1.

Economic Entity Assumption

The accountant keeps all of the business transactions of a sole proprietorship separate from the
business owner's personal transactions. For legal purposes, a sole proprietorship and its owner
are considered to be one entity, but for accounting purposes they are considered to be two
separate entities.
2. Monetary Unit Assumption
Economic activity is measured in U.S. dollars, and only transactions that can be expressed in
U.S. dollars are recorded.
Because of this basic accounting principle, it is assumed that the dollar's purchasing power has
not changed over time. As a result accountants ignore the effect of inflation on recorded
amounts. For example, dollars from a 1960 transaction are combined (or shown) with dollars
from a 2013 transaction.
3. Time Period Assumption
This accounting principle assumes that it is possible to report the complex and ongoing activities
of a business in relatively short, distinct time intervals such as the five months ended May 31,
2013, or the 5 weeks ended May 1, 2013. The shorter the time interval, the more likely the need
for the accountant to estimate amounts relevant to that period. For example, the property tax bill
is received on December 15 of each year. On the income statement for the year ended
December 31, 2012, the amount is known; but for the income statement for the three months
ended March 31, 2013, the amount was not known and an estimate had to be used.
It is imperative that the time interval (or period of time) be shown in the heading of each income
statement, statement of stockholders' equity, and statement of cash flows. Labeling one of
these financial statements with "December 31" is not good enoughthe reader needs to
know if the statement covers the one week ended December 31, 2012 the month ended
December 31, 2012 the three months ended December 31, 2012 or theyear
ended December 31, 2012.
4. Cost Principle
From an accountant's point of view, the term "cost" refers to the amount spent (cash or the cash
equivalent) when an item was originally obtained, whether that purchase happened last year or
thirty years ago. For this reason, the amounts shown on financial statements are referred to
as historical cost amounts.
Because of this accounting principle asset amounts are not adjusted upward for inflation. In fact,
as a general rule, asset amounts are not adjusted to reflect any type of increase in value. Hence,
an asset amount does not reflect the amount of money a company would receive if it were to sell
the asset at today's market value. (An exception is certain investments in stocks and bonds that
are actively traded on a stock exchange.) If you want to know the current value of a company's
long-term assets, you will not get this information from a company's financial statementsyou
need to look elsewhere, perhaps to a third-party appraiser.
5. Full Disclosure Principle

If certain information is important to an investor or lender using the financial statements, that
information should be disclosed within the statement or in the notes to the statement. It is
because of this basic accounting principle that numerous pages of "footnotes" are often attached
to financial statements.
As an example, let's say a company is named in a lawsuit that demands a significant amount of
money. When the financial statements are prepared it is not clear whether the company will be
able to defend itself or whether it might lose the lawsuit. As a result of these conditions and
because of the full disclosure principle the lawsuit will be described in the notes to the financial
statements.
A company usually lists its significant accounting policies as the first note to its financial
statements.
6. Going Concern Principle
This accounting principle assumes that a company will continue to exist long enough to carry out
its objectives and commitments and will not liquidate in the foreseeable future. If the company's
financial situation is such that the accountant believes the company will not be able to continue
on, the accountant is required to disclose this assessment.
The going concern principle allows the company to defer some of its prepaid expenses until
future accounting periods.
7. Matching Principle
This accounting principle requires companies to use the accrual basis of accounting. The
matching principle requires that expenses be matched with revenues. For example, sales
commissions expense should be reported in the period when the sales were made (and not
reported in the period when the commissions were paid). Wages to employees are reported as
an expense in the week when the employees worked and not in the week when the employees
are paid. If a company agrees to give its employees 1% of its 2013 revenues as a bonus on
January 15, 2014, the company should report the bonus as an expense in 2013 and the amount
unpaid at December 31, 2013 as a liability. (The expense is occurring as the sales are occurring.)
Because we cannot measure the future economic benefit of things such as advertisements (and
thereby we cannot match the ad expense with related future revenues), the accountant charges
the ad amount to expense in the period that the ad is run.
(To learn more about adjusting entries go to Explanation of Adjusting Entries and Quiz
for Adjusting Entries.)
8. Revenue Recognition Principle
Under the accrual basis of accounting (as opposed to the cash basis of
accounting), revenues are recognized as soon as a product has been sold or a service has
been performed, regardless of when the money is actually received. Under this basic accounting
principle, a company could earn and report $20,000 of revenue in its first month of operation but
receive $0 in actual cash in that month.

