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Module 1: Accounting issues

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XSIQ
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Accounting - Revenue and expense recognition

Revenue and expense recognition

These alternative accounting systems should be treated in two separate
stages:

A transaction is defined as "an external event involving the transfer of
something of value between two or more entities". The accounting system
records the effects of the transactions. It follows that the point(s) at
which a firm records depends upon the type(s) of transactions it
recognises. There are two methods for recognising and hence recording
transactions.

a. The cash method; which recognises and records only the receipt and
payment of cash.

b. The accrual method; which recognises and records transactions both when
they are entered into (earned or incurred) and when cash is received and/or
paid. This method recognises and records both credit and cash transactions.


View the video on small businesses.

Determination of profit by time periods is a primary function of
accounting. The reasons for the determination of accounting profit
periodically include the needs of management/proprietors for financial
information and legal requirements for individuals to submit personal tax
returns. Two bases of determining periodic profit are possible:

a. The modified cash basis; under which periodic profit/loss is arrived at
after matching revenue (defined as all cash received from operations)
against expenses (defined as all cash paid on operations except for the
inclusion of adjustments for stock on hand and depreciation of fixed
assets). This basis, which is a mixture of the cash and accrual bases, has
been developed and used to satisfy the provisions of the Income Tax
Assessments Act. Where the firm regularly gives or receives credit, the
financial information produced by using this basis of determining periodic
profit is not regarded as being sufficiently reliable for management
purposes.

b. The accrual basis; under which periodic profit/loss is arrived at by
matching revenue earned in the period with expenses incurred in that
period. The matching principle is important for reliable periodic profit
determination.

The basis used to determine periodic profit has no necessary connection
to the method used for recognising and recording transactions. Balance day
adjustments can convert cash transaction records into the accrual basis of
profit measurement.

Modified cash basis [1]

* simple to prepare and operate

* less time consuming

* tax is only paid on income received, not earned

* less skill required in report preparation

Accrual basis [2]

* reports are more accurate, particularly where the reporting period is
less than one year

* more accurate reports then lead to better planning for the future

* performance can be more accurately evaluated

* in the balance sheet a more detailed list of assets and liabilities are
provided

When discussing records only talk in terms of journals and ledgers
whereas reports include Profit and Loss, cash budgets and balance sheet.

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[1] http://alison.com/#
[2] http://alison.com/#