CFAS REVIEWER

SAMPLE OF ASSET- OFFICE LAND, EQUIPTMENT, CASH,

MACHINES,

Substance over form

Substance over form is the concept that the financial statements and
accompanying disclosures of a business should reflect the underlying realities
of accounting transactions . Conversely, the information appearing in the
financial statements should not merely comply with the legal form in which
they appear. In short, the recordation of a transaction should not hide its true
intent, which would mislead the readers of a company's financial statements.

Substance over form is a particular concern under Generally Accepted

Accounting Principles (GAAP), since GAAP is largely rules-based, and so
creates specific hurdles that must be achieved in order to record a transaction in
a certain way. Thus, someone intent on hiding the true intent of a transaction
could structure it to just barely meet GAAP rules, which would allow that
person to record the transaction in a manner that hides its true intent.
Conversely, International Financial Reporting Standards (IFRS) are more
principles-based, so it is more difficult for someone to justifiably hide the
intent of a transaction if they are using the IFRS framework to construct
financial statements.

Thus far, the substance over form argument assumes that someone is attempting
to deliberately hide the true intent of a transaction - but it may also arise simply
because a transaction is extremely complex, which makes it quite difficult to
 ascertain what the substance of the transaction is - even for a law-abiding
accountant.

Examples of substance over form issues are:

 Company A is essentially an agent for Company B, and so should only

record a sale on behalf of Company B in the amount of the related commission .
However, Company A wants its sales to appear larger, so it records the entire
amount of a sale as revenue.

 Company C hides debt liabilities in related entities, so that the debt does
not appear on its balance sheet .

 Company D creates bill and hold paperwork to legitimize the sale of

goods to customers where the goods have not yet left the premises of Company
D.

Outside auditors are continually examining the transactions of their clients to

ensure that the substance over form criterion is being followed. The issue is of
some importance to auditors, since they are being asked to attest to the fairness
of presentation of a set of financial statements, and fairness of presentation and
the substance over form concept are essentially the same thing.
Cost = cash payment
Amount of revenue= gross profit x amount of collection
Liabilities
are the present obligation of the entity in the form of legally enforceable and result
from past events. Liabilities will have future economic outflow from an entity.
Those liabilities including account payable, salary payable, noted payable, accrual
liabilities, short term loan, and long term loan.
If the entity financial statements are prepared according to IFRS, then those
liabilities should meet the recognition criteria of liabilities in the conceptual
framework.

The following are the recognition criteria of liabilities from the conceptual
framework:
A liability is recognized in the balance sheet when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take place can be measured
reliably. In practice, obligations under contracts that are equally proportionately
unperformed (for example, liabilities for inventory ordered but not yet received)
are generally not recognized as liabilities in the financial statements. However,
such obligations may meet the definition of liabilities and, provided the recognition
criteria are met in the particular circumstances, may qualify for recognition. In
such circumstances, recognition of liabilities entails recognition of related assets or
expenses.

Financial Position
Definition of Statement of Financial Position
The statement of financial position is another name for the balance sheet. It is one
of the main financial statements.
The statement of financial position reports an entity's assets, liabilities, and the
difference in their totals as of the final moment of an accounting period.
The structure of the statement of financial position is similar to the basic
accounting equation. For a corporation the format will be: Assets = Liabilities
+ Stockholders' Equity. A nonprofit organization's format will be: Assets =
Liabilities + Net Assets.
The statement of financial position must reflect the basic accounting principles and
guidelines such as the cost, matching, and full disclosure principle to name a few.
Accordingly, the statement of financial position is more meaningful when it is
prepared under the accrual method of accounting.

Financial Performance
Financial performance is a subjective measure of how well a firm can use assets
from its primary mode of business and generate revenues. The term is also used as
a general measure of a firm's overall financial health over a given period.
Analysts and investors use financial performance to compare similar firms across
the same industry or to compare industries or sectors in aggregate.
A Financial Performance Report is a summary of the Financial Performance of a
Company that reports the financial health of a company helping various investors
and stakeholders take their investment decision.