For example, if ABC Consulting completes its service at an agreed price of $1,000, ABC should
recognize $1,000 of revenue as soon as its work is doneit does not matter whether the client
pays the $1,000 immediately or in 30 days. Do not confuse revenue with a cash receipt.
9. Materiality
Because of this basic accounting principle or guideline, an accountant might be allowed to violate
another accounting principle if an amount is insignificant. Professional judgement is needed to
decide whether an amount is insignificant or immaterial.
An example of an obviously immaterial item is the purchase of a $150 printer by a highly
profitable multi-million dollar company. Because the printer will be used for five years,
the matching principle directs the accountant to expense the cost over the five-year period.
The materiality guideline allows this company to violate the matching principle and to
expense the entire cost of $150 in the year it is purchased. The justification is that no one would
consider it misleading if $150 is expensed in the first year instead of $30 being expensed in each
of the five years that it is used.
Because of materiality, financial statements usually show amounts rounded to the nearest dollar,
to the nearest thousand, or to the nearest million dollars depending on the size of the company.
10. Conservatism
If a situation arises where there are two acceptable alternatives for reporting an item,
conservatism directs the accountant to choose the alternative that will result in less net income
and/or less asset amount. Conservatism helps the accountant to "break a tie." It does not direct
accountants to be conservative. Accountants are expected to be unbiased and objective.
The basic accounting principle of conservatism leads accountants to anticipate or disclose
losses, but it does not allow a similar action for gains. For example, potential losses from
lawsuits will be reported on the financial statements or in the notes, but potential gains will not
be reported. Also, an accountant may write inventory downto an amount that is lower than the
original cost, but will not write inventory up to an amount higher than the original cost.

1. We expect the accounting information to be reliable, verifiable, and

objective.
2. We expect consistency in the accounting information.
3. We expect comparability in the accounting information.

1. Reliable, Verifiable, and Objective

In addition to the basic accounting principles and guidelines listed in Part 1, accounting
information should be reliable, verifiable, and objective. For example, showing land at its original
cost of $10,000 (when it was purchased 50 years ago) is considered to be more reliable,
verifiable, and objective than showing it at its current market value of $250,000. Eight
different accountants will wholly agree that the original cost of the land was $10,000they can
read the offer and acceptance for $10,000, see a transfer tax based on $10,000, and review
documents that confirm the cost was $10,000. If you ask the same eight accountants to give you

the land'scurrent value, you will likely receive eight different estimates. Because the current
value amount is less reliable, less verifiable, and less objective than the original cost, the original
cost is used.
The accounting profession has been willing to move away from the cost principle if there are
reliable, verifiable, and objective amounts involved. For example, if a company has an investment
in stock that is actively traded on a stock exchange, the company may be required to show the
current value of the stock instead of its original cost.

2. Consistency
Accountants are expected to be consistent when applying accounting principles, procedures,
and practices. For example, if a company has a history of using the FIFO cost flow
assumption, readers of the company's most current financial statements have every reason to
expect that the company is continuing to use the FIFO cost flow assumption. If the company
changes this practice and begins using the LIFO cost flow assumption, that change must
be clearly disclosed.

3. Comparability
Investors, lenders, and other users of financial statements expect that financial statements of one
company can be compared to the financial statements of another company in the same
industry.Generally accepted accounting principles may provide
for comparability between the financial statements of different companies. For example,
the FASB requires that expenses related to research and development (R&D) be expensed
when incurred. Prior to its rule, some companies expensed R&D when incurred while other
companies deferred R&D to the balance sheet and expensed them at a later date.

