4 - Accrual Accounting Concepts

Question 1

When is revenue generally considered to be earned (recognized)?

Answer 1

When goods or services are exchanged for cash or claims to cash (such as accounts receivable), which result in an increase in future economic benefits.

Question 2

Revenue recognition occurs when which 3 conditions are met?

Answer 2

• The sales or performance effort is substantially complete
• The revenue amount is determinable (measurable)
• The collection of the revenue is reasonably assured

Question 3

What is revenue also known as?

Answer 3

Income

Question 4

Just as revenues are related to increases in future economic benefit, what are expenses related to?

Answer 4

Decreases in future economic benefit.

Question 5

When is an expense recognized?

Answer 5

Similar to revenue recognition, expense recognition is not tied to the payment of cash. Expenses are recognized when incurred regardless of whether cash is paid or not.

Question 6

How is expense recognition is linked to revenue recognition?

Answer 6

Expense recognition is linked to revenue recognition when there is a direct association between the expenses incurred and the generation of revenue. This is known as matching as the effort (expenses) is matched with the results (revenues).

Question 7

What do the combined application of revenue recognition and expense recognition result in?

Answer 7

Accrual basis accounting.

Question 8

What is accrual basis accounting?

Answer 8

Accrual basis accounting means that transactions affecting a company’s financial statements are recorded in the periods in which the events occur, rather than when the company actually receives or pays cash.

Question 9

Under accrual basis accounting, when is revenue recognized?

Answer 9

Revenues are recognized when they are earned rather than only when cash is received.

Question 10

Under accrual basis accounting, when are expenses recognized?

Answer 10

Expenses are recognized in the period in which goods are consumed or services are used, rather than only when cash is paid.

Question 11

What is cash basis accounting?

Answer 11

Under cash basis accounting, revenue is recorded only when cash is received, and an expense is recorded only when cash is paid.

Question 12

Although cash basis accounting seems appealing because of its simplicity, why can it result in misleading information for decision-making?

Answer 12

Because it leaves a time gap between the matching of efforts (expenses) with results (revenues).

Question 13

Why is accrual accounting considered the most appropriate method of financial reporting?

Answer 13

Because revenues and expenses are recognized in the period to which they relate, regardless of whether there has been a receipt or payment of cash.

Question 14

What’s the purpose of adjusting entries?

Answer 14

For revenues to be recorded in the period in which they are earned, and for expenses to be recorded when incurred, we may have to record adjusting entries to update accounts at the end of the accounting period.

Question 15

What does adjusting entries ensure?

Answer 15

Adjusting entries ensures that revenue recognition and expense recognition are properly applied and make it possible to produce up-to-date and relevant financial information at the end of the accounting period.

Question 16

What are the last 5 steps in the accounting cycle?

Answer 16

5. Journalize and post adjusting entries: Prepayments/Accruals
6. Prepare an adjusted trial balance
7. Prepare financial statements (4)
8. Journalize and post closing entries
9. Prepare a post-closing trial balance

Question 17

Adjusting entries are necessary because the trial balance may not contain complete and up-to-date information. What’s the first reason this is true?

Answer 17

Some events are not recorded daily because it would not be useful or efficient to do so.
Ex: The use of supplies and the earning of salaries by employees.

Question 18

Adjusting entries are necessary because the trial balance may not contain complete and up-to-date information. What’s the second reason this is true?

Answer 18

Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions.
Ex: Rent, insurance, depreciation

Question 19

Adjusting entries are necessary because the trial balance may not contain complete and up-to-date information. What’s the third reason this is true?

Answer 19

Some items may be unrecorded.
Ex: a utility service bill that will not be received until the next accounting period. The bill, however, covers services delivered in the current accounting period.

Question 20

What is an unadjusted trial balance?

Answer 20

The trial balance before adjusting entries.

Question 21

What are the two categories and related subcategories of adjusting entries?

Answer 21

Prepayments

• Prepaid expenses
• Unearned revenu

Accruals

• Accrued revenue
• Accrued expenses

Question 22

What are prepaid expenses?

Answer 22

Expenses paid in cash and recorded as assets before they are used.

Question 23

What is unearned revenue?

Answer 23

Cash received and recorded as liabilities before revenue is earned.

Question 24

What are accrued revenues?

Answer 24

Revenues earned but not yet received in cash or recorded.

Question 25

What are accrued expenses?

Answer 25

Expenses incurred but not yet paid in cash or recorded,

Question 26

If a trial balance has no preceding adjective in its title, what kind of trial balance is it assumed to be?

Answer 26

Unadjusted trial balance

Question 27

How do prepayments affect the accounting equation?

