Question

Define the following terms and show their accounting treatment:

(a)      Account expenses.                                                          [2 marks]

(b)      Prepaid expenses.                                                           [2 marks]

(c)      Unused stationery.                                                         [2 marks]

(d)      Unexpired expenses.                                                      [2 marks]

(e)      Omitted invoice.                                                             [3 marks]

(f)       Drawings.                                                                      [3 marks]

(g)      Accrued income.                                                             [3 marks]

(h)     Advance income.                                                            [2 marks]

(i)       Bad debts, bad debts recovered, provision for bad debts.[4 marks

(j)       Depreciation.   

Answer 1

a) Account Expenses

What are Accounts Expenses?
An expense in accounting is the money spent, or costs incurred, by a business in their effort to generate revenues. Essentially, accounts expenses represent the cost of doing business; they are the sum of all the activities that result in (hopefully) a profit.

Accounts Expenses

It is important to understand the difference between “cost” and “expense” since they each have a distinct meaning in accounting. Cost is the monetary measure (cash) that has been given up in order to buy an asset. An expense is a cost that has expired or been taken up by activities that help generate revenue. Therefore, all expenses are costs, but not all costs are expenses.

What is an Expense?
An expense is defined in the following ways:

An expense in office supplies uses up the cash (asset)
A purchase in capital equipment (e.g., a machine or a building) decreases the book value of the asset over the years through depreciation expense
A prepaid expense, such as prepaid rent, is an asset that turns into a cash expense as the rent is used up each month

A summary of all expenses is included in the income statement as deductions from the total revenue. Revenue minus expenses equals the total net profit of a company for a given period.

In the double-entry bookkeeping system, expenses are one of the five main groups where financial transactions are categorized. Other categories include the owner’s equity, assets, liabilities, and revenue. Expenses in double-entry bookkeeping are recorded as a debit to a specific expense account. A corresponding credit entry is made that will reduce an asset or increase a liability.

The purchase of an asset such as land or equipment is not considered a simple expense but rather a capital expenditure. Assets are expensed throughout their useful life through depreciation and amortization.

Expenses in Cash Accounting and Accrual Accounting
Expenses are recorded in the books on the basis of the accounting system chosen by the business, either through an accrual basis or a cash basis. Under the accrual method, the expense for the good or service is recorded when the legal obligation is complete; that is when the goods have been received or the service has been performed.

Under cash accounting, the expense is only recorded when the actual cash has been paid. For example, a utility expense incurred in April but paid in May will be recorded as an expense in April under the accrual method but recorded as an expense in May under the cash method – as this is when the cash is actually paid.

Accrual accounting is based on the matching principle that ensures that accurate profits are reflected for every accounting period. The revenue for each period is matched to the expenses incurred in earning that revenue during the same accounting period. For example, sale commission expenses will be recorded in the period that the related sales are reported, regardless of when the commission was actually paid.

Types of Expenses
Expenses affect all financial accounting statements but exert the most impact on the income statement. They appear on the income statement under five major headings, as listed below:

1. Cost of Goods Sold (COGS)
Cost of Goods Sold (COGS) is the cost of acquiring raw materials and turning them into finished products. It does not include selling and administrative costs incurred by the whole company, nor interest expense or losses on extraordinary items.

For manufacturing firms, COGS includes direct labor, direct materials, and manufacturing overhead.
For a service company, it is called a cost of services rather than COGS.
For a company that sells both goods and services, it is called cost of sales.
Examples of COGS include direct material, direct costs, depreciation expense, and production overhead.

2. Operating Expenses – Selling/General and Admin
Operating expenses are related to selling goods and services and include sales salaries, advertising, and shop rent.

General expenses include expenses incurred while running the core line of the business and include executive salaries, R&D, travel and training, and IT expenses.

3. Financial Expenses
These are costs incurred from borrowing or earning income from financial investments. They are expenses outside the company’s core business. Examples include loan origination fees and interest on money borrowed.

4. Extraordinary Expenses
Extraordinary expenses are costs incurred for large one-time events or transactions outside the firm’s regular business activity. They include laying off employees, selling land, or disposal of a significant asset.

5. Non-Operating Expenses
These are costs that cannot be linked back to operating revenues. Interest expense is the most common non-operating expense. Interest is the cost of borrowing money. Loans from banks usually require interest payments, but such payments don’t generate any operating income. Hence, they are classified as non-operating expenses.