How Principles and Guidelines Affect

Financial Statements
The basic accounting principles and guidelines directly affect the way financial statements are
prepared and interpreted. Let's look below at how accounting principles and guidelines influence
the (1) balance sheet, (2) income statement, and (3) the notes to the financial statements.

1. Balance Sheet
Let's see how the basic accounting principles and guidelines affect the balance sheet of Mary's
Design Service, a sole proprietorship owned by Mary Smith. (To learn more about the balance
sheet go to Explanation of Balance Sheet and Quiz for Balance Sheet.)
A balance sheet is a snapshot of a company's assets, liabilities, and owner's equity at one
point in time. (In this case, that point in time is after all of the transactions through September 30,
2013 have been recorded.) Because of the economic entity assumption, only the assets,
liabilities, and owner's equity specifically identified with Mary's Design Service are shownthe
personal assets of the owner, Mary Smith, are not included on the company's balance sheet.

The assets listed on the balance sheet have a cost that can be measured and each amount
shown is the original cost of each asset. For example, let's assume that a tract of land was
purchased in 1956 for $10,000. Mary's Design Service still owns the land, and the land is now
appraised at $250,000. The cost principle requires that the land be shown in the asset
account Land at its original cost of $10,000 rather than at the recently appraised amount of
$250,000.
If Mary's Design Service were to purchase a second piece of land, the monetary unit
assumption dictates that the purchase price of the land bought today would simply be added
to the purchase price of the land bought in 1956, and the sum of the two purchase prices would
be reported as the total cost of land.
The Supplies account shows the cost of supplies (if material in amount) that were obtained by
Mary's Design Service but have not yet been used. As the supplies are consumed, their cost will
be moved to the Supplies Expense account on the income statement. This complies with
the matching principle which requires expenses to be matched either with revenues or with
the time period when they are used. The cost of the unused supplies remains on the balance
sheet in the asset account Supplies.
The Prepaid Insurance account represents the cost of insurance that has not yet expired. As the
insurance expires, the expired cost is moved to Insurance Expense on the income statement
as required by the matching principle. The cost of the insurance that has not yet expired remains
on Mary's Design Service's balance sheet (is "deferred" to the balance sheet) in the asset
account Prepaid Insurance. Deferring insurance expense to the balance sheet is possible
because of another basic accounting principle, the going concern assumption.
The cost principle and monetary unit assumption prevent some very valuable assets from ever
appearing on a company's balance sheet. For example, companies that sell consumer products
with high profile brand names, trade names, trademarks, and logos are not reported on their
balance sheets because they were not purchased. For example, Coca-Cola's logo and Nike's
logo are probably the most valuable assets of such companies, yet they are not listed as assets

on the company balance sheet. Similarly, a company might have an excellent reputation and a
very skilled management team, but because these were not purchased for a specific cost and we
cannot objectively measure them in dollars, they are not reported as assets on the balance sheet.
If a company actually purchases the trademark of another company for a significant cost, the
amount paid for the trademark will be reported as an asset on the balance sheet of the company
that bought the trademark.

2. Income Statement
Let's see how the basic accounting principles and guidelines might affect the income statement
of Mary's Design Service. (To learn more about the income statement go to Explanation of
Income Statement and Quiz for Income Statement.)
An income statement covers a period of time (or time interval), such as a year, quarter,
month, or four weeks. It is imperative to indicate the period of time in the heading of the income
statement such as "For the Nine Months Ended September 30, 2013". (This means for the period
of January 1 through September 30, 2013.) If prepared under the accrual basis of
accounting, an income statement will show how profitable a company was during the stated
time interval.

