(3) Accrual Accounting Concepts

Question 1

Describe the accounting cycle.

Hint: there are 9 stages

Answer 1

1. Analyse transactions
2. Journalise transactions
3. Post to ledger accounts
4. Prepare a trial balance
5. Journalise and post adjusting entries: prepayments/accruals
6. Prepare and adjusted trial balance
7. Prepare financial statements
8. Journalise and post closing entries (only at the end of the financial year)
9. Prepare a post-closing trial balance (only at the end of the financial year)

Question 2

Explain the difference between cash-based accounting and accrual-based accounting

Answer 2

Cash-based accounting:

• revenues recognised when cash is received
• expenses incurred when cash is paid

Accrual-based accounting:

• revenue recognised when an entity satisfies a performance obligation by transferring a good or service to the customer
• expenses recognised when incurred (when assets are consumer or liabilities incurred)

Accrual accounting better reflects the revenues recognised and expenses incurred during the period.

Question 3

Define accrual-based accounting.

Answer 3

Accrual-based accounting records transactions and events in the accounting periods in which they occur rather than in the periods in which the entity receives or pays the related cash.

Question 4

What accounting concept is used in relation to the revenue and expense criteria?

Answer 4

Accounting period concept: economic life of business can be divided into artificial periods for reporting purposes.

This concept relates to the revenue recognition criteria and the expense recognition criteria which forms the revenue and expense criteria (part of the GAAP).

Question 5

What is the income recognition under the CF?

Answer 5

Income recognition occurs at the same time as:

• the initial recognition of an asset, or an increase in the carrying amount of an asset; or
• the derecognition of a liability, or a decrease in the carrying amount of a liability

Essentially, revenue is recognised when an entity satisfies a performance obligation (AASB 15 Revenue from Contracts with Customers)

Question 6

What is revenue recognition criteria?

Answer 6

• The contract has been approved by parties to the contract
• Each party’s rights in relation to the goods to be transferred have been identified
• The payment terms have been identified
• The contract has commercial substance
• It is probable that the consideration to which the entity is entitled in exchange for the goods or services will be collected

Question 7

What is the New Accounting Standard for Revenue Recognition?

Answer 7

1. Identify the contract(s) with a customer
2. Identify the performance obligation in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligation in the contract
5. Recognise revenue when (or as) the entity satisfies the performance obligation

Question 8

What is the expenses recognition under the CF?

Answer 8

Expenses recognition occurs at the same time as:

• the initial recognition of a liability, or an increase in the carrying amount of a liability; or
• the derecognition of an asset, or a decrease in the carrying amount of an asset

Expenses should be recognised on the basis of a direct association with revenues.

Question 9

What is the difference between prepaid expenses and accrued expenses?

Answer 9

Prepaid expenses have been recorded and accrued expenses have not.

Question 10

Why are adjusting entries needed?

Answer 10

Adjusting entries are needed to ensure that the recognition criteria are followed for assets, liabilities, revenues and expenses

Question 11

How often are adjusting entries prepared?

Answer 11

As often as financial statements are prepared.

Question 12

What are the 2 types of adjusting entries?

Answer 12

Prepayments and Accruals

Question 13

What are the prepayments?

Hint: expenses and revenue

Answer 13

Prepaid expenses: cash outflow precedes the entity receiving goods or services

Revenue received in advance: cash inflow precedes the entity supplying goods or services to customers

Question 14

What are the accruals?

Hint: expenses and revenues

Answer 14

Accrued revenues: amounts not yet received or recorded for which goods or services have been provided

Accrued expenses: the receipt of goods or provision of services precedes cash outflow to suppliers

Question 15

Prepare an adjusting entry for prepaid insurance initially treated as an asset.

Answer 15

For prepaid insurance initially treated as an asset, the adjustment is needed for the “expired” future economic benefit.

Original transaction:
DR Prepaid Insurance
CR Cash at Bank

Adjusting entry:
DR Insurance Expense
CR Prepaid Insurance

Question 16

Prepare an adjusting entry for prepaid insurance initially treated as an expense.

Answer 16

For prepaid insurance initially treated as an expense, the adjustment is needed to recognise the future economic benefit that remains in the asset (prepaid insurance)

Original transaction:
DR Insurance Expense
CR Cash at bank

Adjusting entry:
DR Prepaid Insurance
CR Insurance Expense

Question 17

How are adjusting entries for accruals prepared?

Answer 17

Accrued revenues:
Revenue and a receivable are recorded. When cash is received, the receivable is reduced.

Accrued expenses:
Expense and payable are recorded. When cash is paid, the payable is reduced

Question 18

Explain the adjusted trial balance.

Answer 18

The adjusted trial balance is prepared after all adjusting entries have been made.

