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Understanding Accounting from Techies Mind

Posted on June 8th, 2007 by Sanjit Anand |Print This Post Print This Post |Email This Post Email This Post

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Indeed, this is one of good area, where most of techies have lot of confusion and illusion about when accounting comes. Many of consultant came from Technical background and gradually moved into doing some techno -functional role or pure functional role, thus it is essestintial to understand the basic accounting and Guided principal .

Normally, there are two basic accounting methods available in the business world:

  • Cash
  • Accrual

And most of the ERP accounting products weather its SUN system, Oracle financial or SAP have functionality to capture on the basis of set up.

Then want is the difference:

handCash Basis Accounting
This is what "Based on Realization"

We Most of us use the cash method to keep track of our personal financial activities.

The cash method recognizes revenue when payment is received, and recognizes expenses when cash is paid out.

For example, our local grocery store's record is based on the cash method. Expenses are recorded when cash is paid out and revenue is recorded when cash or check deposits are received

If we summarize, under the cash basis accounting, revenues and expenses are recognized as follows:

  • Revenue recognition: Revenue is recognized when cash is received.
  • Expense recognition: Expense is recognized when cash is paid.

Take a note the word "cash" is not meant literally - it also covers payments by check, credit card, barter, etc.

Moreover it is not standard method in compliance with accountings matching principle.

handAccrual Basis Accounting
This is what "Based on Recognition"

The accrual method of accounting requires that revenue be recognized and assigned to the accounting period in which it is earned. Similarly, expenses must be recognized and assigned to the accounting period in which they are incurred.

Then the underline question is what is accounting Period, Let explain like this normally a company tracks the summary of the accounting activity in time intervals, which we normally called as Accounting periods. These periods are usually a month long. It is also common for a company to create an annual statement of records. This annual period is also called a Fiscal or an Accounting Year.

In the accrual method relies on the principle of matching revenues and expenses. This principle says that the expenses for a period, which are the costs of doing business to earn income, should be compared to the revenues for the period, which are the income earned as the result of those expenses. In other words, the expenses for the period should accurately match up with the costs of producing revenue for the period.

Take a case:
logo mvp 152Company is doing a business and they have to pay sales commissions expense, so sales commissions expense should be reported in the period when the sales were made (and not reported in the period when the commissions were paid). Similarly, Salary/Wage to employees are reported as an expense in the week/month when the employees worked and not in the week/month when the employees are paid. If a company agrees to give its employees 2-month equivalent salary of its 2006 revenues as a bonus on January 25, 2007, the company should report the bonus as an expense in 2006 and the amount unpaid at December 31, 2006 as a liability. This is most simple kind of matching principal normally has.

In general, there are two types of adjustments that need to be made at the end of the accounting period.

  1. The first type of adjustment arises when more expense has been recorded than was actually incurred or earned during the accounting period.
  2. Similarly, there may be revenue that was received but not actually earned during the accounting period. Also known as Un-earned Revenue.

The accrual method generates tax obligations before the cash has been collected (because revenue leads to tax and revenue is recognized against receivable and not against receipt of money).

If we summarize, under the accrual basis accounting, revenues and expenses are recognized as follows:

  • Revenue recognition: Revenue is recognized when both of the following conditions are met:
    • Revenue is earned
      • i.e. when products are delivered or services are provided.
    • Revenue is realized or realizable.
      • i.e. either cash is received or it is reasonable to expect that cash will be received in the future.
  • Expense recognition: Expense is recognized in the period in which related revenue is recognized (Matching Principle).

Timing differences in recognizing revenues and expenses
Various accounting books did mention four potential timing differences in recognizing revenues and expenses between these of two. Just to recap of those:

a. Accrued Revenue: Revenue is recognized before cash is received.
b. Accrued Expense: Expense is recognized before cash is paid.
c. Deferred Revenue: Revenue is recognized after cash is received.
d. Deferred Expense: Expense is recognized after cash is paid.

Compare with a Case to explain these two methods

Your company purchase a new Laptop on credit in May 2007 and pay $1,500 for it in July 2007, two months later.

Under the both case see how this makes a difference:

  • Using the cash method accounting, you would record a $1,500 payment for the month of July, the month when the money is actually paid.
  • Under the accrual method, you would record the $1,500 payment in May, when you take the Laptop and become obligated to pay for it.

Pros and cons of these Two accounting method
Maintence
: The cash method is easier to maintain because you don't record income until you receive the cash, and you don't record an expense until the cash is paid, where as in the accrual method, you will typically record more transactions.

Cash-basis accounting defers all credit transactions to a later date. It is more conservative for the seller in that it does not record revenue until cash receipt. In a growing company, this results in a lower income compared to accrual-basis accounting.

Do you what is meant by GAAP?
No, I don't know, but knows most of ERP follows these. Lets explain this way:
The word"generally accepted accounting principles" (or "GAAP") consists of three important sets of rules:
(1) The basic accounting principles and guidelines,
(2) The detailed rules and standards issued by FASB(Financial Accounting Standards Board and its predecessor the Accounting Principles Board (APB)
(3) The generally accepted industry practices.