Revenues are the fees that were earned during the period of time shown in the heading.
Recognizing revenues when they are earned instead of when the cash is actually received
follows the revenue recognition principle and the matching principle. (The
matching principle is what steers accountants toward using the accrual basis of accounting rather
than the cash basis. Small business owners should discuss these two methods with their tax
advisors.)
Gains are a net amount related to transactions that are not considered part of the company's
main operations. For example, Mary's Design Service is in the business of designing, not in the
land development business. If the company should sell some land for $30,000 (land that is
shown in the company's accounting records at $25,000) Mary's Design Service will report

a Gain on Sale of Land of $5,000. The $30,000 selling price will not be reported as part of
the company's revenues.
Expenses are costs used up by the company in performing its main operations. The matching
principle requires that expenses be reported on the income statement when the related sales are
made or when the costs are used up (rather than in the period when they are paid).
Losses are a net amount related to transactions that are not considered part of the company's
main operating activities. For example, let's say a retail clothing company owns an old computer
that is carried on its accounting records at $650. If the company sells that computer for $300, the
company receives an asset (cash of $300) but it must also remove $650 of asset amounts from
its accounting records. The result is a Loss on Sale of Computer of $350. The $300 selling
price will not be included in the company's sales or revenues.

3. The Notes To Financial Statements

Another basic accounting principle, the full disclosure principle, requires that a company's
financial statements include disclosure notes. These notes include information that helps readers
of the financial statements make investment and credit decisions. The notes to the financial
statements are considered to be an integral part of the financial statements.

The main type 2 accounting errors that do not affect the balancing of
the trial balance are as follows:

Error of omission. This occurs when a transaction is

completely omitted from the books of accounts. This error will
not be detected by the trial balance because the trial balance
does not know that the transaction exists as it is off the
books.
Error of reversal. This error occurs when a transaction that
should have been posted as a debit is posted as credit, for

example, in a cash sale, sales are debited and cash is

credited. This is technically wrong but since the duality
concept of the double entry has been applied, the trial
balance will still balance.

Error of principle. This error occurs when a bookkeeper

wrongly applies an accounting principle, for example by
recording assets as expenses. Assets and expenses are both
recorded in the books as debits so this is a technical error.
Error commission. This occurs when, for example, in the
debtor's account an amount owed to M Woman is recorded
as being owed to K Woman. The individual debtor accounts
will be incorrect because one account will be overstated and
the other will be understated, however the total debtors of the
business will be correct and the big picture correctly reports
the business debtors. This error shares the same
characteristics as the error of principle except that it occurs in
accounts of the same class.
Errors of subsidiary entry. This occurs when an error is made
in the subsidiary entry or the book of original entry. For
example, if a business buys stock for 1,000 on credit and the
stock account is debited by 100 and the creditor is also
credited by 100, rather debiting and crediting both accounts
by 1,000. The trial balance will not be able to detect this
error because the error applies to both the debit and credit
entries as the wrong amount has been used in the two double
entry accounting entries.
Compensating errors; these are rare and are likely to occur
by chance. Compensating errors occur when, for example,
debtors are overstated by 5000, and by chance creditors are
also overstated by the same amount. As a result these two

errors will compensate for each other and therefore will

cancel out each other.

hen these type of errors are discovered, their correction is journalized in the General
Journal to be posted to their respective ledgers.

Errors Of Omission
Occurs when a transaction is being COMPLETELY OMITTED
from the books
Example:
A cash receipt of $500.00 from a trade debtor, Mr.ABC has been
omitted from the books
The correcting entry should be:
Debit: Bank $500.00
Credit: Mr ABC $500.00
Being omission of aforesaid entry now adjusted

Errors Of Commission
An entry has been posted to the correct side of the Ledger but to
the wrong account.
Example:
Billing to Mr. A of $500.00 was wrongly posted to Mr Bs a/c
[ both are trade debtors in the books of account]
Debit: Mr. A $500.00
Credit: Mr. B $500.00
Being correction of error, sales to Mr. A wrongly debited to Mr. Bs
account.

Errors Of Principle
A transaction which is incorrectly dealt with like should be taken
up into expenses a/c (income statement) but now wrongly taken up
into the balance sheet a/c
Example:
Office maintenance of $1,000.00 wrongly posted into Machinery
a/c

Debit: Office maintenance a/c $1,000.00

Credit: Machinery a/c $1,000.00
Being correction of error, revenue expenditure being treated
incorrectly as capital expenditure

Compensating Errors
An error on the debit side being compensated by an error of equal
amount on the credit side.
Example:
Purchases a/c was overcast by $1,000.00 and so is Sales a/c
Debit: Sales A/c $1,000.000
Credit: Purchases a/c $1,000.00
Being correction of overcasts of $1,000 each in the Sales a/c and
Purchases a/c which compensated for each other.

