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Chapter 3

Accrual Accounting and the Balance Sheet


Difference between Accrual accounting and Cash accounting:Accural Accounting
Cash Accounting
Record Incomes or Revenue
Record Incomes or Revenue when
when it's earned. Regardless of
money is received. Regardless of
when cash is paid.
when the sale is made.
Record Expenses when it is
Record Expenses when it is paid.
incurred. Regardless of when
Regardless of when sale is made.
expenses is paid.
Accural basis of accounting is
used in all kinds of organization
Cash basis of accounting is used in
whether it is a small scale/
small units or small scale industries.
private limited companies etc.
Use of accural basis of
accounting is mandatory as
instructed by GAAP (Generally
Accepted Accounting Principles).

Cash basis of accounting is not


recognized by GAAP (Generally
Accepted Accounting Principles).
Hence it is not used by companies.

Operating Cycle of Business: Operating cycle of a business starts from cash brought in by owners which is
used to by inputs. These are converted into finished products or services and
sold to customers. To create receivables. When receivables are collected, we
get cash again to buy inputs.
The different phases of this cycle are shown below.
Diagram of Operating cycle of a Business

Purchases

Cash

Inventory

Collections

Accounts
Payable

Accounts
Receivable

Production

Sales
Finished
Goods

The Balance Sheet shows where the funds are i.e Assets and who has helped
business to acquire them i.e Liabilities.
Sound Financial Management of a company involves matching the sources and uses
of cash, so that obligations become due as assets mature into cash.
Review of Balance Sheet:With sound review of a company's Balance Sheet, one can monitor the ability of that
company to
collect revenues
manage its inventory
Plus satisfy its creditors and shareholders.
Balance Sheet Terms:Assets:- Are anything of value that is owned or due to the business. Classified as
Non-current
Current
Others
(i) Non-Current Assets consists of: Net Fixed Assets:- Include Land, Buildings, Machinery and Equipment,
Furniture and Fixtures, Vehicles etc.
Are long term investments that enables the business to carry on
its operations.
Stated at book their value which is calculated as Gross Fixed
Assets (cost) less accumulated depreciation.
Investments in subsidiaries:- Common forms of investment of surplus
funds, by the companies are as follows =>
Government or Trust Securities.
Shares, Debentures, or Bonds.
Immovable properties.
In capital of subsidiaries.
Intangibles:- Represent the use of cash to purchase assets with an
undetermined life and may never mature into cash.
Research and Development.
Market Research.
Patents.
Goodwill.
Standard accounting principles require most intangibles to be
expensed as purchased and not capitalized except purchased
patents that may be amortized over the life of the patent.
Others.
(ii) Current Assets consists of: Cash:- Cash pays bills and obligations.
Other assets cannot pay bills unless they are converted into cash.
Includes all bank accounts, money market and short-term savings
accounts.
Accounts Receivables:- Are money due from customers.

Are third most liquid asset after cash and short term investments.
Some receivables can become uncollectible.
This expense is termed as 'bad debts'.
These can be recorded by two methods
Allowance method:- An estimate is prepared for bad debts for the
period and expense is recorded by journal entry.
Bad Debts (dr)
To Allowance for Bad debts (cr)
The estimate is based on
- % of sales method - income statement approach or
- aging of receivables - balance sheet method
Direct write off method:- The expenses is recorded when specific
account goes bad.
Journal entry is passed to debit Bad Debt expenses and credit
Accounts Receivables - for Xxx Company.
The method does not comply with Matching Revenue principle,
as expenses is recorded much later when specific account is uncollectible and goes bad.
Inventory:- Consists of materials company purchases to convert and sell
as finished products.
The level of inventory has to be managed in such a way that required
materials are always available for production and sale with minimum
funds locked in it.
The correct level of inventory is a function of the length of the
company's inventory cycle.
Inventory Cycle in Days = Ordering phase in days + Production phase
in days + Finished Goods and Delivery Phase in days.
Notes Receivables:- Both Receivables and Inventory can be managed by
controlling their quality which is measured in days as follows:Receivables Days =
Actual Receivables x 360
Sales in a year
Inventory Days =
Actual Inventory x 360
Cost of Goods sold in a year
Quality Measurement & Goals
Both Receivables and Inventory can be managed by controlling their
quality which is measured in days.
Ideal receivables days should be close to average days of credit
allowed to customers.
Ideal inventory days should be just over inventory cycle days.
Investment in Inventory and Accounts receivable is a function of sales
and days.
Increase due to sales is healthy.
But due to increase in days is costly as it is an indication of
overstocking and inefficient collections.
Prepaid Expenses:- 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.
Others Current Assets:- A firm's assets that do not include cash, securities,
receivables, inventory and prepaid assets, and can be convertible into
cash within one business cycle, which is usually one year. Other current
assets are listed on a firm's balance sheet, and are a component of a
firm's total assets. Restricted cash or investments may be included in this
figure.
Liabilities:"Liabilities and Net Worth are sources of cash listed in descending order from the
soonest to mature obligations to never to mature obligations".
Liabilities are mentioned below as:o Current Liabilities
o Non-Current Liabilities
o Contingent Liability
o Equity
{i} Current Liabilities:- Are those obligations that mature and must be paid within
12 months.
They include Accounts Payable, Accrued Expenses, Notes Payable (both Bank
and Other) and Current Portion of Long Term Debit (that part payable in next 12
months).
{ii} Non-Current Liabilities:- Are those obligations that are not due to payable in the
coming year.
Include long term secured or non secured loans, funds received from
associates and promoters.
{iii} Cotingent Liabilities:- Are those obligations that hopefully never become due.
They are potential liabilities which are not due on the day of reporting, but
may, depending upon results of pending law suits and warranties and cross
guarantees issued.
These are indicated by a foot note in the Balance Sheet.
{iv} Equity and Net Worth:- Equity and net worth are last to mature source of funds.
It has two parts:Purchased Equity - Paid up Equity Shares and Preference Shares
Earned Equity - Retained earnings (profits) shown as Reserves and Earned Surplus.
Summary: "Accural accounting records revenues as earned and expense as
incurred, ignoring when payments arranged".
"Operating cycle of business involves process of converting the raw
material to cash".
"Matching principle demands that against revenue of a period all
expenses in that period are included".
"Non-current assets are those that do not mature into cash in a year".

"Contingent Liabilities are potential and not actual ones as of date".