Equity in Accounting
It’s the Value Remaining After Liabilities. Equity is the remaining value of an
owner’s interest in a company, after all liabilities have been deducted. You may
hear of equity being referred to as “stockholders’ equity” (for corporations) or
“owner’s equity” (for sole proprietorships). Equity can be calculated as:

Equity = Assets – Liabilities.

The word “equity” can also be used to refer to personal finances. For instance, if
someone owns a $400,000 home, and has a $150,000 mortgage on it, then the
owner can say he has “$250,000 in equity”, in the property.

Recognition Criteria of Assets

In order for an asset to be recognized in the financial statements, it must the
following definition laid down in the IASB Framework:
Asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity (IASB
Framework).
It is worth noting that the framework defines asset in terms of control rather than
ownership. While control is generally evidenced through ownership, this may not
always be the case. Therefore, an asset may be recognized in the financial
statement of the entity even if ownership of the asset belongs to someone else. For
instance, if a machine is leased to a company for the entire duration of its useful
life, the machine may be recognized in its Statement of Financial Position (Balance
Sheet) since the entity has control over the economic benefits that would be
derived from the use of the asset. This illustrates the use of Substance Over Form
whereby the economic substance of the transaction takes precedence over the legal
aspects of a transaction in order to present a true and fair view.

Future Economic Benefit

The future economic benefit embodied in an asset is the potential to contribute,
directly or indirectly, to the flow of cash and cash equivalents to the entity or with
respect of not-for-profit entities, whether in the public or private sector, the future
economic benefits are also used to provide goods and services in accordance with
the entities' objectives.
What is meant by Economic benefits and how they flow to the entity?

It is easy to understand that entities around the world hold different sets of
machinery, plant, equipment, building, land and other kinds of assets through
which it offers products or services to its customers and in return earn income
and generate cash.
Meaning of economic benefits when taken in context of asset’s definition is the
capability or potential of asset to generate cash flows (in form of cash and cash
equivalents) for the entity. Asset can generate cash flows either by contributing to
cash flow generation or by having the capacity to be readily converted into cash
and cash equivalents. As in the above example, manufacturers use machinery to
produce item which are ultimately sold for cash and thus machinery helps in
generating cash flows.
Future economic benefits in any assets can be rendered by the entity in number of
ways. Some of the examples are as follows:

 Asset may be used individually or with other assets in combination to

produce goods (inventory or stock) that will be ultimately sold to
customers generating cash and cash equivalents
 Asset may be used individually or when used together with other assets to
provide services to entity’s customers and helps entity to generate cash
flows
 Asset may be used to settle liabilities in kind or by converting into cash
 Asset may be used for exchange purposes to acquire other assets
 Asset may be distributed to the owners of the entity for example at the
time of liquidation or paying dividends in the course of business.

cost principle definition

The accounting guideline requiring amounts in the accounts and on the financial
statements to be the actual cost rather than the current value. Accountants can
show an amount less than cost due to conservatism, but accountants are generally
prohibited from showing amounts greater than cost. (Certain investments will be
shown at fair value instead of cost.
Cost Principle
The cost principle is an accounting principle that requires assets, liabilities, and
equity investments to be recorded on financial records at their original cost.
According to the cost principle, transactions should be listed on financial records
at historical cost – i.e. the original cash value at the time the asset was purchased –
rather than the current market value.
The cost principle is also known as the historical cost principle and the historical
cost concept.

The cost principle, appreciation, and depreciation

It is common for an asset’s price to diverge from its historical cost; however,
because the cost principle specifies that financial records should not be adjusted,
you should always follow specific processes to account for any changes.
Appreciation is an increase in the value of an asset. Appreciation is treated as a
gain and the difference in value should be recorded as ‘revaluation surplus’.
For example, a company purchases an office for £100,000 in 2012. In 2018, the
property is valued at £120,000. Rather than changing entries in accounting records
to reflect the new market value, the difference in price should be credited to an
equity account called ‘revaluation surplus’.
Depreciation is the decrease in the value of an asset. There are several different
ways to account for depreciation but, in general, depreciation is treated as a loss
and is expensed throughout the asset’s useful life.
For example, a laptop is purchased for £1,000. It expected to have a useful life of 5
years and a residual value of £200. The balance sheet continues to report the value
 of the laptop as £1,000, but £160 is expensed to a depreciation account each year
of its useful life.