Errors Of Original Entry

A wrong amount is recorded in the subsidiary book and posted to
the accounts
Example:
A sales to Mr. A $560.00 was entered in the books as $650.00
Debit: Sales $90.00
Credit: Mr. As a/c $90.00
Being correction of error, sales overstated by $90.00

Complete Reversal Of Entry

This is where the correct accounts are used but each item is shown
on the wrong side of the account.
Example:
Payment of $100.00 to trade creditor Mr. X was entered on the
debit side of the Cash book in error and credited to Mr. Xs a/c
This type of error requires an adjustment to cancel the error and the
actual entry itself. Normally, this is done by one journal adjustment
by doubling the actual amount first recorded.

Debit: Mr Xs a/c $100.00 x 2 = $200.00

Credit: Bank a/c $200.00
Being correction of error, payment of cash to Mr. X $100.00
debited to cash and credited to Mr. X incorrectly.

Part 1 illustrates the errors that do not affect the Trial Balance.
In this article, we shall discuss the different type of errors which affect the agreement of the Trial
Balance. To make the Trial Balance agree, a suspense account is used as a balancing figure.
Earlier in my article on Suspense account, I have also explained about suspense account which:

Is created when we discovered errors before the Final Accounts and Balance Sheet are
prepared,

The account is to records the difference between the total of the debits and the total of the
credits in the Trial Balance and

Suspense account helps to balance the Trial Balance by temporarily putting into an account
which after the errors being found, the suspense account be adjusted and become zero/nil
balance.

Trial Balance As At 31 st March 2006

Debit
Credit
$
$
Total of accounts listed 10,500 10,000
Suspense Account (balancing figure) 500
Before the difference are discovered, the suspense account will appear as either a debit item ( current
asset ) or credit item (credit liability ) in the Balance Sheet.
It is a must that wherever possible suspense account should never be in the books.
Suspense account can be treated in two ways when errors are discovered:

It might need to be expensed off or written back into the Income Statement when the
correcting entry is to the items in the Income Statement. Hence, it might over or under state
profits. ( Credit suspense a/c and Debit into Income statement )

Or the errors in the suspense can actually relate to the Balance Sheet which will have the effect
of overstating or understated assets and liabilities. ( Credit suspense a/c and Debit into Assets
a/c in the Balance Sheet)

Next, lets look at what are the types of errors that affect the Trial Balance:

Omission Of One Entry In A Transaction

Example:
Assuming there is a debit balance of $100.00 appearing in the
Suspense account.
It was subsequently discovered that this is due to:
Postages paid of $100.00 was correctly taken up in the Cash book
but not omitted in the Postage account
The correcting entry should be:
Debit: Postage $100.00
Credit: Suspense a/c $100.00
Being omission of one entry in the postage account for $100.00

Incorrect Additions In The Books

Example:
Assuming there is a debit balance of $1,000.00 appearing in the
Suspense account.
It was subsequently discovered that this is due to:
Purchases being under-cast by $1,000.00
The correcting entry should be:
Debit: Purchases $1,000.00
Credit: Suspense a/c $1,000.00
Being correction of incorrect/under cast in the purchases account.

Caused By More Than One Error

Example 1:
Assuming there is a credit balance of $1,800.00 appearing in the
Suspense account.
It was subsequently discovered that this is due to:
Returns Outwards of $900.00 been debited to Return Inwards
Account
The correcting entry is:
Debit: Suspense a/c $1,800.00
Credit: Return Outwards a/c $900.00

Credit: Return Inwards a/c $900.00

Being correction of error, Return Outwards treated incorrectly as
Return Inwards
Example 2:
Assuming there is a credit balance of $400.00 appearing in the
Suspense account.
It was subsequently discovered that this is due to:
Discount received $200.00 was wrong treated as discount allowed.
The correcting entry is:
Debit : Suspense a/c $400.00
Credit: Discount allowed $200.00
Credit: Discount received $200.00
Being correction of error, discount received $200 wrongly treated
as discount allowed.

