Trial balance

A trial balance is a list of all the nominal ledger (general ledger) accounts contained in the
ledger of a business. This list will contain the name of the nominal ledger account and the value
of that nominal ledger account. The value of the nominal ledger will hold either a debit balance
value or a credit value balance. The debit balance values will be listed in the debit column of the
trial balance and the credit value balance will be listed in the credit column. The profit and loss
statement and balance sheet and other financial reports can then be produced using the ledger
accounts listed on the trial balance.

The name comes from the purpose of a trial balance which is to prove that the value of all the
debit value balances equal the total of all the credit value balances. Trialing, by listing every
nominal ledger balance, ensures accurate reporting of the nominal ledgers for use in financial
reporting of a businesses performance. If the total of the debit column does not equal the total
value of the credit column then this would show that there is an error in the nominal ledger
accounts. This error must be found before a profit and loss statement and balance sheet can be
produced.

The trial balance is usually prepared by a bookkeeper or accountant who has used daybooks to
record financial transactions and then post them to the nominal ledgers and personal ledger
accounts. The trial balance is a part of the double-entry bookkeeping system and uses the classic
'T' account format for presenting values.

Trial balance limitations

A trial balance only checks the sum of debits against the sum of credits. That is why it does not
guarantee that there are no errors. The following are the main classes of error that are not
detected by the trial balance:

 An error of original entry is when both sides of a transaction include the wrong amount.
For example, if a purchase invoice for £21 is entered as £12, this will result in an
incorrect debit entry (to purchases), and an incorrect credit entry (to the relevant creditor
account), both for £9 less, so the total of both columns will be £9 less, and will thus
balance.
 An error of omission is when a transaction is completely omitted from the accounting
records. As the debits and credits for the transaction would balance, omitting it would
still leave the totals balanced. A variation of this error is omitting one of the ledger
account totals from the trial balance.
 An error of reversal is when entries are made to the correct amount, but with debits
instead of credits, and vice versa. For example, if a cash sale for £100 is debited to the
Sales account, and credited to the Cash account. Such an error will not affect the totals.
 An error of commission is when the entries are made at the correct amount, and the
appropriate side (debit or credit), but one or more entries are made to the wrong account
 of the correct type. For example, if fuel costs are incorrectly debited to the postage
account (both expense accounts). This will not affect the totals.
 An error of principle is when the entries are made to the correct amount, and the
appropriate side (debit or credit), as with an error of commission, but the wrong type of
account is used. For example, if fuel costs (an expense account), are debited to stock (an
asset account). This will not affect the totals.
 Compensating errors are multiple unrelated errors that would individually lead to an
imbalance, but together cancel each other out.
 A Transposition Error is a Computing error caused by switching the position of two
adjacent digits. Since the resulting error is always divisible by 9, accountants use this fact
to locate the misentered number. For example, a total is off by 72, dividing it by 9 gives 8
which indicates that one of the switched digit is either more, or less, by 9 than the other
digit. Hence the error was caused by switching the digits 8 and 0 or 1 and 9. This will
also not affect the totals.

General ledger
The general ledger, sometimes known as the nominal ledger, is the main accounting record of a
business which uses double-entry bookkeeping. It will usually include accounts for such items as
current assets, fixed assets, liabilities, revenue and expense items, gains and losses. Each General
Ledger is divided into two sections. The left hand side lists debit transactions and the right hand
side lists credit transactions. This gives a 'T' shape to each individual general ledger account.

A "T" account showing debits on the left and credits on the right.

Debits Credits
   
   
   
   

The general ledger is a collection of the group of accounts that supports the value items shown in
the major financial statements. It is built up by posting transactions recorded in the sales
daybook, purchases daybook, cash book and general journals daybook. The general ledger can be
supported by one or more subsidiary ledgers that provide details for accounts in the general
ledger. For instance, an accounts receivable subsidiary ledger would contain a separate account
for each credit customer, tracking that customer's balance separately. This subsidiary ledger
would then be totaled and compared with its controlling account (in this case, Accounts
Receivable) to ensure accuracy as part of the process of preparing a trial balance.[1]

There are seven basic categories in which all accounts are grouped:

1. Assets
2. Liability
 3. Owner's equity
4. Revenue
5. Expense
6. Gains (Profits)
7. Losses

The balance sheet and the income statement are both derived from the general ledger. Each
account in the general ledger consists of one or more pages. The general ledger is where posting
to the accounts occurs. Posting is the process of recording amounts as credits, (right side), and
amounts as debits, (left side), in the pages of the general ledger. Additional columns to the right
hold a running activity total (similar to a checkbook).