Advantages and disadvantages of the cost principle

The cost principle is considered one of the fundamental guidelines for bookkeeping
and accounting; however, it is fairly controversial. As such, accounting standards
are starting to move away from the cost principle. According to critics of the cost
principle, it's main disadvantage is lack of accuracy. Because assets appreciate and
depreciate, financial records which follow the cost principle are unlikely to
accurately reflect a business’s actual financial position.
The cost principle also means that some valuable, non-tangible assets are not
reported as assets on the balance sheet. For example, goodwill, brand identity,
and intellectual property can add a lot of value to a business but, because they are
built up over time, they do not have an initial purchase price to record on financial
statements.
On the other hand, advantages of the cost principle include:

 Ease: It is much quicker and more straight-forward to record assets at their

original value than to continually update financial reports to reflect current market
value.
 Objectivity: The cost principle means that recorded values are objective and
verifiable as invoices, sales receipts, and bank transactions easily confirm the
original purchase price.
 Cost: Because it is quicker and easier to verify the value of assets,
accountants and auditors need to spend less time verifying financial records,
making it cheaper for the companies who employ them.

Exceptions to the cost principle

 According to some accounting standards, particular assets, liabilities, and equity
investments are exempt from the cost principle. For example:

 Accounts receivable should be shown at net realisable value.

 Highly liquid assets (assets which are expected to be turned into cash in the
very near future) should be recorded at their current market value.
 Assets that have a quoted, market-ready value should be recorded at their
current market value.
 Financial investments should be recorded at fair value at the end of each
accounting period.

What is cash transaction

A cash transaction is the immediate payment of cash for the purchase of an asset.
A cash transaction can have many different definitions. Essentially, it is an
immediate cash payment in exchange for the receipt of an item. Under some
definitions, market stock transactions can be considered cash transactions because
they happen close to instantly in the marketplace at whatever the current price is at
that point in time. The trade is executed, and the parties involve exchange money
for shares, despite the fact that the trade may not settle for a few days.
In contrast, a futures contract is not considered a cash transaction. Although the
price and quantity of an item to be sold are agreed upon when the parties enter into
the contract, the exchange of money and delivery of the item does not happen
immediately. Purchase with a credit card is not considered a cash transaction, as
the person making the purchase does not pay for the item until they pay their credit
card bill, which may not occur until much later. Under some definitions of a cash
transaction, all aspects of the trade, including the delivery of payment, must be be
finalized on the trade date.
Example of a Cash Transaction
For example, a person walks into a store and uses a debit card to purchase an
apple. The debit card functions the same as cash as it removes the payment for the
apple immediately from the purchaser's bank account. This is a cash transaction. If
the person had used a credit card to purchase the apple, no money would have been
immediately forfeited by the purchaser, so it would not be a cash transaction. The
purchaser would not actually give up money for the apple until they paid the
"apple" line item on their credit card bill.Federal law requires a person to report
cash transactions of more than$10,000 to the IRS. Here are some facts about
reporting these payments.
Cash Transactions and the Internal Revenue Service (IRS)
According to federal law, cash transactions in excess of $10,000 must be reported
to the Internal Revenue Service (IRS) using Form 8300. Cash includes "coins and
currency of the United States or any foreign country. For some transactions (PDF),
it’s also a cashier’s check, bank draft, traveler’s check or money order with a face
amount of $10,000 or less."
A person must report cash of over $10,000 received as either a lump sum, in two or
more payments within 24 hours, as a single transaction within 12 months, or as two
or more transactions within 12 months.
Form 8300 must be filed within 15 days after the date the cash is received.

Non cash or exchange transaction

 A nonmonetary transaction includes the exchange of goods or services

without actual money changing hands.
  Nonmonetary transactions include in-kind or barter exchanges, and can be
unidirectional (nothing is given in return) or reciprocal (something traded in
return).
 Nonmonetary transactions raise certain ethical and moral issues as well as
practical concerns around taxation and valuation.
What is a Non-Cash Item?
A non-cash item has two different meanings. In banking, the term is used to
describe a negotiable instrument, such as a check or bank draft, that is deposited
but cannot be credited until it clears the issuer's account.
Alternatively, in accounting, a non-cash item refers to an expense listed on
an income statement, such as capital depreciation, investment gains, or losses, that
does not involve a cash payment.