Capital and Revenue Expenditure

Expenditure on fixed assets may be classified into Capital Expenditure and Revenue
Expenditure. The distinction between the nature of capital and revenue expenditure is important as
only capital expenditure is included in the cost of fixed asset.

Capital Expenditure
Capital expenditure includes costs incurred on the acquisition of a fixed asset and any subsequent
expenditure that increases the earning capacity of an existing fixed asset.
The cost of acquisition not only includes the cost of purchases but also any additional costs incurred
in bringing the fixed asset into its present location and condition (e.g. delivery costs).
Capital expenditure, as opposed to revenue expenditure, is generally of a one-off kind and its benefit
is derived over several accounting periods. Capital Expenditure may include the following:

Purchase costs (less any discount received)

Delivery costs

Legal charges

Installation costs

Up gradation costs

Replacement costs
As capital expenditure results in increase in the fixed asset of the entity, the accounting entry is as
follows:
Debit

Fixed Assets
Credit

Cash/Payable

Revenue Expenditure
Revenue expenditure incurred on fixed assets include costs that are aimed at 'maintaining' rather than
enhancing the earning capacity of the assets. These are costs that are incurred on a regular basis
and the benefit from these costs is obtained over a relatively short period of time. For example, a
company buys a machine for the production of biscuits. Whereas the initial purchase and installation
costs would be classified as capital expenditure, any subsequent repair and maintenance charges
incurred in the future will be classified as revenue expenditure. This is so because repair and
maintenance costs do not increase the earning capacity of the machine but only maintains it (i.e.
machine will produce the same quantity of biscuits as it did when it was first put to use).
Revenue costs therefore comprise of the following:

Repair costs

Maintenance charges

Repainting costs

Renewal expenses
As revenue costs do not form part of the fixed asset cost, they are expensed in the income statement
in the period in which they are incurred. The accounting entry to record revenue expenditure is
therefore as follows:
Debit

Revenue Expense (Income Statement)

Credit

Cash/Payable

Straight Line Depreciation Method

Straight line method depreciates cost evenly through out the useful life of the fixed asset. Straight line
depreciation is calculated as follows:
Depreciation per annum = (Cost - Residual Value) / Useful Life
Where:

Cost includes the initial and any subsequent capital expenditure.

Residual Value is the estimated scrap value at the end of the useful life of the asset.
As the residual value is expected to be recovered at the end of an asset's useful life,
there is no need to charge the portion of cost equaling the residual value.

Useful Life is the estimated time period an asset is expected to be used from the time
it is available for use to the time of its disposal or termination of use. Useful life is
normally calculated in units of years but it may be calculated based on an alternative
basis. Useful life of an oil extraction company may for example be the estimated oil
reserves.

Example
An asset has a useful life of 3 years.
Cost of the asset is $2,000.

Residual Value is $500.

Annual Depreciation cost will be $500 = (2000 - 500) / 3years
Straight line depreciation method is appropriate where economic benefits from the asset are expected
to be realized evenly during its useful life. It is also convenient where no reliable estimate can be
made regarding the pattern of economic benefits over an asset's useful life.
Next page contains explanation and example on how to calculate depreciation usingReducing
Balance Method

Reducing Balance Depreciation

Method
Reducing Balance Method charges depreciation at a higher rate in the earlier years of an asset. The
amount of depreciation reduces as the life of the asset progresses. Depreciation under reducing
balance method may be calculated as follows:
Depreciation per annum = (Net Book Value - Residual Value) x Rate%
Where:

Net Book Value is the asset's net value at the start of an accounting period. It is
calculated by deducting the accumulated (total) depreciation from the cost of the fixed
asset.