The listing of the account names is called the chart of accounts. The extraction of account
balances is called a trial balance. The purpose of the trial balance is, at a preliminary stage of the
financial statement preparation process, to ensure the equality of the total debits and credits.

The general ledger should include the date, description and balance or total amount for each
account. It is usually divided into at least seven main categories. These categories generally
include assets, liabilities, owner's equity, revenue, expenses, gains and losses. The main
categories of the general ledger may be further subdivided into subledgers to include additional
details of such accounts as cash, accounts receivable, accounts payable, etc.

Because each bookkeeping entry debits one account and credits another account in an equal
amount, the double-entry bookkeeping system helps ensure that the general ledger is always in
balance, thus maintaining the accounting equation:

Assets = Liabilities + (Shareholders or Owners equity)

The accounting equation is the mathematical structure of the balance sheet.

Debits and credits

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Debit credit are formal bookkeeping and accounting terms. They are the most fundamental
concepts in accounting, representing the two sides of each individual transaction recorded in any
accounting system. A debit indicates an asset or an expense transaction, a credit indicates a
transaction that will cause a liability or a gain. A debit transaction can also be used to reduce a
credit balance or increase a debit balance. A credit transaction can be used to decrease a debit
balance or increase a credit balance. Debit and credit form the basis of the double-entry
bookkeeping system. Every debit and credit value are recorded in ledgers and from these ledgers
financial reports can then be prepared.

Contents
 1 Introduction
 2 Origin of the terms debit and credit
 3 Operational Principles
 4 Debit and Credit principle
o 4.1 Examples
 5 'T' Accounts
 6 References
 7 External links

Introduction
Debits and credits are a system of notation used in bookkeeping to determine how and where to
record any financial transaction. In bookkeeping, instead of using additions '+' and subtraction '-'
symbols, a transaction uses the symbol DR (Debit) or CR (Credit). In double-entry bookkeeping
debit is used for asset and expense transactions and credit is used for liability, gain and equity
transactions. For bank transactions, money received in is treated as a debit transaction and money
paid out is treated as a credit transaction. Traditionally, transactions are recorded in two columns
of numbers: debits in the left hand column and credits in the right hand column. Keeping the
debits and credits in separate columns allows each to be recorded and totalled independently.
Where the total of the debit value amounts is lower than the total of the credit value amounts, a
balancing debit value is posted to that nominal ledger account. That nominal ledger account is
now "balanced". An account can have either a credit value balance or a debit value balance but
not both.

A debit can also be used to reduce the balance on a liability, gain and equity account. This has
the effect of reducing a credit balance by the value of the debit transaction. The balance in a
nominal that is normally expected to hold a debit balance may change from a debit balance to a
credit balance.

A credit can also be used to reduce the balance on an asset or expense account. This has the
effect of reducing a debit balance by the value of the credit transaction. The balance in a nominal
that is normally expected to hold a credit balance may change from a credit balance to a debit
balance.

In some cases such as fixed assets, all debit transactions will be recorded in one nominal account
and all credit transactions will be recorded in a contra nominal account, with the exception when
an asset is disposed of. The purchase of an asset will be recorded in a fixed asset account (debit
transaction) and the depreciation of the fixed asset (credit transaction) will be recorded in a
contra nominal ledger account, fixed asset depreciation.

Operational Principles
Real Accounts

 In real accounts any increment in assets held by the entity is reflected by increasing the relevant
asset account and depletion by crediting the asset account.
 If any asset account is debited then it is on account of increment in the value or acquisition of
that liability or owner's equity which decreases the resources held by the entity.

As the total resources held by the entity cannot indigenously increment themselves the depletion
has to be matched with a fall in resources within the entity.

Personal Accounts

 In Personal Accounts debiting the personal account of any external entity increases the value of
the liabilities receivable from that entity thus augmenting the resources of the accounting
entity.
 Similarly crediting the personal account of any external entity reduces the value of monies
receivable from that entity thus reducing the resources of the accounting entity.

Nominal Accounts

 In Nominal Accounts the Expense accounts whenever debited are done as the Expense incurred
represents the Goods and/or Services acquired for assumption by the entity and hence are
temporary increments in the resources of the consumers.
 In Nominal Accounts the Income accounts are credited as the Income earned represents the
Epistolary representation of an entity

Cross-Application over Different Types of Accounts

 The principles apply uniformly to all combinations of accounting entries involving different types
of accounts based on varying circumstances.