 In banking, a non-cash item is a negotiable instrument—such as a check or

bank draft—that is deposited but cannot be credited until it clears the issuer's
account.
 In accounting, a non-cash item refers to an expense listed on an income
statement, such as capital depreciation, investment gains, or losses, that does
not involve a cash payment.
Liability recognition principle
A liability is recognized in the balance sheet when it is probable that an outflow of
resources embodying economic benefits will result from the settlement of a present
obligation and the amount at which the settlement will take place can be measured
reliably. In practice, obligations under contracts that are equally proportionately
unperformed (for example, liabilities for inventory ordered but not yet received)
are generally not recognized as liabilities in the financial statements. However,
such obligations may meet the definition of liabilities and, provided the recognition
criteria are met in the particular circumstances, may qualify for recognition. In
such circumstances, recognition of liabilities entails recognition of related assets or
expenses.
 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).
Explanation
The obligation to transfer economic benefits may not only be a legal one. Liability
in respect of a constructive obligation may also be recognized where an entity, on
the basis of its past practices, has a created a valid expectation in the minds of the
concerned persons that it will fulfill such obligations in the future. For example, if
an oil exploration company has a past practice of restoring oil rig sites after they
are dismantled in spite of no legal obligation to do so, and it advertises itself as an
environment friendly organization, then this gives rise to a constructive
liability and must therefore be recognized in the financial statements of the
company. This is because a valid expectation has been created that the company
will restore oil rig sites in the future.
Recognition Criteria
Apart from satisfying the definition of liability, the framework has also advised the
following recognition criteria to be met before a liability could be shown on the
face of a financial statement:
 The outflow of resources embodying economic benefits (such as cash) from
the entity is probable.
 The cost / value of the obligation can be measured reliably.
With regard to the first test, it is logical to recognize a liability only if it is likely
that the entity will be required to settle it. The second test ensures that only
liabilities that can be objectively measured are recognized in the financial
statements.
If an obligation meets the definition of a liability but fails to meet the recognition
criteria, it is classified as a contingent liability. Contingent liability is not presented
as a liability in the statement of financial position but is instead disclosed in the
notes to the financial statements.
Legally enforceable Liability
 Legally enforceable claim on the assets of a company, excluding owner’s equity,
or the property of an individual, calling for a transfer of assets at a determined
future date. Also, any item appearing on the right hand side of a double-entry
accounting system or balance sheet.

What is a constructive liability?

A constructive obligation typically occurs from past conduct. It exists when an

entity (e.g. the company whose accounts are being drawn up) has no realistic
alternative to fulfilling an obligation, even if it is A constructive obligation is an
obligation to pay that arises out of conduct and intent rather than a contract. A
constructive obligation may need to be shown on the BALANCE SHEET as a
liability.

not legally enforceable. Under IFRS, a constructive obligation must be accounted

for as a liability if it meets other criteria that require recording as a liability: the
degree of certainty involved, whether the entity has any discretion to avoid the
liability, etc.

Even if uncertain, a constructive obligation may need to be disclosed as a

contingent liability.
Common examples of constructive obligations that are not legally binding include:

 retirement benefits paid in excess of strict legal obligations (which cannot be

reneged on without creating retention and morale problems),
 retailers' returns policies that are more generous than legal or contractual
requirements (stopping such a practice would damage the retailers
reputation),
 restructuring costs, once plans have been finalised and communicated as
such to those affected. 

In some circumstances, a constructive obligation can become legally enforceable,

which makes it slightly clearer that it needs to be accounted for — but it still needs
to meet the other criteria for recording a liability.
The liability may be a legal obligation or a constructive obligation. A constructive
obligation arises from the entity’s actions, through which it has indicated to others
that it will accept certain responsibilities, and as a result has created an expectation
that it will discharge those responsibilities. Examples of provisions may include:
warranty obligations; legal or constructive obligations to clean up contaminated
land or restore facilities; and obligations caused by a retailer’s policy to make
refunds to customers

INCOME, REVENUE, GAIN

What is the Difference between Income, Revenue, and Gain?