Residual Value is the estimated scrap value at the end of the useful life of the asset.
As the residual value is expected to be recovered at the end of an 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

Year1:

(2000

500)

50%

750

750

Year2:

(1250

500)

50%

375

1125

Year3:

(875

500)

50%

375*

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

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.
As income will be credited to record the accrued income, a corresponding receivable must be created
to account for the debit side of the transaction. The accounting entry to record accrued income will
therefore be as follows:
Debit

Income Receivable (Balance Sheet)

Credit

Income (Income Statement)

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

Interest Income Receivable

Credit

10,000

Interest on Bank Deposit (Income)

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

Interest Income Receivable

10,000

- See more at: http://accounting-simplified.com/accrued-income.html#sthash.YGS7ouEA.dpuf

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.
As expense will be debited to record the accrued expense, a corresponding payable must be created
to account for the credit side of the transaction. The accounting entry to record accrued expense will
therefore be as follows:
Debit

Expense (Income Statement)

Credit

Example

Expense Payable (Balance Sheet)

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

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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

Prepaid Income (Liability)

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

Prepaid Rent Income (Liability)

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

Prepaid Rent Income (Liability)

Credit

Rent Income (Income Statement)

10,000
10,000

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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 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.
Entity should therefore recognize an asset in respect of expense it has paid in advance until such time
as the services that are due in relation to the prepaid expense have been performed by the
suppliers/contractors. Following accounting entry is required to account for the prepaid expense:
Debit

Prepaid Expense (Asset)

Credit

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

Cash

10,000
10,000

The prepaid expense will be recognized as expense in the next accounting period to which the rental
expense relates. Following accounting entry will be recorded in the year 2011:
$
Debit

Rent Expense (Income Statement)

Credit

10,000

Prepaid Rent

10,000

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Bank reconciliation statement is a report which compares the bank balance as per company's
accounting records with the balance stated in the bank statement.
It is normal for a company's bank balance as per accounting records to differ from the balance as per
bank statement due to timing differences. Certain transactions are recorded by the entity that are
updated in the bank's system after a certain time lag. Likewise, some transactions are accounted for
in the bank's financial system before the company incorporates them into its own accounting system.
Such timing differences appear as reconciling items in the Bank Reconciliation Statement.
The purpose of preparing a Bank Reconciliation Statement is to detect any discrepancies between the
accounting records of the entity and the bank besides those due to normal timing differences. Such
discrepancies might exist due to an error on the part of the company or the bank.

Importance of Bank Reconciliation

Preparation of bank reconciliation helps in the identification of errors in the accounting

records of the company or the bank.

Cash is the most vulnerable asset of an entity. Bank reconciliations provide the
necessary control mechanism to help protect the valuable resource through
uncovering irregularities such as unauthorized bank withdrawals. However, in order
for the control process to work effectively, it is necessary to segregate the duties of
persons responsible for accounting and authorizing of bank transactions and those
responsible for preparing and monitoring bank reconciliation statements.

If the bank balance appearing in the accounting records can be confirmed to be

correct by comparing it with the bank statement balance, it provides added comfort
that the bank transactions have been recorded correctly in the company records.

Monthly preparation of bank reconciliation assists in the regular monitoring of cash

flows of a business.

Preparing a Bank Reconciliation

Statement
Following is a sample Bank Reconciliation Statement:
ABC LTD
Bank Reconciliation Statement as at 31 December 2011
Balance as per corrected Cash Book
1
xxx
Add:
Unpresented Cheques
2
xxx
Less:
Deposits in Transit
3
(xxx)
Errors in Bank Statement
4
(xxx)
Balance as per Bank Statement

xxx

1. Balance as per corrected Cash Book:

This is the starting point of a bank reconciliation. Corrected bank balance is calculated by adjusting
the cash book ledger balance for transactions that are recorded by the bank but not by the entity as
shown below:
Balance as per Cash Book
xxx
Add:
Direct Credits
5
xxx
Interest on Deposit
6
xxx
Less:
Bank Charges
7
(xxx)
Direct Debits
8
(xxx)
Standing Order
9
(xxx)
Errors in Cash Book
10
(xxx)
Balance as per corrected Cash Book

xx