Answer 27

Prepayments increase current assets such as prepaid expenses and also affect certain types of non-current assets such as buildings and equipment. A payment can also be received rather than paid, in which case the prepayment increases current liabilities such as unearned revenue.

Question 28

What are prepayments also known as?

Answer 28

Deferrals

Question 29

How do prepaid expenses affect the accounting equation?

Answer 29

An asset (prepaid) account is increased (debited) to show the service or benefit that will be received in the future and cash is decreased (credited)

Question 30

How do prepaid expenses expire?

Answer 30

With the passage of time (ex: insurance) or with use (ex: supplies).

Question 31

It’s not practical to record the expiration of prepaid expenses on a daily basis. Instead, when do we record these expired costs?

Answer 31

When financial statements are prepared.

Question 32

At each statement date, adjusting entries are made for which two purposes?

Answer 32

• To record the expense (expired costs) applicable to the current accounting period
• To show the remaining amounts (unexpired costs) in the asset accounts.

Question 33

What does adjusting entries for a prepaid expense result in?

Answer 33

An increase (debit) to an expense account and a decrease (credit) to an asset (prepaid expenses) account.

Question 34

Until prepaid expenses are adjusted, what is overstated/understated?

Answer 34

Assets are overstated and expenses are understated. If expenses are understated then profit and shareholders’ equity will be overstated,

Question 35

During the accounting period, supplies are used. Rather than record supplies expense as the supplies are used, when and how are supplies expense recognized?

Answer 35

At the end of the accounting period. At that time, the company must count the remaining supplies. The difference between the balance in supplies (asset) account and the actual cost of supplies on hand gives the supplies used (expense) for that period.

Question 36

Insurance payments (premiums) made in advance are normally recorded in the asset account Prepaid Insurance. At the financial statement date, It is necessary to make an adjustment to…

Answer 36

Increase (debit) Insurance expense and decrease (credit) prepaid insurance that has expired during the period.

Question 37

From an accounting standpoint, what is the acquisition of certain types of long-lived assets essentially?

Answer 37

A long-term prepayment for services. Similar to other prepaid expenses, there is a need to recognize the cost that has been used (expense) during the period and to report the unused cost (asset) at the end of the period.

Question 38

What is depreciation?

Answer 38

The process of allocating the cost of long-lived or non-current assets, such as buildings and equipment, to expense over its useful life.

Question 39

Which kind of assets are depreciated?

Answer 39

Only those with specified useful lives called depreciable assets. When an asset, such as land, has an unlimited useful life, it is not depreciated.

Question 40

What is one point about depreciation that is very important to understand?

Answer 40

Depreciation is an allocation concept, not a valuation concept. That is, we depreciate an asset to allocate its cost to the periods over which we use it. We are not trying to record a change in the actual value of the asset.

Question 41

What is the straight-line method of depreciation?

Answer 41

A common practice for calculating depreciation expense for a period of time by which we divide the cost of the asset by its useful life.

Question 42

At the time an asset is acquired, its useful life is not known with any certainty. It must therefore be estimated. What does this say about depreciation?

Answer 42

Because of this, depreciation is an estimate rather than a factual measurement of the cost that has expired.

Question 43

What does accumulated depreciation represent?

Answer 43

The cumulative total of the depreciation expense since the asset was purchased, less any reductions when assets are sold.

Question 44

What kind of account is Accumulated Depreciation - Equipment?

Answer 44

A contra asset account. That means it is offset against an asset account, Equipment, on the statement of financial position. Its normal balance is a credit.

Question 45

What is the simple reason for using a separate contra account instead of decreasing (crediting) Equipment when depreciating?

Answer 45

Using this account discloses both the original cost of the equipment and the total estimated cost that has expired to date. This also helps separate actual amounts (cost) from estimated amounts (accumulated depreciation)

Question 46

What is the carrying amount of an asset?

Answer 46

The difference between the cost of a depreciable asset and its related accumulated depreciation. Commonly known as net book value.

Question 47

What is important to understand about carrying amounts?

Answer 47

The asset’s carrying amount and its fair value (the price at which it could be sold) are two different amounts.

Question 48

What does unearned revenue affect the accounting equation?

Answer 48

Cash in increased (debited) and the liability account Unearned Revenue is increased (credited) to recognize that the company has received cash in advance and has an obligation to provide a service int he future, or refund the cash.

Question 49

What is unearned revenue the opposite of?

Answer 49

Unearned revenues are the opposite of prepaid expenses. Indeed, unearned revenue on the books of one company is likely to be a prepaid expense on the books of the company that has made the advance payment.

Question 50

What do we do since it is not practical to make daily journal entries as unearned revenue is earned?