Non-Cash Expenses
The sole purpose of a non-cash expense is to reduce net profit and eventually, taxes. It is not an income statement category. Depreciation is the most common type of non-cash expense because it conforms to the definition that an expense decreases owner’s equity by using up the asset. Depreciation also results in other non-cash effects such as:

A debit to a depreciation account increases the account balance
A credit to a contra asset account like accumulated depreciation increases the balance of the depreciation account
On the income statement, the book value of the asset decreases by the same amount as the accumulated depreciation.
Expenses are income statement accounts that increase the debit side of a contra account. When the expense is recorded, a corresponding credit is recorded to an asset or liability.

b) Prepaid Expenses

A prepaid expense is a type of asset on the balance sheet that results from a business making advanced payments for goods or services to be received in the future. Prepaid expenses are initially recorded as assets, but their value is expensed over time onto the income statement

c) Unused Stationary

Generally Stationery items are debited to Profit and Loss Account as they are treated as expense. But if the stationery is the main item of trading, then it shall be shown as Inventory in the Revised Schedule VI Balance Sheet at cost or selling price whichever is lower

d) Unexpired Expenses

An unexpired cost is any cost that has not yet been charged to expense because it still represents some residual value. This cost is frequently associated with revenue that has not yet been recognized; under the matching principle, an unexpired cost is maintained on the books as an asset until the associated revenue is recognized, at which point the asset is charged to expense. Examples of unexpired costs are:

A company prepays $12,000 for 12 months of advertising. After three months, $9,000 of this prepayment is still an unexpired cost, because the associated advertising has not yet occurred.
A company acquires $5,000 of merchandise. Until the goods are sold, the $5,000 is an unexpired cost. Once the related sale is recognized, the $5,000 is charged to expense

e) Omitted Invoice

Omitted invoice is an example of error of omission which means when you forget to enter a transaction in the books. You may forget to enter an invoice you’ve paid or the sale of a service.

For example, a copywriter buys a new business laptop but forgets to enter the purchase in the books.
How to find it: Errors of omission are hard to discover. One way to find them is to check if your credits equal your debits in your trial balance. You may have entered a credit for a transaction but no debit. Doing regular bank reconciliations will also help you double check your books for accuracy.

It’s better to act preventatively and have a system in place to enter each transaction. Errors of omission tend to crop up when a company uses petty cash to pay for expenses. Keep your receipts and paperwork and set up a regular time each week to enter the data.

f) Drawings

A drawing account is an accounting record maintained to track money withdrawn from a business by its owners. A drawing account is used primarily for businesses that are taxed as sole proprietorships or partnerships

in other words it is a contra account to the owner's equity. The drawing account's debit balance is contrary to the expected credit balance of an owner's equity account because owner withdrawals represent a reduction of the owner's equity in a business.

g) Accrued Income

Accrued income is revenue that's been earned, but has yet to be received. Both individuals and companies can receive accrued income. Although it is not yet in hand, accrued income is recorded on the books when it is earned, according to accrual accounting methods.

h) Advance Income

Sometimes earned revenue that belongs to a future accounting period is received in the current accounting period, such income is considered as income received in advance. It is also known as Unearned Income and is received before the related benefits are provided.

When a company receives money in advance of earning it, the accounting entry is a debit to the asset Cash for the amount received and a credit to the liability account such as Customer Advances or Unearned Revenues.

i) Bad debts , recovery of bad debts , provision for bad debts

Bad debts expense is related to a company's current asset accounts receivable. Bad debts expense is also referred to as uncollectible accounts expense or doubtful accounts expense. Bad debts expense results because a company delivered goods or services on credit and the customer did not pay the amount owed.

Examples of Bad Debts Expense
There are two methods for reporting the amount of bad debts expense:

direct write-off method
allowance method
The direct write-off method requires that a customer's uncollectible account be removed from Accounts Receivable and at that time the following entry is made: debit Bad Debts Expense and credit Accounts Receivable.

The allowance method anticipates and estimates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for the estimated amount. (The Allowance for Doubtful Accounts is a contra asset account that when presented along with Accounts Receivable indicates a more realistic amount that will be turning to cash.)

For financial statement purposes the allowance method is the better method since 1) the balance sheet will be reporting a more realistic amount that will be collected from the company's accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales. However, for income tax purposes the direct write-off method must be used.

Bad debt recovery is a payment received for a debt that was written off and considered uncollectible. The receivable may come in the form of a loan, credit line, or any other accounts receivable. Because it generally generates a loss when it is written off, bad debt recovery usually produces income.

The accounting for a bad debt recovery is a two-step process, as follows: Reverse the original recordation of a bad debt. This means creating a debit to the accounts receivable asset account in the amount of the recovery, with the offsetting credit to the allowance for doubtful accounts contra asset account

The provision for doubtful debts, which is also referred to as the provision for bad debts or the provision for losses on accounts receivable, is an estimation of the amount of doubtful debt that will need to be written off during a given period

j) Depreciation

In accountancy, depreciation refers to two aspects of the same concept: first, the actual decrease of fair value of an asset, such as the decrease in value of factory equipment each year as it is used

Depreciation expense is recognized on the income statement as a non-cash expense that reduces the company's net income. For accounting purposes, the depreciation expense is debited, and the accumulated depreciation is credited