The principle of Substance over legal form is central to the faithful
representation and reliability of information contained in the financial
statements. By placing the responsibility on the preparers of the financial
statements to actively consider the economic reality of transactions and events to
be reflected in the financial statements, it will be more difficult for the preparers
to justify the accounting of transactions in a manner that does fairly reflect the
substance of the situation. However, the principle of substance over form has so
far not been recognized by IASB or FASB as a distinct principle in their
Comparability/Consistency
Example:
If a company that retails leather jackets valued its inventory on the basis of
FIFO method in the past, it must continue to do so in the future to preserve
consistency in the reported inventory balance. A switch from FIFO to LIFO
basis of inventory valuation may cause a shift in the value of inventory between
the accounting periods largely due to seasonal fluctuations in price.
Understandability
Transactions and events must be accounted for and presented in the financial
statements in a manner that is easily understandable by a user who possesses a
reasonable level of knowledge of the business, economic activities and
accounting in general provided that such a user is willing to study the
information with reasonable diligence.
Understandability of the information contained in financial statements is
essential for its relevance to the users. If the accounting treatments involved and
the associated disclosures and presentational aspects are too complex for a user
to understand despite having adequate knowledge of the entity and accountancy
in general, then this would undermine the reliability of the whole financial
statements because users will be forced to base their economic decisions on
undependable information.
Example:
One of the main problems with the financial statements of ENRON was that it
contained a very complicated structure of special purpose entities that were
presented in a manner that concealed the financial risk exposure of the company.
The accounting treatments of ENRON were not comprehensible by the capital
market participants who consistently overvalued its worth until the inevitable
collapse of its share price in 2001 upon the news of its bankruptcy.
Materiality
Information is material if its omission or misstatement could influence the
economic decisions of users taken on the basis of the financial statements (IASB
Framework).
Materiality therefore relates to the significance of transactions, balances and
errors contained in the financial statements. Materiality defines the threshold or
cutoff point after which financial information becomes relevant to the decision
making needs of the users. Information contained in the financial statements
must therefore be complete in all material respects in order for them to present a
true and fair view of the affairs of the entity.
Materiality is relative to the size and particular circumstances of individual
companies.
Example - Size
A default by a customer who owes only $1000 to a company having net assets
of worth $10 million is immaterial to the financial statements of the company.
However, if the amount of default was, say, $2 million, the information would
have been material to the financial statements omission of which could cause
users to make incorrect business decisions.
Example - Nature
If a company is planning to curtail its operations in a geographic segment which
has traditionally been a major source of revenue for the company in the past,
then this information should be disclosed in the financial statements as it is by
its nature material to understanding the entity's scope of operations in the future.
Materiality is also linked closely to other accounting concepts and principles:
Relevance: Material information influences the economic decisions of the
users and is therefore relevant to their needs.
Accruals Concept
Financial statements are prepared under the Accruals Concept of accounting
which requires that income and expense must be recognized in the accounting
periods to which they relate rather than on cash basis. An exception to this
general rule is the cash flow statement whose main purpose is to present the
cash flow effects of transaction during an accounting period.
Expenses, on the other hand, must be recorded in the accounting period in which
they are incurred. Therefore, accrued expense must be recognized in the
accounting period in which it occurs rather than in the following period in which
it will be paid. Conversely, prepaid expense must be not be shown as expense in
the accounting period in which it is paid but instead it must be presented as such
in the subsequent accounting periods in which the services in respect of the
prepaid expense have been performed.
Accruals basis of accounting ensures that expenses are "matched" with the
revenue earned in an accounting period. Accruals concept is therefore very
similar to the matching principle.
The business entity concept also explains why owners' equity appears on the
liability side of a balance sheet (i.e. credit side). Share capital contributed by a
sole trader to his business, for instance, represents a form of liability (known as
equity) of the 'business' that is owed to its owner which is why it is presented on
the credit side of the balance sheet.
Assets may be classified into Current and Non-Current . The distinction is made
on the basis of time period in which the economic benefits from the asset will
flow to the entity.
Current Assets are ones that an entity expects to use within one-year time from
the reporting date.
Non Current Assets are those whose benefits are expected to last more than one
year from the reporting date.
Following are the most common types of Assets and their Classification along
with the economic benefits derived from those assets.
