Question

 

The Malaysian government, like most government, has decided to change from cash basis accounting and to accrual accounting basis. The government has decided to expense the amount in the year it was originally allocated rather than in the period the payments would be made.

Required:

a. Explain the concepts of cash basis accounting and accrual basis accounting.

b. Provide justifications on the adoption of accrual basis accounting in place of cash basis accounting.

c. On May 1 2020, Desa Petaling Cleaning Services paid $1,200 for a one-year fire insurance policy beginning May 1. The payment was recorded as Debit in Prepaid Insurance. On May 31 the account shows a balance of $1,200. Each month insurance expires $100 (i.e., $1,200 ÷ 12 months). Based on this information, answer the following questions:

i. Make the necessary journal entries for the above transaction in complying with the concept of revenues and expenses recognition.

ii. How does accrual basis of accounting relate to assumption accounting of time period in the context of recognizing revenues and expenses?

Answer 1

a. Explain the concepts of cash basis accounting and accrual basis accounting.

Cash Basis Accounting: Cash basis of Accounting is the method of accounting where only all the cash related transactions are accounted while accounts receivable and accounts payable are not accounted. This is suitable for small businesses as it will be easy for them to record the transactions when the cash received and paid. It is used to know the cash in hand or bank at the given particular point of time.

Accrual Basis Accounting: Under this method of Accounting, the transactions are recorded when they are incurred or earned rather than when they are received or paid. It is used for the large business organizations. This method of accounting is recommended by IFRS and GAAP for the purpose of accounting and also for tax purposes.

b. Provide justifications on the adoption of accrual basis accounting in place of cash basis accounting.

When a cash based accounting is used it records the transactions only which are cash based and ignores the credit related sales or purchases which are actually related to that particular year and thus the profitability of the business affects. The liabilities and the assets of the business also affects as it does not considers the accounts receivable and accounts payable. IFRS and GAAP mandates the companies to follow the Accrual basis of accounting. For the purpose of tax also Accrual method of accounting is used. Hence, it is better to adopt Accrual Basis of Accounting in the place of Cash basis of Accounting

c i) Make the necessary journal entries for the above transaction in complying with the concept of revenues and expenses recognition.

The Journal entry when the Amount paid for life Insurance is as follows:

    Prepaid Insurance A/c...Dr       $1,200

                   Cash A/c...Cr                             $1,200

Each month, when the insurance expires $100, the journal entry is as follows:

Insurance Expense A/c....Dr.     $100

        Prepaid Insurance A/c...Cr            $100

C ii. How does accrual basis of accounting relate to assumption accounting of time period in the context of recognizing revenues and expenses?   

The main difference between the Cash basis of Accounting and Accrual basis of Accounting lies in the timing of when the purchases and sales are recognized and accounted. So, the Accrual basis is related to the assumption of the time period in the context pf recognizing the revenues and expenses when they are earned rather than when they are actually received.