The cut off concept in accounting aims to ensure events and transactions are posted in the correct accounting period. It helps to calculate profit/loss without any error or misstatement. Besides profit/loss, cut off concept has an extensive impact on the financial statement. For instance, if the profitable sales made in the month of January are recorded in February, the following errors can be expected in the month of January.
- Overstatement of inventory balance in the month of January.
- Understatement of sales in the month of January.
- Understatement of profit in the month of January.
- Understatement of receivables/cash in January.
If amounts are material for the given impacts, it might lead to a material misstatement in the financial statement. Similarly, the impact is more severe if a cut off error is found at the time of year-end.
The term cut-off date is frequently used to apply the concept. It’s the date of the accounting period’s end. For instance, if the accounting period ends December 31st, the cut-off date would be the same. This date is used as the termination date to prepare the financial statement. Further, all economic activities performed before/on this date are included in the current accounting period. On the other hand, economic activities performed next day are reported in the next accounting period.
So, who is responsible for ensuring no cut off error in the financial statement?
Primarily, it’s the responsibility of the management/business to ensure there is no cut-off error while closing books of accounts. Secondly, the auditor of the company needs to ensure there is no cut off error and record date of the transaction is the same as the date of transaction occurrence/economic/business activity.
Let’s understand the mechanics of cut-off and how auditors need to ensure their duty in terms of cut off concept. Auditors need to perform different procedures on account balance transactions. Let’s review some important account balances or financial statement areas.
Cut off procedures for inventory.
Inventory is one of the most important areas of the financial statement. It’s inversely proportional to sales. For instance, if sales is not recorded in the specific accounting period, it leads to an overstatement of inventory. On the other hand, if excess sales are recorded in the accounting period, it leads to an understatement of inventory and an inaccurate financial statement.
Let’s understand how auditors can perform audit procedures on the inventory.
Review last three goods dispatched notes for the accounting period ended. The delivery date must fall within the same accounting period of sales recorded. For instance, if the cut off date isis December 31st, the goods must have been dispatched on or before December 31st. On the other hand, the termination date for a particularDecember 31st, inventory must have been dispatched on or before December 31st.
Similarly, obtain three dispatch notes for the next accounting period (January); the date of inventory dispatch must fall on January 1st and later. It should help the auditor ensure that there is no cut off error in the financial statement.
Cut off procedures for accounts receivable.
Recording for the accounts receivable is dependent on the sales invoice date and date of dispatch. The date of dispatching goods or rendering services should be the same as the date of invoice and the date of creating accounts receivables.
So, auditors need to compare the date of the sales invoice, goods dispatched note, and the date of creating accounts receivables. However, an important point to verify is if goods dispatched on or before the cut off date (suppose December 31st) have been recorded in the accounting period ended December. Similarly, goods dispatched on and after January are recorded in the next accounting period.
Cut off procedures accounts payable.
Recording for the accounts payable is dependent on the date of goods received. For instance, if goods are received in December, they must be reflected in the financial statement of December. So, auditors can reconcile the date on the goods receipt note and the date payable created. If goods are received in January, related accounts payable must be reflected in January.
So, cut off procedures is all about comparing dates to ensure the correct recording for the transaction.
Cut off examples
- Goods delivered to the customers in April must reflect sales and the creation of accounts receivables in the same month.
- Goods received from the supplier in April must be reflected as purchases, Increase of inventory and creation of accounts payable in the month of April.
- If your business rendered services in January, the income earned must be reflected in January.
- If your business has received services in January, the expense made must be reflected in the financial statement for January.
Cut off procedures examples.
- Compare the date of goods dispatched notes with the date on the sales invoice.
- Compare the date of goods receipt notes with the date of purchase invoice.
It’s important to note that collection/payment is not relevant to the cut-off concept; rather, it’s dependent on the date of a risk transfer.
Cut off in accounting is an important concept. It helps accountants of the company to comply periodicity concept and ensure reporting economic activities in the correct accounting period. If the concept of cut off is not applied appropriately, it leads to misstatement in the balance sheet and other areas of the financial statement.
Frequently asked questions
What is meant by purchase cut off?
Purchase cut off means purchases made in May must be recorded in May. In simple words, if a vehicle is purchased in December. It must be recorded in December. If it’s recorded in the next month, it will lead to an understatement of PPE (assets), an understatement of the depreciation (expense) in the month of December.
Why cut off is an important accounting concept?
Cut off is important to ensure compliance with the periodicity concept of accounting. It helps to ensure economic activities and their financial impact is reflected in the same accounting period. So, if an economic activity occurs in one period and is reflected in another period, it leads to cut off error.
What is sales cut off meaning?
Sales cuts off means the goods dispatched in December should be reflected in December in the form f sales recorded.
What is purchase cut off testing in an audit?
Purchase cut of testing means to test if the date of goods receipt falls in the same accounting period as the date of the corresponding purchase invoice.