Asset
Machine
Used
for
the
Non-current production of goods
for sale to customer.
Office Building
Provides space to
employees
for
Non-current
administering
company affairs.
Vehicle
Used
in
the
transportation
of
Non-current company
products
and
also
for
commuting.
Inventory
Current
Cash
from
is generated
the sale of
inventory.
Cash
Current
Cash!
Receivables
Current
Liabilities
According to IASB Frmework liability is defined as follows:
A liability is a present obligation of the enterprise arising from past events, the
settlement of which is expected to result in an outflow from the enterprise of
resources embodying economic benefits (IASB Framework).
Liability could for instance be a bank loan, which obligates the entity to pay
loan installments over the duration of the loan to the bank along with the
associated interest cost. Alternatively, an entity's liability could be a trade
payable arising from the purchase of goods from a supplier on credit.
Current Liability is one which the entity expects to pay off within one year from
the reporting date.
Non-Current Liability is one which the entity expects to settle after one year
from the reporting date.
Following are examples of some of the common types of liabilities along with
their usual classification:
Liability
Classification
Non-current
Bank Overdraft
Current
Current
Trade Payble
Current
Debenture
Non-current
Tax Payble
Current
It may be appropriate to break up a single liability into their current and non
current portions. For instance, a bank loan spanning two years and carrying 2
equal installments payable at the end of each year would be classified half as
current and half as non-current liability at the inception of loan.
Liability
Classification
Non-current
Bank Overdraft
current
current
Trade Payble
current
Debenture
Non-current
Tax Payble
Current
It may be appropriate to break up a single liability into their current and non
current portions. For instance, a bank loan spanning two years and carrying 2
equal installments payable at the end of each year would be classified half as
current and half as non-current liability at the inception of loan.
Equity
Equity is the residual interest in the assets of the entity after deducting all the
liabilities (IASB Framework).
Equity is what the owners of an entity have invested in an enterprise. It
represents what the business owes to its owners. It is also a reflection of the
capital left in the business after assets of the entity are used to pay off any
outstanding liabilities.
Equity therefore includes share capital contributed by the shareholders along
with any profits or surpluses retained in the entity. This is what the owners take
home in the event of liquidation of the entity.
The Accounting Equation may further explain the meaning of equity:
Assets - Liabilities = Equity
This illustrates that equity is the owner's interest in the Net Assets of an entity.
Rearranging the above equation, we have
Assets = Equity + Liabilities
Assets of an entity have to be financed in some way. Either by debt (Liability) or
by share capital and retained profits (Equity). Hence, equity may be viewed as a
type of liability an entity has towards its owners in respect of the assets they
financed.
Examples of Equity recognized in the financial statements include the
following:
Ordinary Share Capital
Preference Share Capital (irredeemable)
Retained Earnings
Revaluation Surpluses
Income
Income is increases in economic benefits during the accounting period in the
form of inflows or enhancements of assets or decreases of liabilities that result
in increases in equity, other than those relating to contributions from equity
participants (IASB Framework).
Income is therefore an increase in the net assets of the entity during an
accounting period except for such increases caused by the contributions from
owners. The first part of the definition is quite easy to understand as income
must logically result in an increase in the net assets (equity) of the entity such as
by the inflow of cash or other assets. However, net assets of an entity may
increase simply by further capital investment by its owners even though such
increase in net assets cannot be regarded as income. This is the significance of
the latter part of the definition of income.
There are two types of income:
Sale Revenue: Income earned in the ordinary course of business activities
of the entity;
Gains: Income that does not arise from the core operations of the entity.
For instance, sale revenue of a business whose main aim is to sell biscuits is
income generated from selling biscuits. If the business sells one of its factory
machines, income from the transaction would be classified as a gain rather than
sale revenue.
Following are common sources of incomes recognized in the financial
statements:
Sale revenue generated from the sale of a commodity.
Interest received on a bank deposit.
Dividend earned on entity's investments.
Rentals received on property leased by the entity.
Gain on re-valuation of company assets.
Income is accounted for under the accruals principal whereby it is recognized
for the whole accounting period in full, irrespective of whether payments have
been received or not.
