(3) Accrual Accounting Concepts Flashcards
Describe the accounting cycle.
Hint: there are 9 stages
- Analyse transactions
- Journalise transactions
- Post to ledger accounts
- Prepare a trial balance
- Journalise and post adjusting entries: prepayments/accruals
- Prepare and adjusted trial balance
- Prepare financial statements
- Journalise and post closing entries (only at the end of the financial year)
- Prepare a post-closing trial balance (only at the end of the financial year)
Explain the difference between cash-based accounting and accrual-based accounting
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.
Define accrual-based accounting.
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.
What accounting concept is used in relation to the revenue and expense criteria?
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).
What is the income recognition under the CF?
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)
What is revenue recognition criteria?
- 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
What is the New Accounting Standard for Revenue Recognition?
- Identify the contract(s) with a customer
- Identify the performance obligation in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligation in the contract
- Recognise revenue when (or as) the entity satisfies the performance obligation
What is the expenses recognition under the CF?
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.
What is the difference between prepaid expenses and accrued expenses?
Prepaid expenses have been recorded and accrued expenses have not.
Why are adjusting entries needed?
Adjusting entries are needed to ensure that the recognition criteria are followed for assets, liabilities, revenues and expenses
How often are adjusting entries prepared?
As often as financial statements are prepared.
What are the 2 types of adjusting entries?
Prepayments and Accruals
What are the prepayments?
Hint: expenses and revenue
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
What are the accruals?
Hint: expenses and revenues
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
Prepare an adjusting entry for prepaid insurance initially treated as an asset.
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
Prepare an adjusting entry for prepaid insurance initially treated as an expense.
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
How are adjusting entries for accruals prepared?
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
Explain the adjusted trial balance.
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.
Describe the preparation of financial statements.
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
What are temporary accounts?
Temporary accounts relate to only one accounting period.
E.g. revenues, expenses, dividends
What are permanent accounts?
Permanent accounts are carried forward to future accounting periods.
E.g. assets, liabilities, equity
What are closing entries?
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.
What are the 2 main purposes of closing entries?
- Reset the balance of the temporary accounts to 0
- 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
What are the steps in preparing closing entries?
- Close each revenue and expense account to the Profit or Loss Summary (another temporary account)
- Close the Profit or Loss Summary account to Retained Earnings
- Close dividends account to the Retained Earnings
- 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
What is a post-closing trial balance? What is its purpose?
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.
What is a worksheet?
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.
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?
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.
What is depreciation?
Depreciation is the process of allocating the cost of an asset to expense over its useful life.
Depreciation expense = (cost - residual value) / useful life
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.
DR Depreciation expense 2,000
CR Accumulated depreciation 2,000
*accumulated depreciation is a contra-asset account. Its normal balance is a credit
Formula for interest expense
Interest = loan-pricipal borrowed * annual interest rate * time in terms of 1 year
E.g. $5000 * 12% * 1/12 = $50
What is the adjusting entry for prepaid expenses if the amount is initially recorded as an expense?
Hint: use a general term – asset, expense
DR Asset
CR Expense
What is the adjusting entry for prepaid expenses if the amount is initially recorded as an asset?
Hint: use a general term – assets, expenses
DR Expenses
CR Assets
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
DR Cash or a/c receivable
CR Liabilities
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
DR Liabilities
CR Revenues
What is the adjusting entry for accrued revenues?
Hint: use a general term – assets, revenues
DR Assets
CR Revenues
*Assets would be a/c receivable or cash
What is the adjusting entry for accrued expenses?
Hint: use a general term – expenses, liabilities
DR Expenses
CR Liabilities
What are the columns in the worksheet? From left to right.
Account no., Account name, Trial balance, Adjustments, Adjusted trial balance, Statement of profit or loss, Statement of financial position
