Accounting Business Reporting for Decision Making

222 Accounting: Business Reporting for Decision Making

31 December 2016 (the end of the reporting period), ATC has not commenced the training sessions. The

sessions will not be conducted until January 2017. Under a cash accounting system, income of $12 000

would be recognised in ATC’s accounts for December 2016 because the money has been received by ATC.

Under an accrual accounting system, no income in the current reporting period should be recognised in

ATC’s accounts because ATC had not rendered any services to Tennis Australia in December 2016. To reflect

this in the accounts, it is necessary to do an adjusting entry. The initial recording of the transaction has

resulted in income being overstated by $12 000 for December 2016. The adjusting entry necessary would be

to reduce income by $12 000, thereby reducing profit and hence equity. The dual nature of the transaction

would be reflected with a corresponding entry recognising that the business has a liability at the end of the

reporting period as it owes services to Tennis Australia. This liability is income received in advance (being

cash received for goods or services not yet provided) related to the coaching program. In January 2017,

when ATC conducts the training squad, the liability would decrease and the income would be recognised.

ILLUSTRATIVE EXAMPLE 6.4

Recognising an expense without paying cash (accrued expense)

Advantage Tennis Coaching (ATC) uses a mobile telephone for business purposes. At the end of the

reporting period, being 31 December 2016, ATC had not paid for the December telephone charges,

estimated to be $500. This account will be paid in January 2017. Under a cash accounting system, no

expense would be recognised in ATC’s accounts in relation to the December mobile telephone charges

as no payment has been made to the mobile telephone service provider. Under a cash system, this

would be recorded as an expense in the month that it is paid (i.e. January 2017). Under an accrual

accounting system, the expense associated with December mobile telephone usage would be recog-

nised in ATC’s accounts because the coach had been using the mobile telephone during December.

An adjusting entry at the end of December 2016 is required to record the expense. The transaction

would be recorded by increasing expenses by $500, thereby reducing profit and hence equity. The

corresponding entry to keep the accounting equation in balance is to record a liability at the end of

December 2016. This liability is an accrued expense, being the December mobile phone charges owed

by ATC to the provider of the mobile telephone service. When ATC pays the mobile phone bill in January

2017, the liability will decrease and an asset account (cash) will decrease.

ILLUSTRATIVE EXAMPLE 6.5

Paying cash but not recognising an expense (prepaid expense)

Advantage Tennis Coaching (ATC) paid a $2400, 12-month premium for public liability insurance at

the start of December 2016. The transaction recorded is a decrease in an asset account (cash) and

an increase in an expense account (insurance) that reduces profit and hence equity. Under a cash

accounting system, an expense of $2400 would be recognised in the statement of profit or loss at the

end of the reporting period of 31 December 2016 because the premium has been paid. Under an accrual

accounting system, it is necessary to consider what expense has been incurred in December 2016. ATC

has received the benefit for only one month of the insurance premium as at end of December. Therefore,

the expense recognised in December would be 1/12 of the annual premium (1/12 of $2400 = $200).

Given how the transaction was initially recorded, an increase in expense of $2400, the expense for

December is overstated. An adjusting entry is needed. The transaction to be recorded to adjust the

accounts is to reduce the expense from $2400 to $200, a decrease of $2200. Further, the dual nature

of this transaction would be reflected in ATC’s accounts, with a corresponding entry recognising that

ATC has an asset at the end of December representing the unused insurance premium. This asset is

a prepaid expense or prepayment, being the amount paid in cash and recorded as an asset until the

economic benefits are used or consumed. The prepayment is the $2200 of insurance premium for the

next 11 months that had already been paid for by ATC.

(continued)