As income is an element of the income statement, it is calculated over the entire
accounting period (usually one year) unlike balance sheet items which are
calculated specifically for the year end date.
Expense
Expenses are the decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that
result in decreases in equity, other than those relating to distributions to equity
participants (IASB Framework).
Expense is simply a decrease in the net assets of the entity over an accounting
period except for such decreases caused by the distributions to the owners. The
first aspect of the definition is quite easy to grasp as the incurring of an expense
must reduce the net assets of the company. For instance, payment of a
company's utility bills reduces cash. However, net assets of an entity may also
decrease as a result of payment of dividends to shareholders or drawings by
owners of a business, both of which are distributions of profits rather than
expense. This is the significance of the latter part of the definition of expense.
Following is a list of common types of expenses recognized in the financial
statements:
Salaries and wages
Utility expenses
Cost of goods sold
Administration expenses
Finance costs
Depreciation
Impairment losses
Expense is accounted for under the accruals principal whereby it is recognized
for the whole accounting period in full, irrespective of whether payments have
been made or not.
As expense is an element of the income statement, it is calculated over the entire
accounting period (usually one year) unlike balance sheet items which are
calculated specifically for the year end date.
gets a bottle of dink. This simple transaction has two effects from the
perspective of both, the buyer as well as the seller. The buyer's cash balance
would decrease by the amount of the cost of purchase while on the other hand
he will acquire a bottle of drink. Conversely, the seller will be one drink short
though his cash balance would increase by the price of the drink.
Accounting attempts to record both effects of a transaction or event on the
entity's financial statements. This is the application of double entry concept.
Without applying double entry concept, accounting records would only reflect a
partial view of the company's affairs. Imagine if an entity purchased a machine
during a year, but the accounting records do not show whether the machine was
purchased for cash or on credit. Perhaps the machine was bought in exchange of
another machine. Such information can only be gained from accounting records
if both effects of a transaction are accounted for.
Traditionally, the two effects of an accounting entry are known as Debit (Dr)
and Credit (Cr). Accounting system is based on the principal that for every Debit
entry, there will always be an equal Credit entry. This is known as the Duality
Principal.
Debit entries are ones that account for the following effects:
Increase in assets
Increase in expense
Decrease in liability
Decrease in equity
Decrease in income
Credit entries are ones that account for the following effects:
Decrease in assets
Decrease in expense
Increase in liability
Increase in equity
Increase in income
Double Entry is recorded in a manner that the Accounting Equation is always in
balance.
Assets - Liabilities = Capital
Any increase in expense (Dr) will be offset by a decrease in assets (Cr) or
increase in liability or equity (Cr) and vice-versa. Hence, the accounting
equation will still be in equilibrium.
Examples of Double Entry
1. Purchase of machine by cash
Debit
Credit
Ledger Accounts
Accounting Entries are recorded in ledger accounts. Debit entries are made on
the left side of the ledger account whereas Credit entries are made to the right
side. Ledger accounts are maintained in respect of every component of the
financial statements. Ledger accounts may be divided into two main types:
balance sheet ledger accounts and income statement ledger accounts.
Balance Sheet Ledger Accounts
Balance Sheet ledger accounts are maintained in respect of each asset, liability
and equity component of the statement of financial position.
Following is an example of a receivable ledger account:
Receivable Account
Debit
Credit
Balance b/d
1 500
Cash
3 500
Sales
2 1000
Balance c/d
4 1000
1500
1500
This is the amount of cash received from the debtor. Receiving cash has
the effect of reducing the receivable asset and is therefore shown on the
credit side. As it can seen, the corresponding debit entry is made in the
cash ledger.
This represents the balance due from the debtor at the end of the
accounting period. The figure has been arrived by subtracting the amount
shown on the credit side from the sum of amounts shown on the debit side.
This accounting period's closing balance is being carried forward as the
opening balance of the next period.
Similar ledger accounts can be made for other balance sheet components such as
payables, inventory, equity capital, non current assets and so on.
Cash
1 1,000
1,000
Credit
Income Statement
$
2 1,000
1,000
This is the amount of cash paid against electricity bill. The expense ledger
is being debited to account for the increase in expense. The corresponding
credit entry has been made in the cash ledger.
This represents the amount of expense charged to the income statement.