These accounting terms are usually presented and seen in the income statement.
They may have similarities, but they are actually different from each other.
Financial statements preparers, accountants, and other accounting professionals
should learn how to distinguish the three to better reflect and present these
elements in the financial statements. Furthermore, business owners, entrepreneurs,
investors, managers and other business people should also learn how to distinguish
those three to make better financial and economic judgments.
To understand the differences among income, revenue, and gain, we go to their
definitions as defined by the IASB (International Accounting Standards Board) in
the IFRS (International Financial Reporting Standards) Framework and IAS
(International Accounting Standards).
Income – represents 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. [F 4.25(a)].
Revenue – represents the gross inflow of economic benefits (cash, receivables,
other assets) arising from the ordinary operating activities of an entity (such as
sales of goods, sales of services, interest, royalties, and dividends). [IAS 18.7]
Gains – represent other items that meet the definition of income and may, or may
not, arise in the course of the ordinary activities of an entity. Gains represent
increases in economic benefits and as such are no different in nature from revenue.
Hence, they are not regarded as constituting a separate element in the IFRS
Framework. [F 4.29 and F 4.30]

Based on the definitions above, we can say that income covers both revenue and
gains. This means that both revenues and gains can be considered as income or part
of the income. In other words, income is a generic term, which can be a revenue, a
gain, or both.

Between revenue and gain, the difference is that revenue always arises in the
course of the business’ ordinary activities (e.g., sales of goods or sales of services),
while gain represents other items that are considered as income which may or may
not arise in the ordinary activities of the business or entity (e.g., gain from sale of
an old property or gain from the sale of investments).
Revenue vs. Income: An Overview
Revenue is the total amount of income generated by the sale of goods or services
related to the company's primary operations. Revenue, also known as gross sales, is
often referred to as the "top line" because it sits at the top of the income statement.
Income, or net income, is a company's total earnings or profit. When investors and
analysts speak of a company's income, they're actually referring to net income or
the profit for the company. 

 Revenue is the total amount of income generated by the sale of goods or

services related to the company's primary operations.
 Income or net income is a company's total earnings or profit. 
 Both revenue and net income are useful in determining the financial strength
of a company, but they are not interchangeable.

Revenue Recognition Principle

Revenue recognition is a generally accepted accounting principle (GAAP)
that identifies the specific conditions in which revenue is recognized and
determines how to account for it. Typically, revenue is recognized when a critical
event has occurred, and the dollar amount is easily measurable to the company.
For example, revenue accounting is fairly straightforward when a product is sold,
and the revenue is recognized when the customer pays for the product. However,
accounting for revenue can get complicated when a company takes a long time to
produce a product. As a result, there are several situations in which there can be
exceptions to the revenue recognition principle.
  Revenue recognition is a generally accepted accounting principle (GAAP)
that stipulates how and when revenue is to be recognized.
 The revenue recognition principle using accrual accounting requires that
revenues are recognized when realized and earned–not when cash is
received.
 The revenue recognition standard, ASC 606, provides a uniform framework
for recognizing revenue from contracts with customers.

Overview: What is the revenue recognition principle?

