(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