Normally Standard GAAP will have various guided Principal, such as

  • Economic Entity Assumption
  • Time Period Assumption
  • Cost Principle
  • Matching Principle
  • Revenue Recognition Principle

Will take a seprate case of some of them to understand in better way.

If you want to know more about GAAP, weather US-GAAP, UK-GAAP , refer wikipedia

ERP/Oracle Financials
Oracle Financials have been developed to meet GAAP requirements as well as the special needs of different countries. For example, in Oracle Payables you can choose whether to record journal entries for invoices and payments on an accrual basis, a cash basis, or a combined basis where accrual journal entries are posted to one set of books and cash basis journal entries are sent to a second set of books.

Will continue with some additional accounting stuff, keep reading and commenting.icn thumbs 32x32

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Posted in Basic Accounting, Beginner, JumpStart | 16 Comments »Email This Post Email This Post | Print This Post Print This Post

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16 Responses
  1. Venki Says:

    Dear Anand,

    The article is very good one and it is useful for the technical guys like me who has very less exposure to Accounting.

    Cheers, Please keep it up…

  2. Naresh Gunda Says:

    This article is excellent.This is very much useful to learn accounting who are not from accounting background.
    Keep forwarding!!!!!

    Thank you.

  3. pavan Says:

    great work anand..cheers

  4. Prativa Says:

    Hi Anand, Thanks for the nice work. Just awesome.
    Please keep it up.
    Regards,
    Prativa.

  5. aleida Says:

    dear anand,
    please let me know, is there possible to run a combined basis, accrual and cash basis in one set of books

  6. Sanjit Anand Says:

    As far as my knowledge , Oracle ERP have provision to manage either accural or cash basis but cann’t both.

    In AR you can setup Accural and Cash Basis. However, they must be completely different organizations as you cannot have two different accounting methods in the same organization,ie same SOB.

    FYI…… I am not sure, what adjectly you are looking , but I best of my knowledge, there are Public sector Oracle Financial application that have provision to have such options. As from documentation:

    There are three pieces of Combined Basis functionality.

    1. Combined Basis Accounting in AP.

    Standard functionality in Payables that allows the automatic maintenance of both an Accrual and a Cash Set Of Books.

    2. Combined Basis Accounting in Public Sector (International) AR.

    Functionality in Public Sector Financials (International) Receivables that complements the AP functionality and allows automatic maintenance
    of both an Accrual and a Cash Set Of Books.

    3. Cash & Accrual Support in Public Sector (International) GL.

    Functionality in Public Sector Financials (International) General Ledger that allows the linking of an Accrual Set Of Books with a Cash
    Set Of Books. Once linked ‘manual’ and ‘external interface’ journals can be entered in one Set Of Books and copied to the other. It is
    also possible to view both Sets Of Books and the linked Journal Lines through a new screen.

    Oracle Does confirms , Items (2) and (3) are available as part of Public Sector Financials (International).

    In Oracle this can be achieved by the use of database triggers and procedures. Data entry and the relational design of the Oracle Receivables database is
    not altered to accommodate Combined Basis Accounting functionality.

    More over, you should take a note, combined Basis Accounting is not available in standard Oracle Receivables.

    This feature is available in AR only as part of Public Sector Financials (International) and as such is only available in selected European countries.

    Would suggest you to ask Oracle support to discuss this.

  7. Hirendra Says:

    Hi Sanjit,

    Really very good information. It help us to have overall view of purchasing. Really very good doc. Keep it up.

    One thing i would like to know.
    can you please explain basic P-2-P Cycle with it a/cing entries at various level. Also if possible give a list of reports which need to be taken from purchasing.Inventory & payable to recocile with GL at period end.

    I would like to know entire cycle in toto from a/cing point of view with reconcilation of all required a/cs.

    Thanks in Advance …waiting for your response..

    Regards
    Hirendra

  8. Bhavani Says:

    Hi Anand,
    Good Job!Its Very useful for Beginners and very easy to understand!

  9. Understanding “Balance Sheet” from Techies Mind Says:

    […] is based out of accounting equation, which I have discussed in one of old post […]

  10. Understanding “Cash Flow Statement” Says:

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  11. Naveen Says:

    Hi Sanjit,
    Very good article. I have read so many article and books on same subject but this one is the best.Very good for techie people.Actually , all the article from you is very good and informative. I think you should write a book. Please, keep up the good work.
    -Naveen

  12. preeti Says:

    excellent article!!

  13. Sonia Says:

    This is great! It was easy to understand….for someone who is horrible with this stuff.
    Maybe if you get a chance you could explain a little bit more on
    Assets = Liabilities + Equity.

    Thanks

  14. vinay Says:

    Its simply amazing.

  15. Sridhar Says:

    Wonderful document.Its very simple and clear.

  16. Nadia Siddiqui Says:

    Dear Mr.Sanjit Anand This article is awesome. I want to have more detailed information on GAAP if it is possible to upload as a tutorial ASAP.

    Keep it up :)

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