Accounting Concepts

Question 1

As a sale is made, the appropriate charges for cost of goods sold, or other expenses directly corresponding to the sale, should be recorded in the same accounting period.

A. True
B. False

Answer 1

A. True

See pages 1.121 in the Fraud Examiner’s Manual

Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching principle, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognized at the same time as the income derived from the sale of the goods.

Question 2

Generally speaking, _________________ is the proper basis for initially recording a piece of equipment on a company’s books.

A. Current market value
B. Estimated replacement value
C. Historical cost
D. Appraised value

Answer 2

C. Historical cost

See pages 1.122 in the Fraud Examiner’s Manual

Standard accounting principles require that property, plant, and equipment be initially recognized at historical cost. According to the historical cost basis of asset measurement, assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition.Notes payable, current assets, retained earnings, and accumulated depreciation can all be found on the balance sheet. The balance sheet is an expansion of the accounting equation, Assets = Liabilities + Owners’ Equity. That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the Standard accounting principles require that property, plant, and equipment be initially recognized at historical cost. According to the historical cost basis of asset measurement, assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition.

Question 3

According to the going concern disclosure requirements, if there is substantial doubt about a company’s ability to fulfill its financial obligations over a reasonable period of time, it must be disclosed in the company’s financial statements.

A. True
B. False

Answer 3

A. True

See pages 1.118-1.119 in the Fraud Examiner’s Manual

A company’s management is required to provide disclosures when existing events or conditions indicate that it is more likely than not that the entity might be unable to meet its obligations within a reasonable period of time after the financial statements are issued. There is an underlying assumption that an entity will continue as a going concern; that is, the life of the entity will be long enough to fulfill its financial and legal obligations. Any evidence to the contrary must be reported in the entity’s financial statements.

Question 4

Which of the following appears on the balance sheet?

A. Revenues
B. Cost of goods sold
C. Current assets
D. Expenses

Answer 4

C. Current assets

See pages 1.107-1.110 in the Fraud Examiner’s Manual

The balance sheet, or statement of financial position, is an expansion of the accounting equation, Assets = Liabilities + Owners’ Equity. That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the other side. Assets are classified as either current or noncurrent. Current assets consist of cash or other liquid assets that are expected to be converted to cash, sold, or used up, usually within a year or less. Current assets listed on the balance sheet include cash, accounts receivable, inventory, supplies, and prepaid expenses.

Revenues, expenses, and cost of goods sold are all items that appear on a company’s income statement.

Question 5

Chapman Inc. has always used the first-in, first-out (FIFO) inventory valuation method when calculating its cost of goods sold. This is also the standard inventory valuation method for other comparable entities in Chapman’s industry. Chapman’s controller wants to change to the weighted-average cost method because it will make Chapman’s net income appear much larger than the FIFO valuation will. After several years of poor performance, management wants to improve the company’s appearance to potential investors. However, Chapman must continue to use the FIFO inventory valuation method. This is reflected in which of the qualitative characteristics of financial reporting?

A. Valuation
B. Comparability
C. Relevance
D. Going concern

Answer 5

B. Comparability

See pages 1.117-1.118 in the Fraud Examiner’s Manual

Users of financial statements base their decisions on comparisons between different entities and on similar information from a single entity for another reporting period. Comparability is the qualitative characteristic that enables users to identify and understand similarities and differences between such items. Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal.

However, both comparability and consistency do not prohibit a change in an accounting principle previously employed. An entity’s management is permitted to change an accounting policy if one of the following circumstances applies:

The change is required by a standard or interpretation.
The change would result in the financial statements providing more reliable and relevant information about the effects of transactions; other events; or conditions on the entity’s financial position, financial performance, or cash flows.
The entity’s financial statements must include full disclosure of any such changes. The desire to project an artificially strong performance is not a justifiable reason for a change in accounting principle. Since Chapman has always used first-in, first-out (FIFO), and since FIFO is the industry norm, a change to the weighted-average cost method is not justifiable.

Question 6

Which of the following is an acceptable justification for a departure from generally accepted accounting principles (GAAP)?

A. The literal application of GAAP would result in misleading financial statements
B. Departing from GAAP would make the company appear more profitable
C. Following GAAP is significantly more expensive than using an alternative method
D. None of the above

Answer 6

A. The literal application of GAAP would result in misleading financial statements

See pages 1.123-1.124 in the Fraud Examiner’s Manual

The question of when it is appropriate to deviate from generally accepted accounting principles (GAAP) is a matter of professional judgment; there is not a precise set of circumstances that justifies such a departure. However, the fact that complying with GAAP would be more expensive or would make the financial statements look weaker is not a reason to use a non-GAAP method of accounting for a transaction.