Real Account Debited Personal Account Debited Nominal Account Debited

Amortisation or Depreciation
Real Acquisition of an Asset in Cash Sale of an Asset on Credit -
of an Asset - Depreciation
Account - Machinery Account Debited, Buyer's Account Debited,
Account Debited, Machinery
Credited Cash Account Credited Machinery Account Credited
Account Credited

Personal Acquisition of an Asset on Transfer of a Debt Accrual of Expenditure -

Account Credit - Machinery Account Receivable to another - New Electricity Account Debited,
Credited Debited, Seller's Account Debtor's Account Debited, Electricity Company's Account
 Old Debtor's Account
Credited Credited
Credited

Inter head transfer of

Capitalisation of Expenditure -
Nominal Sale of Goods on Credit - Expenditure - New
Machinery Account Debited,
Account Buyer's Account Debited, Expenditure Head Debited,
Research and Development
Credited Sales Account Credited Old Expenditure Head
Account Credited
Credited

Simple Thumb Rules to remember which accounts to credit and which to debit:

Personal accounts: Debit: the receiver; Credit: the giver

Real/Asset Accounts: Debit: what comes in; Credit: what goes out

Nominal/Expense Accounts: Debit: all expenses/losses; Credit: all income/gains

Debit and Credit principle

Each transaction consists of debits and credits, and for every transaction they must be equal.

For Every Transaction: The Value of Debits = The Value of Credits

The extended accounting equation must also balance: 'A + E = L + OE + R'

(where A = Assets, E = Expenses, L = Liabilities, OE = Owner's Equity and R = Revenues)

So 'Debit Accounts (A + E) = Credit Accounts (L + R + OE)'

Debits are on the left and increase a debit account and reduce a credit account.

Credits are on the right and increase a credit account and decrease a debit account.

Examples

1. When you pay rent with cash: you increase rent (expense) by recording a debit transaction, and
decrease cash (asset) by recording a credit transaction.
2. When you receive cash for a sale: you increase cash (asset) by recording a debit transaction, and
increase sales (revenue) by recording a credit transaction.
3. When you buy equipment with cash: You increase equipment (asset) by recording a debit
transaction, and decrease cash (asset) by recording a credit transaction.
4. When you borrow with a cash loan: You increase cash (asset) by recording a debit transaction,
and increase loan (liability) by recording a credit transaction.
 5. When you pay salary with cash: you increase salary (expenses) by recording a debit transaction,
and decrease cash (asset) by recording a credit transaction.

Account Debit Credit

1. Rent 100

Cash 100

2. Cash 50

Sale 50

3. Equip. 5200

Cash 5200

4. Cash 11000

Loan 11000

5. Salary 5000

Cash 5000

'T' Accounts
The process of using debits and credits creates a ledger format that resembles the letter 'T'. The
term 'T' account is commonly used when discussing bookkeeping.

A 'T' account showing debits on the left and credits on the right.

Debits Credits

   

   

   

   

   

TYPE DEBIT CREDIT

Asset + −
Liability − +

Income − +

Expense + −

Equity − +

Therefore, if an Asset account is debited, the Asset amount (value) is increased. Same with an
Expense account. If a Liability or an Income account is debited, the numerical figure will
decrease, etc. If a particular account is credited, there must be a corresponding Debit in another
account in order to balance the transaction.

As used in banking terminology, 'Debits" refer to withdrawals, not necessarily in the same
context as discussed here.

Cost of goods sold

Cost of goods sold refers to the inventory costs of those goods a business has sold during a
particular period. Costs are associated with particular goods using one of several formulas,
including specific identification, first-in first-out (FIFO), or average cost. Costs include all costs
of purchase, costs of conversion and other costs incurred in bringing the inventories to their
present location and condition. Costs of goods made by the business include material, labor, and
allocated overhead. The costs of those goods not yet sold are deferred as costs of inventory until
the inventory is sold or written down in value.

Contents
[hide]

 1 Overview
 2 Importance of inventories
 3 Cost of goods for resale
 4 Cost of goods made by the business
 5 Identification conventions
 6 Example
 7 Write-downs and allowances
 8 Alternative views
 9 See also
 10 Further reading
 11 References
Overview
Many businesses sell goods that they have bought or made. When the goods are bought or made,
the costs associated with such goods are capitalized as part of inventory (or stock) of goods.
These costs are treated as an expense in the period the business recognizes income from sale of
the goods.

Determining costs requires keeping records of goods or materials purchased and any discounts
on such purchase. In addition, if the goods are modified, the business must determine the costs
incurred in modifying the goods. Such modification costs include labor, supplies or additional
material, supervision, quality control, use of equipment, and other overhead costs. Principles for
determining costs may be easily stated, but application in practice is often difficult due to a
variety of consideration in the allocation of costs.

Cost of goods sold may also reflect adjustments. Among the potential adjustments are decline in
value of the goods (i.e., lower market value than cost), obsolescence, damage, etc.

