As CFA class progresses, we were introduced to the dynamics of preparing financial statements beyond the debits and credits of simple transactions. One would have thought accounting was very straight forward, thanks to our creative and amusing faculty in person of Professor Akintola, who have continuously simplified learnings for non-accounting students.
It goes beyond application of a single method but rather an understanding of the substance of each business transaction. There are basic financial principles that must be followed to avoid creative accounting (redesigning the figures to derive a desired result).
This gives rise to a need for Adjustments within the accounting periods.
- Fiscal and Calendar Years
A fiscal year is an accounting period that is one year in length. It begins with the first day of a month and ends twelve months later on the last day of a month. Most businesses use the calendar year (January 1 to December 31) as their accounting period. Some do not. Guinness Nigeria for example uses 1st of July to 31st of June as their accounting year. Companies must prepare their financial statement at the least annually to reflect the records and activities that occurred within the fiscal year.
- Accrual- vs. Cash-Basis Accounting
Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the events occur. For example, using the accrual basis to determine net income means companies recognize revenues when earned rather than when they receive cash. It also means recognizing expenses when incurred rather than when paid.
Under cash-basis accounting on the other hand, companies record revenue when they receive cash. They record an expense when they pay out cash. The cash basis seems appealing due to its simplicity, but it often produces misleading financial statements. It fails to record revenue that a company has earned but for which it has not received the cash. Also, it does not match expenses with earned revenues. Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP).
- Recognizing Revenues and Expenses
It can be difficult to determine the amount of revenues and expenses to report in a given accounting period. Two principles simplifies it- the revenue recognition principle and the expense recognition principle.
Revenue Recognition Principles
The revenue recognition principle requires that companies recognize revenue in the accounting period in which it is earned. In a service enterprise, revenue is earned at the time the service is performed. To illustrate, assume that Kquinxtarbells Dry Cleaning cleans clothing on June 30 but customers do not claim and pay for their clothes until the first week of July. Under the revenue recognition principle, Kquinxtarbells earns revenue in June when it performed the service, rather than in July when it received the cash. At June 30, Kquinxtarbells would report a receivable on its balance sheet and revenue in its income statement for the service performed.
Expense Recognition Principle
Accountants follow a simple rule in recognizing expenses: “Let the expenses follow the revenues.” Thus, expense recognition is tied to revenue recognition. In the dry-cleaning example, this means that Kquinxtarbells should report the salary expense incurred in performing the June 30 cleaning service in the same period in which it recognizes the service revenue. The critical issue in expense recognition is when the expense makes its contribution to revenue. This may or may not be the same period in which the expense is paid. If Kquinxtarbells does not pay the salary incurred on June 30 until July, it would report salaries payable on its June 30th balance sheet.
Till next time!