Accounting in the Real World

Accounting in the Real World

In this lesson, you’re expected to learn about:
– accrued & deferred expenses / income
– bank account reconciliation
– cash and cheque payments

In the real world, accounting is not as simple. There are lots of exceptions that you have to deal with.

Let’s now look at the most common ones:

Accrued Expenses (Accruals)

Sometimes, you may have incurred a cost in a month but not yet received an invoice or paid the supplier.

In order to allow for the cost in this month, a journal entry is used. You need to tell the system which nominal accounts to adjust and by how much, and enter a date so the system knows which month the entry belongs in.

This journal will make the following entries:
• increase accruals
• decrease retained profit

You also have to make accrued expenses when you’ve received an invoice from the supplier but it has a date that is after the month in which the expense belongs. This is because most accounting systems work off the date of the relevant source document.

If you enter an invoice dated March but want that cost to appear in February, you have to make an accrual with a February date. You cannot just change the date on a source document to suit yourself.

Now, when you do the March accounts, you’re still going to have to enter the invoice because of the VAT – which means you’ll be recording the cost twice in your accounts.

To combat this problem, you need to reverse the accrual i.e. you make the journal entries you made except the other way around so that they cancel each other out.

You give the second journal a March date so that the entries are recorded in March.

The table below gives an overview of how to reverse an accrual:
• Column 0: Simplified balance sheet at the end of February before making the accrual.
Column 1: Journal entries for the accrual (€350 in this case before VAT).
 Note that when we accrue for costs in this way, we don’t allow for VAT because it is determined solely by the dates on invoices.
• Column 2: Balance sheet at the end of February.
• Column 3: shows the three entries when you enter the invoice dated March. Notice that the €350 cost is being deducted from retained profit twice.
• Column 4: shows the second journal entry dated March that cancels out the February entry.
• Column 5: Balance sheet at the end of March that correctly reflects the trade creditors, tax liability, and retained profit.
Similarly, you can do the same thing for Accrued Income.

You would simply:
• increase accrued income
• increase retained profit

[Optional] Reversing Entries
Deferred Income

So what happens if you invoice a customer in February but you’ve invoiced them in advance, so the sale is actually taking place in March?

From the table below, we can see the following:
• Column 2: the deferred income journal cancels out the impact of the invoice on retained profit in February.

• The deferred income nominal account is a claim over the assets. We’ve invoiced the customer but haven’t given them the goods/service yet so they have a claim over the company’s assets.

Deferred Expenses (Prepayments) 

The same situation applies if a supplier invoices us in advance of providing the goods or services. We want to defer the expense into a subsequent period.

This nominal account is usually called ‘prepayments’.

[Optional] What are Accruals and Prepayments?
Watch this 3-minute video to learn more:
Cash Payments or Receipts with No Source Document

If you have a bank loan, the bank will simply take the interest each month or quarter out of your bank account and show it on your bank statement.

This means that entry in your bank statement does the following:
• Recognizes the interest transaction (and acts as a source document).
• Settles the interest transaction.

You could however enter this as two separate transactions(using the journal functionality of your accounting system)

• Recognize the interest expense
– increase liability to the bank
– decrease retained profit

• Settle the payment of the interest
– decrease cash
– decrease liability to the bank

Cheque Payments   

For cheque payments, you could either use the cheque stub as your source document or wait until you see the payment going out of your bank account (i.e. use the bank statement as the source document).

However, keep in mind that it could take a few days for someone to cash a cheque and there is also the possibility of a cheque bouncing. So, it’s a much better practice to use the cheque stubs.

This allows your accounting system to be able to tell you at any given time how much cash you have available.

Bank Account Reconciliation

This refers to checking whether, at any given point in time, your bank balance according to your accounting system is the same as your bank balance according to your actual bank statement. This is important for the following reasons:

• You need to know exactly how much cash you have at all times – running out of cash is a disaster for a business.

• Many of the mistakes you might make when doing your accounting will show up when you try to reconcile your bank account(s).

Some companies with big accounts departments reconcile their bank accounts every day. You must at least do it whenever you do your accounts. 
Using cheque stubs as your source document 

Even if you don’t ever make a mistake, you will often find a difference between the accounting system figure and the bank statement figure because the accounting system will reflect all cheques right up to the balance sheet date, whereas the bank statements will only show those that have cleared.

Given the much reduced usage of cheques these days, this is less of an issue than it used to be.

[Optional] Bank Reconciliation


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