Accrued Expense and Income

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                           Expense Payable (Balance Sheet)

Example

ABC LTD pays loan interest for the month of December 2014 of $10,000 on 3rd January 2015. ABC LTD has an accounting year end of 31st December 2014. ABC LTD will recognize interest expense of $10,000 in the financial statements of year 2014 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          $10,000

Credit                           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           $10,000

Credit                           Cash                            $10,000

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.

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 2014 on 3rd January 2015. ABC LTD has an accounting year end of 31st December 2014.

ABC LTD will recognize interest income of $10,000 in the financial statements of year 2014 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                  $10,000

Credit                           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                                                    $10,000

Credit                           Interest Income Receivable                  $10,000

Prepaid Expense and Income

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 2014 in respect of office rent for the following year.

ABC LTD has an accounting year end of 31^st December 2014. ABC LTD will recognize an asset of $10,000 in the financial statements of year 2014 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 2014:

Debit                            Prepaid Rent                            $10,000

Credit                           Cash                                        $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 2015:

Debit                            Rent Expense (Income Statement)       $10,000

Credit                           Prepaid Rent                                        $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                           Prepaid Income (Liability)

Example

ABC LTD receives advance rent from its tenant of $10,000 on 31st December 2014 in respect of office rent for the following year. ABC LTD has an accounting year end of 31^st December 2014.

ABC LTD will recognize a liability of $10,000 in the financial statements of year 2014 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 2014:

Debit                            Cash                                                    $10,000

Credit                           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 2015:

Debit                            Prepaid Rent Income (Liability)                       $10,000

Credit                           Rent Income (Income Statement)         $10,000

Cash Flow Statement

Introduction to Cash Flow Statement

The statement of cash flows is one of the main financial statements. (The other financial statements are the balance sheet, income statement, and statement of stockholders' equity.)

The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state "For the Three Months Ended December 31, 2015" or "The Fiscal Year Ended September 30, 2015".

The cash flow statement organizes and reports the cash generated and used in the following categories:

What Can The Statement of Cash Flows Tell Us?

Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement.

Here are a few ways the statement of cash flows is used.

1. The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash.
2. Some investors believe that "cash is king". The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value.
3. Some financial models are based upon cash flow.

General Assumptions about cash:

• When an asset (other than cash) increases, the Cash account decreases.
• When an asset (other than cash) decreases, the Cash account increases.
• When a liability increases, the Cash account increases.
• When a liability decreases, the Cash account decreases.
• When owner's equity increases, the Cash account increases.
• When owner's equity decreases, the Cash account decreases.

Accrual Basis Of Accounting

The accounting method under which revenues are recognized on the income statement when they are earned (rather than when the cash is received). The balance sheet is also affected at the time of the revenues by either an increase in Cash (if the service or sale was for cash), an increase in Accounts Receivable (if the service was performed on credit), or a decrease in Unearned Revenues (if the service was performed after the customer had paid in advance for the service).

Under the accrual basis of accounting, expenses are matched with revenues on the income statement when the expenses expire or title has transferred to the buyer, rather than at the time when expenses are paid. The balance sheet is also affected at the time of the expense by a decrease in Cash (if the expense was paid at the time the expense was incurred), an increase in Accounts Payable (if the expense will be paid in the future), or a decrease in Prepaid Expenses (if the expense was paid in advance).

Introduction to Accounting Basics

Accountancy is the process of communicating financial information about a business entity to users such as shareholders and managers (Elliot, Barry & Elliot, Jamie: Financial accounting and reporting).

Accounting has been defined as:

the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof.(AICPA)

Users of Accounting Information - Internal & External

Accounting information helps users to make better financial decisions. Users of financial information may be both internal and external to the organization.

Internal users (Primary Users) of accounting information include the following:

1. Management: for analysing the organization's performance and position and taking appropriate measures to improve the company results.
2. Employees: for assessing company's profitability and its consequence on their future remuneration and job security.
3. Owners: for analysing the viability and profitability of their investment and determining any future course of action.

Accounting information is presented to internal users usually in the form of management accounts, budgets, forecasts and financial statements.

External users (Secondary Users) of accounting information include the following:

1. Creditors: for determining the credit worthiness of the organization. Terms of credit are set by creditors according to the assessment of their customers' financial health. Creditors include suppliers as well as lenders of finance such as banks.
2. Tax Authorities: for determining the credibility of the tax returns filed on behalf of the company.
3. Investors: for analyzing the feasibility of investing in the company. Investors want to make sure they can earn a reasonable return on their investment before they commit any financial resources to the company.
4.  Customers: for assessing the financial position of its suppliers which is necessary for them to maintain a stable source of supply in the long term.
5. Regulatory Authorities: for ensuring that the company's disclosure of accounting information is in accordance with the rules and regulations set in order to protect the interests of the stakeholders who rely on such information in forming their decisions.

External users are communicated accounting information usually in the form of financial statements. The purpose of financial statements is to cater for the needs of such diverse users of accounting information in order to assist them in making sound financial decisions.

Accountancy encompasses the recording, classification, and summarizing of transactions and events in a manner that helps its users to assess the financial performance and position of the entity. The process starts by first identifying transactions and events that affect the financial position and performance of the company. Once transactions and events are identified, they are recorded, classified and summarized in a manner that helps the user of accounting information in determining the nature and effect of such transactions and events.

Accounting is a very dynamic profession which is constantly adapting itself to varying needs of its users. Over the past few decades, accountancy has branched out into different types of accounting to cater for the different needs of the users.