When multiple goods are bought or made, it may be necessary to identify which costs relate to
which particular goods sold. This may be done based on specific identification of the goods or an
identification convention, such as first-in-first-out (FIFO) or average cost. Alternative systems
may be used in some countries, such as LIFO, gross profit method, retail method, or
combinations of these.

Cost of goods sold may be the same or different for accounting and tax purposes, depending on
the rules of the particular jurisdiction.

Importance of inventories
Inventories have a significant effect on profits. A business that makes or buys goods to sell must
keep track of inventories of goods under all accounting and income tax rules. An example
illustrates why. Fred buys auto parts and resells them. In 2008, Fred buys 100 worth of parts. He
sells parts for 80 that he bought for 30, and has 70 worth of parts left. In 2009, he sells the
remainder of the parts for 180. If he keeps track of inventory, his profit in 2008 is 50, and his
profit in 2009 is 110, or 160 in total. If he deducted all the costs in 2008, he would have a loss of
20 in 2008 and a profit of 180 in 2009. The total is the same, but the timing is much different. All
countries' accounting and income tax rules (if the country has an income tax) require the use of
inventories for all businesses that regularly sell goods they have made or bought.

Cost of goods for resale

Cost of goods purchased for resale includes purchase price as well as all other costs of
acquisitions. This cost should reflect any discounts. Additional costs may include freight paid to
acquire the goods, customs duties, sales or use taxes not recoverable paid on materials used, and
fees paid for acquisition. For financial reporting purposes such period costs as purchasing
department, warehouse, and other operating expenses are usually not treated as part of inventory
or cost of goods sold. For U.S. income tax purposes, some of these period costs must be
capitalized as part of inventory.Costs of selling, packing, and shipping goods to customers are
treated as operating expenses related to the sale. Both International and U.S. accounting
standards require that certain abnormal costs, such as those associated with idle capacity, must be
treated as expenses rather than part of inventory.

Value added tax is generally not treated as part of cost of goods sold if it may be used as an input
credit or otherwise recoverable from the taxing authority.

Cost of goods made by the business

The cost of goods produced in the business should include all costs of production. The key
components of cost generally include:

 Parts, raw materials and supplies used,

 Labor, including associated costs such as payroll taxes and benefits, and
 Overhead of the business allocable to production.

Most business make more than one of a particular item. Thus, costs are incurred for multiple
items rather than a particular item sold. Determining how much of each of these components to
allocate to particular goods requires either tracking the particular costs or making some
allocations of costs. Parts and raw materials are often tracked to particular sets (e.g., batches or
production runs) of goods, then allocated to each item.

Labor costs include direct labor and indirect labor. Direct labor costs are the wages paid to those
employees who spend all their time working directly on the product being manufactured. Indirect
labor costs are the wages paid to other factory employees involved in production. Costs of
payroll taxes and fringe benefits are generally included in labor costs, but may be treated as
overhead costs. Labor costs may be allocated to an item or set of items based on timekeeping
records.

Materials and labor may be allocated based on past experience, or standard costs. Where
materials or labor costs for a period exceed the expected amount of standard costs, a variance.
Such variances are then allocated among cost of goods sold and remaining inventory at the end
of the period.

Determining overhead costs often involves making assumptions about what costs should be
associated with production activities and what costs should be associated with other activities.
Traditional cost accounting methods attempt to make these assumptions based on past experience
and management judgment as to factual relationships. Activity based costing attempts to allocate
costs based on those factors that drive the business to incur the costs.

Overhead costs are often allocated to sets of produced goods based on the ratio of labor hours or
costs or the ratio of materials used for producing the set of goods. Overhead costs may be
referred to as factory overhead or factory burden for those costs incurred at the plant level or
overall burden for those costs incurred at the organization level. Where labor hours are used, a
burden rate or overhead cost per hour of labor may be added along with labor costs. Other
methods may be used to associate overhead costs with particular goods produced. Overhead rates
may be standard rates, in which case there may be variances, or may be adjusted for each set of
goods produced.

Variable production overheads are allocated to units produced based on actual use of production
facilities. Fixed production overheads are often allocated based on normal capacities or expected
production. More or fewer goods may be produced than expected when developing cost
assumptions (like burden rates). These differences in production levels often result in too much
or too little cost being assigned to the goods produced. This also gives rise to variances.

