UNIVERSITY OF MAKATI

SUBJECT: AUDITING AND ASSURANCE CONCEPTS AND APPLICATION – PART 1

ACTIVITY 5
CHAPTER 5: CASH AND ACCRUAL BASIS

1. Describe cash basis and accrual basis of accounting.

● Cash basis accounting is the recognition of cash only when received and not when
earned. Income from credit accounts is not included in cash basis accounting until in the
businesses account. The accounting for expenses paid is when the business pays them,
not when incurred.
● The accrual basis of accounting is the concept of recording revenues when earned and
expenses as incurred. The use of this approach also impacts the balance sheet, where
receivables or payables may be recorded even in the absence of an associated cash
receipt or cash payment, respectively. The accrual basis of accounting is advocated
under both generally accepted accounting principles (GAAP) and international financial
reporting standards (IFRS).

2. Compare and contrast cash and accrual basis of accounting.

● Cash basis accounting records revenue and expenses when actual payments are
received or disbursed. It doesn't account for either when the transactions that create
them occur. On the other hand, accrual accounting records revenue and expenses when
those transactions occur and before any money is received or paid out.

3. Apply cash basis in accounting for business transactions.

In order to demonstrate, an illustration of a certain business transaction will be provided.

To record sales on account.

Account receivable. XX

Sales XX

To record receipt of note from sales on account.

Note receivable. XX

Sales. XX

To record sales return from a customer.

 Sales returns and allowance. XX

Account receivable XX

To record collection within the discount period.

Cash. XX

Sales discount. XX

Account receivable XX

To record accounts written off.

Allowance for doubtful accounts. XX

Account receivable. XX

To record re-establishment of accounts previously written off.

Account receivable. XX

Allowance for doubtful accounts XX

To record collection of accounts previously written off.

Cash XX

Account receivable XX

To record advances received from customers.

Cash. XX

Advances from customers XX

To record delivery of goods to customers with advances

Advances from customers. XX

Sales. XX

To record the provisions for bad debts during the year.

Bad debts. XX

Allowance for bad debts. XX

 Accounts Receivable

Beginning Balance -AR xx xx Ending Balance - AR

Sales in account xx xx Sales returns and allowances

Recoveries xx xx Sales Discounts

xx Collections including recoveries

xx Write off

TOTAL xx xx

Allowance for Doubtful Accounts

Accounts written off xx xx Beginning Balance

Ending Balance xx xx Doubtful accounts expense

xx Recoveries

TOTAL xx xx

4. Apply accrual basis in accounting for business transactions.

In order to demonstrate, an illustration of a certain business transaction will be provided.

To record collection of rent.

Cash XX

Unearned Rent Income XX

To record adjusting entry of the rent income.

Unearned Rent Income XX

Rent Income XX

To record accrual of rent receivable.

Rent Receivable XX

Rent Income XX

Rent Receivable / Unearned Rent Income

 Beginning Balance -RR xx xx Ending Balance - RR

Ending Balang -URI xx xxBeginning Balance - URI

Rent Income xx xxCollections

TOTAL xx xx

5. Use and apply the T-accounts approach in solving problems.

The following will be used to come up with a T-Account.

ILLUSTRATION: Computation of Rent Income

The following data were reported by ZXY Company during the current year:

Rent Receivable - Jan 1 100,000

Rent Receivable - Dec 31 150,000

Unearned Rent Income - Jan 1 60,000

Unearned Rent Income - Dec 31 50,000

Collection of Rent 500,000

To compute for the total rent income under accrual basis of accounting:

Rent Receivable / Unearned Rent Income

Beginning Balance -RR 100,000 150,000 Ending Balance - RR

Ending Balang -URI 50,000 60,000 Beginning Balance - URI

Rent Income 560,000 500,000 Collections

TOTAL 710,000 710,000

6. Translate accrual income to cash basis income and vice versa.

Accrual Income —> Cash Basis Income
Accrual Basis Income xx
Add: Non-cash expenses xx
 Less: Non-cash income xx
Add: Decreases in current assets xx
Less: Increases in current assets xx
Add: Increases in current liabilities xx
Less: Decreases in current liabilities xx
Cash Basis Income xx

Cash Basis Income —> Accrual Income

Cash Basis Income xx
Add: Accrued expenses xx
Less: Cash Payments xx
Add: Prepaid Expenses xx
Add: Account Receivable xx
Less:Cash Receipts xx
Accrual Basis Income xx

CHAPTER 6: CORRECTION OF ERRORS

1. Define error.

Error refers to an unintentional misstatement in financial statements including the omission of

an amount or a disclosure, including:

1. A mistake in gathering or processing data from which financial statements are prepared;
2. An incorrect accounting estimate arising from oversight or misinterpretation of facts;

3. A mistake in the application of accounting principles relating to measurement, recognition,

classification, presentation or disclosure."