The balance in the ledger has been recycled to the income statement which
is being debited by the same amount. Unlike balance sheet ledger
Accounting Equation
Note:
For all the examples on the next pages, it will be assumed that before any
transaction, Assets of ABC LTD are $10,000 while its Liabilities and Equity are
$5,000 each.
Depreciation
Depreciation is systematic allocation the cost of a fixed asset over its useful life.
It is a way of matching the cost of a fixed asset with the revenue (or other
economic benefits) it generates over its useful life. Without depreciation
accounting, the entire cost of a fixed asset will be recognized in the year of
purchase. This will give a misleading view of the profitability of the entity. The
observation may be explained by way of an example.
Example
ABC LTD purchased a machine costing $1000 on 1st January 2001. It had a
useful life of three years over which it generated annual sales of $800. ABC
LTD's annual costs during the three years were $300.
If ABC LTD expensed the entire cost of the fixed asset in the year of purchase,
its income statement would present the following picture the end of the three
years:
Income Statement
2001
2002
2003
Sales
800
800
800
Cost of Sales
(300)
(300)
(300)
1000
(500)
500
500
As you can see, income statement of ABC LTD shows net loss in the first year
even though it earned the same revenue as in the subsequent years. Conversely,
no fixed asset will appear in ABC LTD's balance sheet although it had earned
revenue from the machine's use through out its useful life of 3 years.
If ABC LTD, instead of charging the entire cost of fixed asset at once,
depreciates the capital expenditure over its useful life, its income statement and
balance sheet would present the following picture at the end of the three years:
Income Statement
2001
2002
2003
Sales
800
800
800
Cost of Sales
(300)
(300)
(300)
333.3
333.3
333.3
(166.7)
(166.7)
(166.7)
2001
2002
2003
Fixed Assets
1,000
1,000
1,000
Accumulated Depreciation
(333.3)
(666.7)
(1,000)
666.7
333.3
Nill
As you can see, the process of relating cost of a fixed asset to the years in which
the economic benefits from its use are realized creates a more balanced view of
the profitability of the company. Hence, depreciation is an application of the
matching principle whereby costs are matched to the accounting periods to
which they relate rather than on the basis of payment.
Accounting Entry
Double entry involved in recoding depreciation may be summarized as follows:
Debit
Credit
333.3
333.3
333.4
Balance c/d
Credit
333.3
2001
$
Depreciation Expense
333.3
2002
Balance c/d
666.6
333.3
2002
Balance b/d
333.3
2002
Depreciation Expense
333.3
666.6
2003
Balance c/d
1000
333.3
666.6
2003
Balance b/d
666.6
2003
Depreciation Expense
333.4
1000
1000
asset's useful life, there is no need to charge the portion of cost equaling
the residual value.
Rate of depreciation is defined according to the estimated pattern of an
asset's use over its life term.
Example:
An asset has a useful life of 3 years.
Cost of the asset is $2,000.
Residual Value is $500.
Rate of depreciation is 50%.
Depreciation expense for the three years will be as follows:
NBV
R.V
Rate
Depreciation
Accumalated Depreciation
750
1125
Year3: (875
1500
*Under reducing balance method, depreciation for the last year of the asset's
useful life is the difference between net book value at the start of the period and
the estimated residual value. This is to ensure that depreciation is charged in
full.
As you can see from the above example, depreciation expense under reducing
balance method progressively declines over the asset's useful life.
Reducing Balance Method is appropriate where an asset has a higher utility in
the earlier years of its life. Computer equipment for instance has better
functionality in its early years. Computer equipment also becomes obsolete in a
span of few years due to technological developments. Using reducing balance
method to depreciate computer equipment would ensure that higher depreciation
is charged in the earlier years of its operation.
Methods of Depreciation
Cost of fixed asset must be charged to the income statement in a manner that
best reflects the pattern of economic use of the asset. Most common methods of
depreciation include Straight Line Method and Reducing Cost Method.
Prepaid Expense
Accrued Income
Accrued income is income which has been earned but not yet received.
Income must be recorded in the accounting period in which it is earned.
Therefore, accrued income must be recognized in the accounting period in
which it arises rather than in the subsequent period in which it will be received.