Identification conventions
In some cases, the cost of goods sold may be identified with the item sold. Ordinarily, however,
the identity of goods is lost between the time of purchase or manufacture and the time of sale.
Determining which goods have been sold, and the cost of those goods, requires either identifying
the goods or using a convention to assume which goods were sold. This may be referred to as a
cost flow assumption or inventory identification assumption or convention. The following
methods are available in many jurisdictions for associating costs with goods sold and goods still
on hand:

 Specific identification. Under this method, particular items are identified, and costs are
tracked with respect to each item. This may require considerable recordkeeping. This
method cannot be used where the goods or items are indistinguishable or fungible.
 Average cost. The average cost method relies on average unit cost to calculate cost of
units sold and ending inventory. Several variations on the calculation may be used,
including weighted average and moving average.
 First-In First-Out (FIFO) assumes that the items purchased or produced first are sold first.
Costs of inventory per unit or item are determined at the time made or acquired. The
oldest cost (i.e., the first in) is then matched against revenue and assigned to cost of
goods sold.
 Last-In First-Out (LIFO) is the reverse of FIFO. Some systems permit determining the
costs of goods at the time acquired or made, but assigning costs to goods sold under the
assumption that the goods made or acquired last are sold first. Costs of specific goods
acquired or made are added to a pool of costs for the type of goods. Under this system,
the business may maintain costs under FIFO but track an offset in the form of a LIFO
reserve. Such reserve (an asset or contra-asset) represents the difference in cost of
inventory under the FIFO and LIFO assumptions. Such amount may be different for
financial reporting and tax purposes in the United States.
 Dollar Value LIFO. Under this variation of LIFO, increases or decreases in the LIFO
reserve are determined based on dollar values rather than quantities.
 Retail inventory method. Resellers of goods may use this method to simplify
recordkeeping. The calculated cost of goods on hand at the end of a period is the ratio of
cost of goods acquired to the retail value of the goods times the retail value of goods on
hand. Cost of goods acquired includes beginning inventory as previously valued plus
 purchases. Cost of goods sold is then beginning inventory plus purchases less the
calculated cost of goods on hand at the end of the period.

Example
Jane owns a business that resells machines. At the start of 2009, she has no machines or parts on
hand. She buys machines A and B for 10 each, and later buys machines C and D for 12 each. All
the machines are the same, but they have serial numbers. Jane sells machines A and C for 20
each. Her cost of goods sold depends on her inventory method. Under specific identification, the
cost of goods sold is 10 + 12, the particular costs of machines A and C. If she uses FIFO, her
costs are 20 (10+10). If she uses average cost, here costs are 22 ( (10+10+12+12)/4 x 2). If she
uses LIFO, her costs are 24 (12+12). Thus, her profit for accounting and tax purposes may be 20,
18, or 16, depending on her inventory method. After the sales, her inventory values are either 22,
20, or 18.

After year end, Jane decides she can make more money by improving machines B and D. She
buys and uses 10 of parts and supplies, and it takes 6 hours at 2 per hour to make the
improvements to each machine. Jane has overhead, including rent and electricity. She calculates
that the overhead adds 0.5 per hour to her costs. Thus, Jane has spend 20 to improve each
machines (10/2 + 12 + (6 x 0.5) ). She sells machine D for 45. Her cost for that machine depends
on her inventory method. If she used FIFO, the cost of machine D is 12 plus 20 she spent
improving it, for a profit of 13. Remember, she used up the two 10 cost items already under
FIFO. If she uses average cost, it is 11 plus 20, for a profit of 14. If she used LIFO, the cost
would be 12 plus 20 for a profit of 15.

In year 3, Jane sells the last machine for 38 and quits the business. She recovers the last of her
costs. Her total profits for the three years are the same under all inventory methods. Only the
timing of income and the balance of inventory differ. Here is a comparison under FIFO, Average
Cost, and LIFO:

Cost of Goods Sold ------ Profit ------

Year Sales FIFO Avg. LIFO FIFO Avg. LIFO
1 40 20 22 24 20 18 16
2 45 32 31 30 13 14 15
3 38 32 31 30 6 7 8
Total 123 84 84 84 39 39 39

Write-downs and allowances

The value of goods held for sale by a business may decline due to a number of factors. The
goods may prove to be defective or below normal quality standards (subnormal). The goods may
become obsolete. The market value of the goods may simply decline due to economic factors.

Where the market value of goods has declined for whatever reasons, the business may chose to
value its inventory at the lower or cost or market value, also known as net realizable value. This
may be recorded by accruing an expense (i.e., creating an inventory reserve) for declines due to
obsolescence, etc. Current period net income as well as net inventory value at the end of the
period is reduced for the decline in value.

Any property held by a business may decline in value or be damaged by unusual events, such as
a fire. The loss of value where the goods are destroyed is accounted for as a loss, and the
inventory is fully written off. Generally, such loss is recognized for both financial reporting and
tax purposes. However, book and tax amounts may differ under some systems.

FIFO and LIFO accounting

FIFO and LIFO accounting Methods are accounting techniques used in managing inventory
and financial matters involving the money a company tied up within inventory of produced
goods, raw materials, parts, components, or feed stocks.