It is used to proved the equality of the total debit balances and the total credit balances after the adjusting entries have been made.

It is the main basis for preparation of the financial statements.

Question 19

Describe the preparation of financial statements.

Answer 19

Statement of Profit or Loss is prepared from revenue and expense accounts.

The current period profit(loss) and dividends paid is transferred to retained earnings account (part of the Statement of Changes in Equity)
* Balance on the retained earnings account on the ledger has to be the same as the balance of retained earnings shown on the balance sheet

Statement of Financial Position is prepared from asset, liability, equity and balance of retained earnings accounts

Question 20

What are temporary accounts?

Answer 20

Temporary accounts relate to only one accounting period.

E.g. revenues, expenses, dividends

Question 21

What are permanent accounts?

Answer 21

Permanent accounts are carried forward to future accounting periods.

E.g. assets, liabilities, equity

Question 22

What are closing entries?

Answer 22

Closing entries are used to transfer the balances in temporary ledger accounts to a permanent equity account (Retained Earnings or Capital) and to lose the temporary accounts (reset them back to zero balance) for the new accounting period.

Question 23

What are the 2 main purposes of closing entries?

Answer 23

1. Reset the balance of the temporary accounts to 0
2. Update the balance of the retained earnings account
   * balance of the retained earnings account should be the same as the balance shown on the balance sheet

Question 24

What are the steps in preparing closing entries?

Answer 24

1. Close each revenue and expense account to the Profit or Loss Summary (another temporary account)
2. Close the Profit or Loss Summary account to Retained Earnings
3. Close dividends account to the Retained Earnings
4. This will result in all temporary accounts having a closing balance of 0
   * to close credit accounts, amount is recorded on the debit side to reset balance to 0
   * to close debit accounts, amount is recorded on the credit side

Question 25

What is a post-closing trial balance? What is its purpose?

Answer 25

A post-closing trial balance is a list of all permanent accounts and their balances after closing entries are journalised and posted.

Its purpose is to prove the equality of the permanent accounts that are carried forward to the next accounting period.

Question 26

What is a worksheet?

Answer 26

Worksheets are spreadsheets prepared either manually or electronically to assist in the preparation of the adjusting entries and the preparation of the financial statements.

A worksheet is NOT a permanent accounting record, it is neither a journal nor a part of the general ledger - it is merely a device used to make it easier to prepare adjusting entries and the financial statements.

Question 27

When we calculate the closing balance of retained earnings in the Statement of Changes in Equity as
follows, is the balance for the retained earnings account updated?

Answer 27

No.

The calculation of closing balance for retained earnings takes place on the surface of Statement of
Changes in Equity only and it does NOT affect the ledger account of retained earnings, which still shows
opening balance.

That is why you would like to formally bring the retained earnings ledger account’s balance up to date
by performing and posting closing entries.

Question 28

What is depreciation?

Answer 28

Depreciation is the process of allocating the cost of an asset to expense over its useful life.

Depreciation expense = (cost - residual value) / useful life

Question 29

Prepare the adjusting entry for depreciation. The cost of motor vehicle at its purchase is $20,000. After 5 years, it’s residual value is half the cost.

Answer 29

DR Depreciation expense 2,000
CR Accumulated depreciation 2,000

*accumulated depreciation is a contra-asset account. Its normal balance is a credit

Question 30

Formula for interest expense

Answer 30

Interest = loan-pricipal borrowed * annual interest rate * time in terms of 1 year

E.g. $5000 * 12% * 1/12 = $50

Question 31

What is the adjusting entry for prepaid expenses if the amount is initially recorded as an expense?

Hint: use a general term – asset, expense

Answer 31

DR Asset

CR Expense

Question 32

What is the adjusting entry for prepaid expenses if the amount is initially recorded as an asset?

Hint: use a general term – assets, expenses

Answer 32

DR Expenses

CR Assets

Question 33

What is the adjusting entry for revenues received in advance if the amount is initially recorded as revenue?

Hint: use a general term – revenues, liabilities

Answer 33

DR Cash or a/c receivable

CR Liabilities

Question 34

What is the adjusting entry for revenues received in advance if the amount is initially recorded as a liability?

Hint: use a general term – revenues, liabilities

Answer 34

DR Liabilities

CR Revenues

Question 35

What is the adjusting entry for accrued revenues?

Hint: use a general term – assets, revenues

Answer 35

DR Assets
CR Revenues

*Assets would be a/c receivable or cash

Question 36

What is the adjusting entry for accrued expenses?

Hint: use a general term – expenses, liabilities

Answer 36

DR Expenses

CR Liabilities

Question 37

What are the columns in the worksheet? From left to right.

Answer 37

Account no., Account name, Trial balance, Adjustments, Adjusted trial balance, Statement of profit or loss, Statement of financial position