No matter what type of accounting your business is using, the revenue recognition
principle remains the same.
The revenue recognition principle says that revenue should be recorded when it has
been earned, not received. The revenue recognition concept is part of accrual
accounting, meaning that when you create an invoice for your customer for goods
or services, the amount of that invoice is recorded as revenue at that point, and not
when the money is received from the customer.
This is one of the major differences between accrual basis accounting and cash
basis accounting, since with cash accounting, revenue is recognized when payment
is received, not when it’s earned.
Point of Sale (POS) Method Definition
The Point of Sale (POS) Method also known as the Revenue Method or Sales
Method is one of the many methods under the Revenue Principle of Accounting.
This method records the revenue at the point of sale because cash is received on
site or it is reasonably certain that cash will be received soon and is thus a
finalized transaction. They commonly use this method in grocery stores or
other entities such as Wal-Mart. Companies can also record a sale if the amount of
revenue can be measured objectively and the receipt is certain which becomes
useful for companies such as a mining or lumber company. Another use of the
method can be associated with a service that is provided like cable, car services,
and certain utilities.
Point of Sale (POS) Method Examples
Incorporate the method of sales in several different ways. We will give various
examples to explain the method.
Example 1:
Suppose that Fred goes into a music store to buy a CD. He makes a selection and
then pays 15 dollars cash or the price of the CD to the store clerk. The music store
would then use the sales method to record Fred’s purchase of the CD.
The sales method would then post the following journal entries in recording the
sale.
Cash…………………………………$15
Sales Revenue………………………………..$15
COGS………………………………..$10
Inventory……………………………………….$10
Example 2:
Timber Inc. specializes in the cutting and transportation of lumber.
The company has recently sent a load of lumber with a costs of $10,000 to
Furniture Inc. Since Timber Inc. has already delivered the goods to
the customer (Furniture Inc.), Timber Inc. can go ahead and recognize
the revenue because it has been objectively measured and there is reasonable
certainty that the company will receive cash in the near future. Therefore,
record journal entries as follows:
At time of Delivery:
Account Receivable (A/R)………..$10,000
Sales Revenue………………………………..$10,000
 Upon Receipt of Cash:
Cash…………………………………..$10,000
A/R………………………………………………..$10,000
Installment method
When a seller allows a customer to pay for a sale over multiple years, the
transaction is frequently accounted for by the seller using the installment
method. Because of the long period of time involved, the risk of loss from
customer nonpayment is higher, so a prudent person would defer the
recognition of some portion of the sale - which is what the installment method
does.

The primary circumstance under which the installment method is used is a

transaction in which the buyer makes  a number of periodic payments to the
seller, and it is not possible to determine the collectibility of cash from the
customer. This is an ideal recognition method for large-dollar items, such as:

 Real estate

 Machinery

 Consumer appliances

The installment method is better than generic accrual basis accounting when
payments may be received for a number of years, for the accrual basis may
recognize all of the revenue up front, without factoring in all of the risk
inherent in the transaction. The installment method is more conservative, in that
revenue recognition is pushed off into the future, thereby making it easier to tie
actual cash receipts to revenue.
 An overview of the installment method is that someone using it defers the gross
margin on a sale transaction until the actual receipt of cash. When accounts
receivable are eventually collected, a portion of the deferred gross profit from
the following calculation is recognized:

Gross profit % x Cash collected

Use of the installment method requires an enhanced level of record keeping for
the duration of the associated installment payments. The accounting staff
should track the amount of deferred revenue remaining on each contract that
has yet to be recognized, as well as the gross profit percentage on installment
sales in each separate year. The following steps are used to account for an
installment sale transaction:

1. Record installment sales separately from other types of sales, and keep
track of the related receivables, layered by the year in which the receivables
were originally created.

2. Trace cash receipts as they arrive to the installment sales to which they
relate.

3. At the end of each fiscal year , shift the installment sales revenues and
cost of sales occurring in that year to a deferred gross profit account.

4. Calculate the gross profit rate for installment sales occurring in that year.

5. Apply the gross profit rate for the current year to cash collected on
receivables from current year sales to derive the gross profit that can be
realized. 

6.
7. Apply the gross profit rate for prior years to the cash receipts arriving
that relate to installment sales occurring in those prior periods, and recognize
the resulting amount of gross profit.

8. Any deferred gross profit at the end of the current year is carried forward
to the next year, to be recognized at a later date when the associated receivables
are paid.
Intuition Behind the Cost Recovery Method
What is the Cost Recovery Method?
The cost recovery method of revenue recognition is a concept in accounting that
refers to a method in which a business does not recognize income related to a sale
until the cash collected exceeds the cost of the good or service sold. In other words,
using this method, revenue is only recognized when cash payments have recovered
the seller’s cost.
The cost recovery method is a method of revenue recognition in which there is
uncertainty. Therefore, it is used to account for revenue when revenue streams
from a sale cannot be accurately determined. Accounting standards IAS 18 require
a company to recognize revenue only when the amount is measurable and cash
flows are probable. The underlying concept behind this method is as follows:
Net profit is not recognized until the cash collected exceeds the cost of the item
and/or service sold.

What is the cash method?

Under the cash method, income is not counted until payment is actually received,
and expenses are not counted until they are actually paid. The cash method is the
more commonly used method of accounting by small businesses.