FIFO stands for first-in, first-out, meaning that the oldest inventory items are recorded as sold
first but do not necessarily mean that the exact newest physical object has been tracked and sold;
this is just an inventory technique.

LIFO stands for last-in, first-out, meaning that the most recently purchased items are recorded as
sold first. Since the 1970s, U.S. companies have tended to use LIFO, which reduces their income
taxes in times of inflation.

The difference between the cost of an inventory calculated under the FIFO and LIFO methods is
called the LIFO reserve. This reserve is essentially the amount by which an entity's taxable
income has been deferred by using the LIFO method.

LIFO liquidation
Notwithstanding its deferred tax advantage, a LIFO inventory system can lead to LIFO
liquidation, a situation where in the absence of new replacement inventory or a search for
increased profits, older inventory is increasingly liquidated (or sold). If prices have been rising,
for example through inflation, this older inventory will have a lower cost, and its liquidation
leads to the recognition of higher net income and the payment of higher taxes, thus reversing the
deferred tax advantage that initially encouraged the adoption of a LIFO system. Some companies
who use LIFO have decades-old inventory recorded on their books at a very low cost. For these
companies a LIFO liquidation results in an inflated net income (and higher tax payments).
Companies can use liquidations to manage their earnings.

Also mobile telecom operators either use FIFO or LIFO to allocate remaining call credit a
customer did not fully use in a billing period. In telecom terms FIFO is good for the customers
while LIFO is good for the telecom operator. With small amount of carry over duration, call
credit is to be lost sooner with LIFO then with FIFO as a customer first uses his old call
credit( that he had left from previous month) rather than first needing to use all the new credit
before using the old call credit.
Generally Accepted Accounting Principles
Generally Accepted Accounting Principles (GAAP) is a term used to refer to the standard
framework of guidelines for financial accounting used in any given jurisdiction which are
generally known as Accounting Standards. GAAP includes the standards, conventions, and
rules accountants follow in recording and summarizing transactions, and in the preparation of
financial statements.

Contents
[hide]

 1 Overview
 2 International Accounting Standards and Rules
 3 See also
 4 External links

[edit] Overview
Financial Accounting is information that must be assembled and reported objectively. Third-
parties who must rely on such information have a right to be assured that the data are free from
bias and inconsistency, whether deliberate or not. For this reason, financial accounting relies on
certain standards or guides that are called "Generally Accepted Accounting Principles" (GAAP).

Principles derive from tradition, such as the concept of matching. In any report of financial
statements (audit, compilation, review, etc.), the preparer/auditor must indicate to the reader
whether or not the information contained within the statements complies with GAAP.

 Principle of regularity: Regularity can be defined as conformity to enforced rules and

laws.

 Principle of consistency: This principle states that when a business has once fixed a
method for the accounting treatment of an item, it will enter all similar items that follow
in exactly the same way.

 Principle of sincerity: According to this principle, the accounting unit should reflect in
good faith the reality of the company's financial status.

 Principle of the permanence of methods: This principle aims at allowing the coherence
and comparison of the financial information published by the company.
  Principle of non-compensation: One should show the full details of the financial
information and not seek to compensate a debt with an asset, a revenue with an expense,
etc. (see convention of conservatism)

 Principle of prudence: This principle aims at showing the reality "as is": one should not
try to make things look prettier than they are. Typically, a revenue should be recorded
only when it is certain and a provision should be entered for an expense which is
probable.

 Principle of continuity: When stating financial information, one should assume that the
business will not be interrupted. This principle mitigates the principle of prudence: assets
do not have to be accounted at their disposable value, but it is accepted that they are at
their historical value (see depreciation and going concern).

 Principle of periodicity: Each accounting entry should be allocated to a given period,

and split accordingly if it covers several periods. If a client pre-pays a subscription (or
lease, etc.), the given revenue should be split to the entire time-span and not counted for
entirely on the date of the transaction.

 Principle of Full Disclosure/Materiality: All information and values pertaining to the

financial position of a business must be disclosed in the records.

 Principle of Utmost Good Faith: All the information regarding to the firm should be
disclosed to the insurer before the insurance policy is taken.

[edit] International Accounting Standards and Rules

Many countries use or are converging on the International Financial Reporting Standards (IFRS),
established and maintained by the International Accounting Standards Board. In some countries,
local accounting principles are applied for regular companies but listed or large companies must
conforms to IFRS, so statutory reporting is comparable internationally, across jurisdictions.

Revenue recognition
The Revenue recognition principle is a cornerstone of accrual accounting together with
matching principle. They both determine the accounting period, in which revenues and expenses
are recognized. According to the principle, revenues are recognized when they are (1) realised or
realisable, and are (2) earned (usually when goods are transferred or services rendered), no
matter when cash is received. In cash accounting - in contrast - revenues are recognized when
cash is received no matter when goods or services are sold.

