Accounting treatment refers to the process of recording, classifying, and presenting financial transactions in a structured and systematic manner according to recognized accounting standards and principles. This ensures that a company’s financial activities are accurately reflected in the company’s statements for stakeholders to make their assessments of the performance and financial position of the company. Every business transaction—whether it relates to revenue, expenses, assets, liabilities, or equity-needs to be recorded and treated appropriately so that it can be clarified and kept in a lucid and coherent form of financial reporting.
What is Accounting Treatment?
Accounting treatment refers to the method by which the organizational books of accounts treat and handle the financial events and transactions that occur within the organization. It pertains to the identification, measurement, and reporting of such transactions to ensure they form proper records. Hence, an accurate picture can be derived as regards the financial health of a business. An appropriate accounting treatment should be in step with the regulatory requirements of companies, either in compliance with the International Financial Reporting Standards (IFRS) or Generally Accepted Accounting Principles (GAAP). This concern deals with the identification of accounts that are suitable for recording journal entries and the presentation of financial statements showing true and fair views.
Characteristics of accounting treatment include:
- Accurate representation of financial events.
- Proper categorization of transactions as assets, liabilities, income, or expenses.
- Compliance with legal and accounting standards.
Example of Accounting Treatment
This is how accounting treatment can be observed in businesses recording the purchase of an asset. For example, if a company buys machinery for $50,000, accounting treatment would demand recognizing the asset in the books and recognition of the expense incurred from depreciation over its useful life.
Journal Entry Example
Purchase of machinery:
Machinery A/c Dr. $50,000
To Bank/Cash A/c$50,000
Depreciation over time:
Depreciation A/c Dr. $5,000
To Machinery A/c$5,000
This ensures that the cost of the machinery is not expensed immediately but spread over various periods of use.
Another common example is the accounting treatment of inventory, where COGS is recorded at the time of sale to ensure that the margins are reflected in profit calculations made for the period when the revenue is earned.
Types of Accounting Treatment
There are several types of accounting treatment, each depending on the nature of the financial transactions:
Cash Accounting vs. Accrual Accounting
- Cash Accounting: All transaction reports are recorded only when the cash is received or paid. Simple and direct, but not reflecting the financial performance of an enterprise over time.
- Accrual Accounting: This is a method whereby revenues and expenses are recognized if earned or incurred, irrespective of cash flow. This method ensures that income and expenses are properly matched in the right accounting period, thus being the most widely adopted by organizations.
Depreciation Accounting
- Straight-Line Depreciation: Assets depreciate their value by equal amounts over their useful lives. A fixed amount of depreciation is charged every year until the asset’s value has decreased to its salvage value.
- Reduction Balance Method: This is a method under which every year a fixed percentage of the balance book value of the asset gets written off. Under this method, higher depreciation gets charged in the earlier years of the asset’s life.
Provision Accounting
- Provision for Bad Debts: The company makes provisions for probable losses on receivables, so the possible credit losses may be reflected in the financial statements sometime in the future.
- Tax provision: The liability related to tax is estimated and recorded before the actual tax assessments are done for reflection of true potential tax obligations.
Inventory Accounting
- First In, First Out (FIFO): The cost of the first items purchased is recognized first. This usually leaves the remaining inventory reflecting the current market prices.
- LIFO: The cost of the last inventory acquisitions is reported first. When prices are rising, this will cause lower net income.
Accounting Treatment of Depreciation
The treatment of depreciation forms an essential part of the accounting concept and, therefore, goes a long way in portraying the financial picture of the profitability of an organization. Depreciation accounts for the wear and tear on long-term assets over time.
The depreciation is recorded annually with the following journal entry:
Depreciation A/c Dr.$X
To Asset A/c $X
At the end of each accounting period, the depreciation account is closed by transferring the amount to the Profit and Loss account:
Profit and Loss A/c Dr.$X
To Depreciation A/c $X
Methods of Depreciation
1. Straight-Line Method
The straight-line method is one of the most traditional accounting methods applied in calculating the depreciation of an asset. It gives the cost of the asset spread over its useful life, evenly and with clear consistency in depreciation expenses throughout the years. In this method, the asset’s cost is spread evenly over its useful life.
Example: If machinery costs $100,000 and its useful life is 10 years, the annual depreciation will be $10,000.
2. Written Down Value Method
The Written Down Value (WDV) Method, also referred to as the Declining Balance Method or Reducing Balance Method, is an accelerated depreciation technique where the value of any asset decreases at a higher rate in the earlier years of its useful life. The asset using the method reduces its value every year due to its proportionate decrease in book value, and as a consequence the expense regarding depreciation will be reduced over time. Depreciation is calculated as a percentage of the asset’s book value, which decreases each year.
Accounting Treatment for Debentures
The accounting treatment for debentures involves recording the issuance, interest payments, and eventual redemption of the debentures. Debentures are a form of debt, and companies must follow certain rules in how they are treated in financial records.
1. Issuance of Debentures: When a company issues debentures, the amount is credited to the Debentures account and debited from either cash or bank, depending on how the proceeds are received.
Bank A/c Dr.$X
To Debentures A/c $X
2. Interest on Debentures: Interest on Debentures refers to the periodic payment made by a company to debenture holders for borrowing funds through the issuance of debentures. Debentures are long-term debt instruments that companies use to raise capital. Then the interest on them is typically a fixed percentage of the debenture’s face value.
Debenture interest is usually paid semi-annually or annually, and it is recorded as an expense in the company’s books.
Interest on Debentures A/c Dr.$X
To Bank A/c $X
3. Redemption of Debentures: Redemption of Debentures refers to the process by which a company repays the principal amount of debentures to the debenture holders at the end of the specified maturity period. It involves returning the borrowed funds to investors, either in full or in installments, as per the terms of the debenture agreement. At maturity, debentures must be redeemed, and the redemption is recorded as:
Debentures A/c Dr.$X
To Bank A/c $X
Conclusion
The core of preparing and presenting accurate financial statements is the accounting treatment for all the transactions. It ensures that all the financial events are classified, accounted for, and disclosed correctly so that the business stays by the law. While in turn, it allows stakeholders to have the proper view of the financial position and health of the company. Companies must be well aware of the specific treatment of accounting given to assets, liabilities, revenues, and expenses and note their financial records reflecting true and fair financial performance.
Accounting Treatment FAQs
How do accounts for provisions?
Provisions are established to account for expected losses or expenses, such as provision for bad debts, which is accounted for by debiting Profit and Loss accounts and crediting the Provision for Doubtful Debts account.
What is the accounting treatment of depreciation?
It is charged as an expense by debiting the Depreciation account and crediting the Asset account. At the end of the year, it is transferred to the Profit and Loss account.
What is the straight-line method of depreciation and what is the reducing balance method of depreciation?
The same amount is charged every year in the case of the straight-line depr. In the reducing balance depreciation method, a fixed percentage is applied on the book value, and hence the expense decreases every year.
The books, how are the debentures recorded?
Debit the bank or cash account on issue and credit the Debentures account. Interest on debentures is expensive.
What are the types of accounting treatments for inventory?
Among the common types are FIFO-FI: First-In, First-Out, LIFO-Last-In, and First-Out-types, which affect how the cost of inventory is recognized in sales.