For example, a small business makes a sale in December but isn’t paid until
February. Under the cash method, the business would record payment in February.

Deeper definition
The cash method is also known as cash-basis accounting, cash receipts and
disbursements method of account, and cash accounting.

Many small business owners choose the cash method of accounting because it’s a
simpler form of bookkeeping. It’s easy to track money as it moves in and out of a
bank account because it doesn’t take into account receivables or payables.

In addition, the cash method is easier to audit and less of a burden administratively,

but it can be less accurate.

Under the other main form of accounting — accrual accounting, transactions are

counted when they occur, regardless of when the money for them (receivables) is
actually received or paid.

To be sure, these methods differ mainly in the timing of when sales and purchases
are credited or debited to a business’s accounts. And, it’s about how they’re taxed.

For instance, under the cash method, payment of business expenses may be
speeded up before year end to increase the business’s tax deductions. Conversely,
billing for services may be put off until year end, so that payments won’t be
received until the new year, postponing tax payments on that income.

Under the accrual method of accounting, you generally report income in the year

earned and deduct expenses in the year incurred.

The IRS says a business must use accrual accounting if it has sales of more than $5
million a year or if it has inventory to account for. But, the IRS also may favor the
accrual method, since there’s less opportunity for manipulation.
The purpose of an accrual method of accounting is to match income and expenses
in “the correct year,” the IRS says.

Percentage of Completion Method

The percentage of completion method is an accounting method in which the
revenues and expenses of long-term contracts are recognized as a percentage of the
work completed during the period. This is in contrast to the completed contract
method, which defers the reporting of income and expenses until a project is
completed. The percentage-of-completion method of accounting is common for the
construction industry, but companies in other sectors also use the method.
KEY TAKEAWAYS

 The percentage of completion method reports revenues and expenses in

terms of the work completed to date.
 This method can only be used if payment is assured and estimating
completion is relatively straightforward.
 The percentage of completion method has been misused by some companies
to boost short-term results.

Unit of Production Method

What Is the Unit of Production Method?
The unit of production method is a method of calculating the depreciation of the
value of an asset over time. It becomes useful when an asset's value is more closely
related to the number of units it produces rather than the number of years it is in
use. This method often results in greater deductions being taken for depreciation in
years when the asset is heavily used, which can then offset periods when the
equipment experiences less use.
This method can be contrasted with time-based measures of depreciation such
as straight-line or accelerated methods.
KEY TAKEAWAYS