Cash can be received in an earlier or latter period than obligations are met (when goods or
services are delivered) and related revenues are recognized that results in the following two types
of accounts:
  Accrued revenue: Revenue is recognized before cash is received.
 Deferred revenue: Revenue is recognized after cash is received.

Contents
[hide]

 1 General rule
o 1.1 Revenue vs. cash timing
o 1.2 Advances
 2 Exceptions
o 2.1 Revenues not recognized at delivery
o 2.2 Revenues recognized before delivery
 2.2.1 Long-term contracts
 2.2.2 Completion of production basis
o 2.3 Revenues recognized after delivery
 3 See also
 4 References

[edit] General rule

Received advances are not recognized as revenues, but as liabilities (deferred income), until the
conditions (1) and (2) are met.

(1) Revenues are realised when cash or claims to cash (receivable) are received in exchange for
goods or services. Revenues are realisable when assets received in such exchange are readily
convertible to cash or claim to cash.

(2) Revenues are earned when such goods/services are transferred/rendered. Both, such payment
assurance and final delivery completion (with a provision for returns, warranty claims, etc.), are
required for revenue recognition.

Recognition of revenue from four types of transactions:

1. Revenues from selling inventory are recognized at the date of sale often interpreted as the date
of delivery.
2. Revenues from rendering services are recognized when services are completed and billed.
3. Revenue from permission to use company’s assets (e.g. interests for using money, rent for using
fixed assets, and royalties for using intangible assets) is recognized as time passes or as assets
are used.
4. Revenue from selling an asset other than inventory is recognized at the point of sale, when it
takes place.

In practice, this means that revenue is recognized when an invoice has been sent.
[edit] Revenue vs. cash timing

Accrued revenue (or accrued assets) is an asset such as proceeds from a delivery of goods or
services, at which such income item is earned and the related revenue item is recognized, while
cash for them is to be received in a latter accounting period, when its amount is deducted from
accrued revenues. It shares characteristics with deferred expense (or prepaid expense, or
prepayment) with the difference that an asset to be covered latter is cash paid out TO a
counterpart for goods or services to be received in a latter period when the obligation to pay is
actually incurred, the related expense item is recognized, and the same amount is deducted from
prepayments.

Deferred revenue (or deferred income) is a liability, such as cash received FROM a
counterpart for goods or services are to be delivered in a later accounting period, when such
income item is earned, the related revenue item is recognized, and the deferred revenue is
reduced. It shares characteristics with accrued expense with the difference that a liability to be
covered later is an obligation to pay for goods or services received FROM a counterpart, while
cash for them is to be paid out in a later period when its amount is deducted from accrued
expenses.

For example, a company receives an annual software license fee paid out by a customer upfront
on the January 1. However the company's fiscal year ends on May 31. So, the company using
accrual accounting adds only five months worth (5/12) of the fee to its revenues in profit and loss
for the fiscal year the fee was received. The rest is added to deferred income (liability) on the
balance sheet for that year.

[edit] Advances

Advances are not considered to be a sufficient evidence of sale, thus no revenue is recorded until
the sale is completed. Advances are considered a deferred income and are recorded as liabilities
until the whole price is paid and the delivery made (i.e. matching obligations are incurred).

[edit] Exceptions
[edit] Revenues not recognized at delivery

The general rule says that revenue from selling inventory is recognized at the point of sale, but
there are several exceptions.

 Buyback agreements: buyback agreement means that a company sells a product and agrees to
buy it back after some time. If buyback price covers all costs of the inventory plus related
holding costs, the inventory remains on the seller’s books. In plain: there was no sale.
 Returns: companies which cannot reasonably estimate the amount of future returns and/or
have extremely high rates of returns should recognize revenues only when the right to return
expires. Those companies which can estimate the number of future returns and have a relatively
small return rate can recognize revenues at the point of sale, but must deduct estimated future
returns.
[edit] Revenues recognized before delivery

[edit] Long-term contracts

This exception primarily deals with long-term contracts such as constructions (buildings,
stadiums, bridges, highways, etc.), development of aircraft, weapons, and space exploration
hardware. Such contracts must allow the builder (seller) to bill the purchaser at various parts of
the project (e.g. every 10 miles of road built).