2. Enumerate and describe the different types of errors.

TYPES OF ERRORS

I. Balance sheet or statement of financial position errors

II. Income statement errors

III. Combined statement of financial position and income statement errors

a. Counterbalancing errors

b. Non-counterbalancing errors

● Statement of Financial Position or Balance Sheet Errors

❖ Statements of Financial Position or balance sheet errors affect only the
presentation of an asset, liability, or stockholders' equity account.
❖ When the error is discovered in the error year, the company reclassifies the item
to its proper position.
❖ If the error in a prior year is discovered in a subsequent period, the company
should restate the statement of financial position of the prior year for
comparative purposes.
● Income Statement Errors
❖ Income statement errors are errors affecting only the income statement
accounts and may include improper classification of revenues or expenses.
❖ A company must make a reclassification entry when it discovers the error in the
error year.
❖ If the error discovered pertains to a prior year, the company should restate the
income statement of the prior year for comparative purposes.
❖ Since these errors involve two nominal accounts, net income and retained
earnings during the period are unaffected.
● Combined Statement of Financial Position and Income Statement Errors
❖ Errors affecting both the statement of financial position and income statement
can be classified as:

a. Counterbalancing errors

Counterbalancing errors are errors that will offset or be corrected over two
accounting periods. Examples include the following:
 Omissions of the following:

1. Deferred expense (or Prepayments under the expense method.)

2. Deferred income (Precollection under the revenue method.)

3. Accrued Expenses

4. Accrued Revenues

Overstatement Or Understatement of the following:

5. Sales not recorded in the first year and subsequently recorded the following
year (or vice versa).

6. Purchases not recorded in the first year and subsequently recorded the
following year (or vice versa).

7. Error affecting ending inventory.

b. Non-counterbalancing errors Counterbalancing Errors

Non-counter balancing errors do not offset in the next accounting period.

Therefore, companies must make correcting entries, even if they have closed the
books.

Examples:

1. Prepayments under the asset method

2. Precollection under the liability method

3. Error in recording depreciation

4. Improper capitalization of expense

5. Improper expensing of capital expenditure

6. Error in recording of proceeds of sale of an asset (e.g. PPE) as other income

3. Identify the effects of errors in the accounts presented in the financial statement.

Error affecting Net Income: Effect in the Net Income Relationship

If Sales are overstated Overstated Direct

If Cost of sales are overstated Understated Inverse

If Expenses are overstated Understated Inverse

Error affecting Cost of Sale: Effect in the Cost of Sale Relationship

If Beginning Inventories are Overstated Direct

overstated

If Net purchase are overstated Overstated Direct

If Ending Inventories are Understated Inverse

overstated

Working Capital:

Working Capital is the capital of a business that is used in its day-to-day trading
operations, computed as the current assets minus the current liabilities

Error affecting working capital: Effect in the working Relationship

Capital

If the current assets are Overstated Direct

overstated

If the current liabilities are Understated Inverse

overstated

4. Prepare adjusting journal entries to correct errors.

Illustration: Statement of Financial Position Error

 U Can Be A Topnotcher Company reported net income for the first two years of
operation as follows:

2020 5,000,000

2021 6,000,000

In an audit of the financial statement for the year ended December 31, 2021, the
following errors are discovered (all errors were made in 2020):

1) Notes receivable of P10,000 was erroneously debited to accounts receivable.

2) Notes payable of P15,000 was erroneously credited to accounts payable.

3) Land of P100,000 was erroneously debited to investment property account.

Adjusting entries if errors are discovered in:

Year

2020 Notes Receivable 10,000

Accounts Receivable 10,000

Accounts Payable 15,000

Notes Payable 15,000

Land 100,000

Investment Property 100,000

2021 Land 100,000

Investment Property 100,000

2022 Land 100,000

Investment Property 100,000

Illustration: Income Statement Errors

 Dare to Dream Company reported net income for the first two years of operation as
follows: 2020 3,000,000

2021 4,000,000

In an audit of the financial statement for the year ended December 31, 2021, the
following errors are discovered:

1) Interest expense of P20,000 in 2020 was erroneously debited to rent expense.