 The unit of production method for calculating depreciation considers an

asset's practical usage in the production process rather than considering its
time in use.
 This method is particularly utilized for assets that experience a high degree
of wear and tear based on actual use per-unit such as certain pieces of
machinery or production equipment.
 This method can allow companies to show higher depreciation expense in
more productive years, which can offset other increased production costs.
Interest Revenues
Under the accrual basis of accounting, the Interest Revenues account reports the
interest earned by a company during the time period indicated in the heading of the
income statement. Interest Revenues account includes interest earned whether or
not the interest was received or billed. Interest Revenues are nonoperating
revenues or income for companies not in the business of lending money. For
companies in the business of lending money, Interest Revenues are reported in the
operating section of the multiple-step income statement
The Need for Adjusting Entries
There are transactions that are not yet recorded and in order to bring all the
accounts uo to date at the end of accounting period, these transactions have to be
recorded. The entries to record these transactions are called adjusting entries.
Periodicity Principle
The periodicity principle or time period concept states that the entity’s life can be
meaningfully subdivided into equal time periods (accounting periods) for reporting
purposes. An accounting period can be monthly, quarterly, semi-annually or
annually. The most basic accounting period is one year. This one year period may
be calendar year or a fiscal year. A calendar year is one who where the period ends
at December 31 and a fiscal year is a period of twelve months that ends anytime
except December 31.
Cash and Accrual Basis of Accounting
Accrual Basis – Recognize income as it is earned regardless of when it is
received; and expense as it is incurred regardless of when it is paid.
Cash Basis – Revenues and expenses are recognized or recorded only when they
are received and paid, respectively.
Types of Adjusting Entries
1. Accrued Expenses – To take up expenses incurred in one period but remain
unrecorded and unpaid as of the end of the period.
The pro-forma adjustment is:
Expense account                                           XXX
Liability account                                                 XXX
2. Accrued Income – To take up income earned in one period but remain
unrecorded and not received as of the end of the period.
The pro-forma adjustment is:
Asset account                                                 XXX
Income account                                                 XXX
3. Prepaid Expense – To allocate expenses to two or more accounting periods.
There are two methods of accounting for prepaid expense:
1. Asset method – if at the date of the payment, the business debited an asset
account.
2. Expense method – if at the date of the payment, the business debited an
expense account.
There are two methods of accounting for unearned income:
1. Liability method – if at the date of collection, the business credited a liability
account.
2. Revenue method – if at the date of collection, the business credited a revenue
account.
4. Unearned Income – To allocate income to two or more accounting periods.
5. Depreciation – To recognize the amount of used economic benefits of a fixed
asset.
Fixed asset/Plant asset – Physical resources that are owned and used by a
business which are permanent in nature or have a long useful life, ex. land,
building, equipment, automobile, computer, furniture.
Fixed assets except land have limited useful lives and as such are subject to
depreciation.
Depreciation – is the systematic allocation of the cost of the fixed asset over its
useful life.
The proforma adjustment for depreciation is:
Depreciation Expense                                       XXX
Accumulated Depreciation                                XXX
6. Bad Debts – To recognize the possible uncollectible amounts due from
customers as of the end of the period.
When a company directly grants credit to its customers, some customers do not
always pay what they promised or do not pay on time.    These uncollectible
accounts are commonly called bad debts.
Two methods to account for uncollectible accounts:
1. Direct write off method – under this method a loss (bad debts expense) is
recorded by direct transfer of the uncollectible amount from the asset account to
expense account. The pro-forma entry is:
Bad Debts Expense                                              XXX
Accounts Receivable                                             XXX
2. Allowance method – The allowance method requires the use of a contra asset
account known as allowance for bad debts.  The pro-forma entry to record bad
debts expense under this method is:
Bad Debts Expense                                               XXX
Allowance for Bad Debts                                       XXX
IMPREST FUND vs. FLUCTUATING FUND
Imprest fund system:
a. To establish the fund.
Petty cash fund xxx
Cash in bank xxx
b. Disbursement out of the fund.*
-No entry-
c. Replenishment.**
Expenses xxx
Cash in bank xxx
d. Adjustment to petty cash fund.***
Expenses xxx
Petty cash fund xxx
e. To increase the balance of the fund.
Petty cash fund xxx
Cash in bank xxx
f. To decrease the balance of the fund.
Cash in bank xxx
Petty cash fund xxx
Fluctuating fund system:
a. To establish the fund.
Petty cash fund xxx
Cash in bank xxx
b. Disbursement out of the fund.*
Expenses xxx
Petty cash fund xxx
c. Replenishment.**
Petty cash fund xxx
Cash in bank xxx
d. Adjustment to petty cash fund.***
-No entry-
e. To increase the balance of the fund.****
Petty cash fund xxx
Cash in bank xxx
f. To decrease the balance of the fund.
Cash in bank xxx
Petty cash fund xxx
Notes:
*
- Under the imprest fund system, only a formally signed petty cash voucher for
payments of expenses is needed by the petty cash custodian and only memorandum
entries are simply prepared in the petty cash journal. Disbursements are normally
recorded upon replenishment of the fund. In effect, the balance after replenishment
is equal to the balance during the establishment of the fund.
- Under the fluctuating fund system, disbursements are immediately recorded in
contrast with the imprest fund system.
**
- Under the imprest fund system, replenishment of the fund is usually equal to the
petty cash disbursements. Replenishment should only be by means of drawing
checks not from undeposited collections.
- Under the fluctuating fund system, replenishment of the fund may or may not be
the same amount as the petty cash disbursement.
***
- Under the imprest fund system, it is necessary to adjust the unreplenished
expenses in order to state the correct balance of the fund.
- Under the fluctuating fund system, no adjustment is needed because of outright
recording of the expenses.
****
- Under the fluctuating fund system, the fund balance may still be increased despite
an increased effect in the fund balance during the replenishment.