 Percentage-of-completion method says that if (1) the contract clearly specifies the price and
payment options with transfer of ownership, (2) the buyer is expected to pay the whole amount
and (3) the seller is expected to complete the project, then revenues, costs, and gross profit can
be recognized each period based upon the progress of construction (that is, percentage of
completion). For example, if during the year, 25% of the building was completed, the builder can
recognize 25% of the expected total profit on the contract. This method is preferred. However,
expected loss should be recognized fully and immediately due to conservatism constraint.
 Completed contract method should be used only if percentage-of-completion is not applicable
or the contract involves extremely high risks. Under this method, revenues, costs, and gross
profit are recognized only after the project is fully completed. Thus, if a company is working only
on one project, its income statement will show $0 revenues and $0 construction-related costs
until the final year. However, expected loss should be recognized fully and immediately due to
conservatism constraint.

[edit] Completion of production basis

This method allows recognizing revenues even if no sale was made. This applies to agricultural
products and minerals because (1) there is a ready market for these products with reasonably
assured prices, (2) the units are interchangeable, and (3) selling and distributing does not involve
significant costs.

[edit] Revenues recognized after delivery

Sometimes, the collection of receivables involves a high level of risk. If there is a high degree of
uncertainty regarding collectibility then a company must defer the recognition of revenue. There
are three methods which deal with this situation:

 Installment sales method allows recognizing proportional gross profit on cash collection. For
example, if a company collected 45% of total product price, it can recognize 45% of total profit
on that product.
 Cost Recovery Method is used when there is an extremely high probability of uncollectble
payments. Under this method no profit is recognized until cash collections exceed the seller’s
cost of the merchandise sold. For example, if a company sold a machine worth $10,000 for
$15,000, it can start recording profit only when the buyer pays more than $10,000. In other
words, for each dollar collected greater than $10,000 goes towards your anticipated gross profit
of $5,000.
  Deposit Method is used when the company receives cash before sufficient transfer of
ownership occurs. Revenue is not recognized because the risks and rewards of ownership have
not transferred to the buyer.[1]

Comparison of Cash Method and Accrual

Method of accounting
Two primary accounting methods, cash and accrual basis, are used to calculate taxable income
for U.S. federal income taxes. According to the Internal Revenue Code, a taxpayer may compute
taxable income by:

1. the cash receipts and disbursements method;

2. an accrual method;
3. any other method permitted by the chapter; or
4. any combination of the foregoing methods permitted under regulations prescribed by the
Secretary.[1]

As a general rule, a taxpayer must compute taxable income using the same accounting method he
uses to compute income in keeping his books.[2] Also, the taxpayer must maintain a consistent
method of accounting from year to year. Should he change from the cash basis to the accrual
basis (or vice versa), he must notify and secure the consent of the Secretary.[3]

Contents
[hide]

 1 Cash basis
 2 Accrual basis
 3 History
 4 See also
 5 References

[edit] Cash basis

Cash basis taxpayers include income when it is received, and claim deductions when expenses
are paid.[4] A cash basis taxpayer can look to the doctrine of constructive receipt and the doctrine
of cash equivalence to help determine when income is received. Most individuals start as cash
basis taxpayers. There are three types of taxpayers that cannot use the cash basis: (1) C
corporations; (2) partnerships with at least one C corporation partner; and (3) tax shelters.[5]

Similar definition of cash basis accounting is true for financial accounting purposes.[6]
[edit] Accrual basis
Accrual basis taxpayers include items when they are earned and claim deductions when
expenses are incurred.[7] An accrual basis taxpayer looks to the “all-events test” and “earlier-of
test” to determine when income is earned.[8] Under the all-events test, an accrual basis taxpayer
generally must include income "for the taxable year when all the events have occurred that fix
the right to receive income and the amount of the income can be determined with reasonable
accuracy."[9] Under the "earlier-of test", an accrual basis taxpayer receives income when (1) the
required performance occurs, (2) payment therefore is due, or (3) payment therefore is made,
whichever happens earliest.[10] Under the earlier of test outlined in Revenue Ruling 74-607, an
accrual basis taxpayer may be treated, as a cash basis taxpayer, when payment is received before
the required performance and before the payment is actually due. An accrual basis taxpayer
generally can claim a deduction “in the taxable year in which all the events have occurred that
establish the fact of the liability, the amount of the liability can be determined with reasonable
accuracy, and economic performance has occurred with respect to the liability.”[11]

Similar definition of accrual basis accounting is true for financial accounting purposes, except
that revenue can't be recognized until it's earned even if a cash payment has already been
received.[6]

[edit] History
Originally, federal law required all taxpayers to use the cash basis accounting.[12] However, many
businesses used the accrual basis, as most generally accepted accounting principles ("GAAP")
were based thereon, and objected to the new law.[13] Less than a year after the 1913 Revenue Act,
the IRS allowed use of the accrual basis for deductions, then for income, and in 1916, Congress
formally adopted the accrual basis accounting into U.S. tax law.[14]