2) Office supplies expense of P25,000 in 2020 was erroneously debited to purchases.

3) Rent income of P30,000 in 2020 was erroneously credited to miscellaneous income.

Year

2020 Interest Expense 20,000

Rent Expense 20,000

Office Supplies Expense 25,000

Purchases 25,000

Miscellaneous Income 300,000

Rent Income 30,000

2021 No adjusting entries

2022 No adjusting entries

CHAPTER 7: SUBSTANTIVE TEST OF CASH

1. Explain and identify the categories of management assertions.

Categories of Management Assertions

● Assertions about classes of transactions and events for the period under audit:
a. Occurrence - transactions and events that have been recorded have occurred
and pertain to the entity.
 b. Completeness - all transaction and events that should have been recorded have
been recorded.
c. Accuracy - amounts and other data relating to recorded transactions and events
have been recorded appropriately.
d. Cutoff - transactions and events have been recorded in the correct accounting
period.
e. Classification - transactions and events have been recorded in the proper
accounts.
● Assertions about account balances at the period end:
a. Existence - assets, liabilities, amd equity interests exists.
b. Rights and obligation - the entity holds or controls the rights to assets, and
liabilities are the obligations of the entity.
c. Completeness - all assets, liabilities and equityinterests that should have been
recorded have been recorded.
d. Valuation and allocation - assets, liabilities, and equity interests are included in
the financial statements at appropriate amounts and any resulting valuation or
allocation adjustments are appropriately recorded.
● Assertions about presentation and disclosure:
a. Occurrence and rights and obligations - dislclosed events, transactions, and
other matters have occurred and pertain to the entity.
b. Completeness - all disclosure that should have been included in the FS have
been included.
c. Classification and understandibility - financial information is appropriately
presented and described, and disclosure are clearly depressed.
d. Accuracy and valuation - financial and other information are disclose fairly and
at appropriate amounts.

2. Identify the audit objectives for cash and cash equivalents.

When auditing cash and cash equivalent, the principal objective for the substantive tests is to
determine the following:

Assertions Category Account Balances Audit Objectives

Existence All cash on the SFP at a given date is held by the

entity or by others for the entity.

Completeness All cash owned by the entity at the reporting date

is included on the SFP.

Valuation and Allocation Cash, including bank balances, is stated at

realizable value and agrees wth supporting
schedules.

Rights and Obligations The entity owns, or has a legal right to, and has
unrestricted use on all the cash on the SFP at the
reporting date.
Presentation and Disclosure Cash, including bank balances, is properly
classified, described, and disclosed in the FS,
including notes, in accordance with PFRS.

3. Describe the primary substantive audit procedures for cash and cash equivalents.

The auditor’s primary substantive procedures for cash balances and transactions wil typically
include the following:
1. Sending confirmation to banks or financial institutions;
2. Conducting surprise cash counts;
3. Obtaining and testing bank reconciliation and if appropriate, preparing proof of cash;
4. Obtaining bank cutoff statement and tracing bank transfers;
5. Performing cash cutoff tests;
6. Checking the appropriate valuation of cash; and
7. Performing analytical procedures to assess the reasonableness of reported cash.

4. Identify assertions addressed by audit procedures for cash and cash equivalents.

Assertion Category Primary Audit Procedures

Existence ➢ Sending confirmation to banks of

financial institutions
➢ Surprise cash count
➢ Obtaining and testing bank reconciliation
and preparing proof cash (if appropriate)
➢ Obtaining bank cutoff statement and
tracing bank transfer
➢ Cash cut-off test
➢ Analytical procedures on cash

Completeness ➢ Sending confirmation to banks or

financial institutions
➢ Obtaining and testing bank reconciliation
and preparing proof of cash
➢ Obtaining bank cutoff statement and
tracing bank transfers
➢ Cash cut-off test
➢ Analytical procedures on cash

Valuation and Allocation ➢ Sending confirmation to banks or

financial institutions
➢ Surprise cash count
➢ Obtaining and testing bank reconciliation
 and preparing proof cash
➢ Checking the appropriate valuation of
cash

Rights and Obligations ➢ Sending confirmation to banks or

financial institutions
➢ Surprise cash count
➢ Obtaining and testing bank reconciliation
and preparing proof cash
➢ Obtaining bank cutoff statement and
tracing bank transfers
➢ Cash cut-off test
➢ Analytical procedures on cash

Presentation and Disclosure ➢ Sending confirmation to banks or

financial institutions
➢ Checking the appropriate valuation of
cash