Answer 50

Recognition of earned revenue is delayed until the adjustment process. At that time, an adjusting entry is then made to record the revenue that has been earned during the period and to show the liability that remains at the end of the accounting period.

Question 51

How does the adjusting of unearned revenue affect the accounting equation?

Answer 51

The original journal entry to record unearned revenues results in an increase (debit) to the asset (cash) and an increase (credit) to the liability (unearned revenue). The subsequent adjusting entry results in a decrease (debit) to the liability (unearned revenue) account and an increase (credit) to a revenue account.

Question 52

Typically, what is overstated/understated until adjusting entry to unearned revenue is made?

Answer 52

Liabilities are overstated and revenues are understated. If revenues are understated, then profit and shareholders’ equity are also understated.

Question 53

What’s an interesting and important note about adjusting entries for prepayments?

Answer 53

Whether a prepaid expense or an unearned revenue, simple adjusting entries affect one statement of financial position account and one income statement account.

Question 54

What are adjusting entries for accruals required for?

Answer 54

They’re required in order to record revenue earned, or expenses incurred, in the current accounting period.

Question 55

What’s a difference between accruals and prepayments?

Answer 55

Unlike prepayments, accruals have not been recognized through daily entries and thus are not reflected in the accounts.

Question 56

Until an accrual adjustment is made, what is understated/overstated?

Answer 56

Until an accrual adjustment is made, the revenue account (and the related asset account), or the expense account (and the related liability account), is understated. Thus, adjusting entries for accruals will increase both a statement of financial position account and an income statement account.

Question 57

How may accrued revenues be acquired?

Answer 57

Accrued revenues may accumulate (accrue) with the passing of time as in the case of interest revenue, or they may result from services that have been performed but not yet billed or collected, such as fees.

Question 58

Since accrued revenues have not previously been recorded, and adjusting entry is required for which 2 reasons?

Answer 58

• To show the receivable that exists at the end of the period.
• To record the revenue that has been earned during the period.

Question 59

Until an adjustment is made to accrued revenues, what will be overstated/understated?

Answer 59

Both assets and revenues are understated. Consequently, profit and shareholders’ equity will also be understated.

Question 60

What are 5 examples of accrued expenses?

Answer 60

• Interest
• Rent
• Salaries
• Property tax
• Income tax

Question 61

How may accrued expenses be acquired?

Answer 61

Accrued expenses result from the same factors as accrued revenues. In fact, an accrued expense on the books of one company is an accrued revenue to another company.

Question 62

Since accrued expenses have not previously been recorded, and adjusting entry is required for which 2 reasons?

Answer 62

• To record the obligations that exist at the end of the period
• To recognize the expenses that apply to the current accounting period.

Question 63

Until an adjustment is made to accrued expenses, what will be overstated/understated?

Answer 63

Both liabilities and expenses are understated. Consequently, profit and shareholders’ equity are overstated.

Question 64

What does an adjusting entry for accrued revenues result in?

Answer 64

An increase (debit) to an asset account and an increase (credit) to a revenue account.

Question 65

What does an adjusting entry for accrued expenses result in?

Answer 65

An increase (debit) to an expense account and an increase (credit) to a liabilities account.

Question 66

Interest is always expressed in annual terms. the interest accumulation is determined by which 3 factors?

Answer 66

• The principal amount, or face value, of the loan.
• The interest rate, which is always expressed as an annual rate.
• The length of time that the loan is outstanding (unpaid).

Question 67

Which account is used to disclose the two different types of obligations - interest and principal - in the accounts and statements?

Answer 67

Interest Payable instead of bank loan payable.

Interest payable + bank loan payable = total loan.

Question 68

Until an adjustment is made to interest payable, what will be overstated/understated?

Answer 68

Liabilities and expenses will be understated and profit and shareholders’ equity will be overstated.

Question 69

What’s a first interesting and important note about adjusting entries for accruals?

Answer 69

Whether an accrued expense or an accrued revenue, simple adjusting entries affect one statement of financial position account and one income statement account.

Question 70

What’s a second interesting and important note about adjusting entries?

Answer 70

Adjusting entries never involve the Cash account.
In the case of prepayments, cash had already been received or paid and recorded in the original journal entry. the adjusting entry simply reallocates, or adjusts, amounts between a statement of financial position account and an income statement account.
In the case of accruals, cash will be received or paid in the future and recorded then. The adjusting entry simply records the receivable or payable and the related revenue or expense.

Question 71

What does the adjusted trial balance show?

Answer 71

The balances of all accounts at the end of the accounting period, including those that have been adjusted.

Question 72

Why is the adjusted trial balance the main source for the preparation of financial statements?

Answer 72

Because the accounts contain all the data that are needed for financial statements.