Example
ABC LTD receives interest of $10,000 on bank deposit for the month of
December 2010 on 3rd January 2011. ABC LTD has an accounting year end of
31st December 2010.
ABC LTD will recognize interest income of $10,000 in the financial statements
of year 2010 even though it was received in the next accounting period as it
relates to the current period. Following accounting entry will need to be
recorded to account for the interest income accrued:
$
Debit
10,000
10,000
On the date of receipt of interest (i.e. 3rd January of the next year) following
accounting entry will need to be recorded in the subsequent year:
$
Debit
Bank
Credit
10,000
10,000
Accrued Expense
Accrued expense is expense which has been incurred but not yet paid.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, accrued expense must be recognized in the accounting period in
which it occurs rather than in the following period in which it will be paid.
Example
ABC LTD pays loan interest for the month of December 2010 of $10,000 on 3rd
January 2011. ABC LTD has an accounting year end of 31st December 2010.
ABC LTD will recognize interest expense of $10,000 in the financial statements
of year 2010 even though it was paid in the next accounting period as it relates
to the current period. Following accounting entry will need to be recorded to
account for the interest expense accrued:
$
Debit
Interest Expense
Credit
10,000
Interest Payable
10,000
On the date of payment of interest (i.e. 3rd January of the next year) following
accounting entry will need to be recorded in the subsequent year:
$
Debit
Interest Payable
Credit
10,000
Cash
10,000
Prepaid Income
Prepaid income is revenue received in advance but which is not yet earned.
Income must be recorded in the accounting period in which it is earned.
Therefore, prepaid income must be not be shown as income in the accounting
period in which it is received but instead it must be presented as such in the
subsequent accounting periods in which the services or obligations in respect of
the prepaid income have been performed.
Entity should therefore recognize a liability in respect of income it has received
in advance until such time as the obligations or services that are due on its part
in relation to the prepaid income have been performed. Following accounting
entry is required to account for the prepaid income:
Debit
Cash/Bank
Credit
Example
ABC LTD receives advance rent from its tenant of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize a liability of $10,000 in the financial statements of
year 2010 in respect of the prepaid income to acknowledge its obligation to
make the office space available to the tenant in the following year. Following
accounting entry will be recorded in the books of ABC LTD in the year 2010:
$
Debit
Cash
Credit
10,000
10,000
The prepaid income will be recognized as income in the next accounting period
to which the rental income relates. Following accounting entry will be recorded
in the year 2011:
$
Debit
10,000
10,000
Prepaid Expense
Prepaid expense is expense paid in advance but which has not yet been incurred.
Expense must be recorded in the accounting period in which it is incurred.
Therefore, prepaid expense must be not be shown as expense in the accounting
Cash
Example
ABC LTD pays advance rent to its landowner of $10,000 on 31st December
2010 in respect of office rent for the following year. ABC LTD has an
accounting year end of 31st December 2010.
ABC LTD will recognize an asset of $10,000 in the financial statements of year
2010 in respect of the prepaid expense to recognize its right to use office space
in the following year. Following accounting entry will be recorded in the books
of ABC LTD in the year 2010:
$
Debit
Prepaid Rent
Credit
10,000
Cash
10,000
Cash/Bank
10,000
10,000
Trial balance ensures that the account balances are accurately extracted
from accounting ledgers.
Trail balance assists in the identification and rectification of errors.
Example
Following is an example of what a simple Trial Balance looks like:
ABC
Trial Balance as at 31 December 2011
Account Title
LTD
Debit
Credit
Share Capital
15,000
5,000
Building
10,000
Creditor
5,000
Debtors
3,000
Cash
2,000
Sales
10,000
Cost of sales
8,000
2,000
Total
30,000
30,000
Title provided at the top shows the name of the entity and accounting
period end for which the trial balance has been prepared.
Account Title shows the name of the accounting ledgers from which the
balances have been extracted.
Balances relating to assets and expenses are presented in the left column
(debit side) whereas those relating to liabilities, income and equity are
shown on the right column (credit side).
The sum of all debit and credit balances are shown at the bottom of their
respective columns.
LTD
Debit
Credit
Share Capital
10,000
Bank Loan
10,000
Cash
30,000
Salaries Expense
5,000
Sales Revenue
Total
15,000
35,000
35,000
Accounting-Simplified.com