It can be assumed that following GAAP almost always results in financial statements that are fairly presented. However, the standard-setting bodies recognize that, upon occasion, there might be an unusual circumstance when the literal application of GAAP would result in misleading financial statements. In these cases, a departure from GAAP is the proper accounting treatment.

Departures from GAAP can be justified in the following circumstances:

There is concern that assets or income would be overstated and expenses or liabilities would be understated (the conservatism constraint requires that when there is any doubt, one should avoid overstating assets and income or understating expenses and liabilities).
It is common practice in the entity’s industry for a transaction to be reported in a particular way.
The substance of the transaction is better reflected (and, therefore, the financial statements are more fairly presented) by not strictly following GAAP.
A departure produces results that are reasonable under the circumstances, especially if following GAAP produces misleading financial statements and the departure is properly disclosed.
If a transaction is considered immaterial (i.e., it would not affect a decision made by a prudent reader of the financial statements), then it need not be reported.
The expected costs of following GAAP exceed the expected benefits of compliance.

Question 7

Which of the following statements is TRUE regarding the statement of cash flows?

A. There are four types of cash flows: cash flows from operating activities, from investing activities, from financing activities, and from revenue activities.
B. The statement of cash flows is often used in tandem with the income statement to determine a company’s true financial performance.
C. The statement of cash flows shows a company’s financial position at a specific point in time.
D. The statement of cash flows is not always necessary because most companies operate under cash-basis accounting rather than accrual-basis accounting.

Answer 7

B. The statement of cash flows is often used in tandem with the income statement to determine a company’s true financial performance.

See pages 1.109, 1.112-1.113 in the Fraud Examiner’s Manual

The statement of cash flows reports a company’s sources and uses of cash during the accounting period. This statement is often used by potential investors and other interested parties in tandem with the income statement to determine a company’s true financial performance during the period being reported. The statement of cash flows has three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

The nature of accrual-basis accounting allows (and often requires) the income statement to contain many noncash items and subjective estimates that make it difficult to fully and clearly interpret a company’s operating results. However, it is much harder to falsify the amount of cash that was received and paid during the year, so the statement of cash flows enhances the financial statements’ transparency.

The balance sheet shows a company’s financial position at a specific point in time.

Question 8

It is considered acceptable practice to deviate from generally accepted accounting principles (GAAP) in which of the following circumstances?

A. There is concern that assets or income would be overstated
B. It is common practice in the industry to give particular transactions a specific accounting treatment
C. Following GAAP would produce misleading results
D. All of the above

Answer 8

D. All of the above

See pages 1.123 in the Fraud Examiner’s Manual

The question of when it is appropriate to deviate from generally accepted accounting principles (GAAP) is a matter of professional judgment; there is not a precise set of circumstances that justifies such a departure. It can be assumed that following GAAP almost always results in financial statements that are fairly presented. However, the standard-setting bodies recognize that, upon occasion, there might be an unusual circumstance when the literal application of GAAP would result in misleading financial statements. In these cases, a departure from GAAP is the proper accounting treatment.

Departures from GAAP can be justified in the following circumstances:

There is concern that assets or income would be overstated and expenses or liabilities would be understated (the conservatism constraint requires that when there is any doubt, one should avoid overstating assets and income or understating expenses and liabilities).
It is common practice in the entity’s industry for a transaction to be reported in a particular way.
The substance of the transaction is better reflected (and, therefore, the financial statements are more fairly presented) by not strictly following GAAP.
A departure produces results that are reasonable under the circumstances, especially if following GAAP produces misleading financial statements and the departure is properly disclosed.
If a transaction is considered immaterial (i.e., it would not affect a decision made by a prudent reader of the financial statements), then it need not be reported.
The expected costs of following GAAP exceed the expected benefits of compliance.

Question 9

Revenue should NOT be recognized for work that is to be performed in subsequent accounting periods, even though the work might currently be under contract.

A. True
B. False

Answer 9

A. True

See pages 1.120-1.121 in the Fraud Examiner’s Manual

In general, revenue is recognized to represent the transfer of promised goods or services to a customer in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. According to the revenue recognition principle, revenue should not be recognized for work that is to be performed in subsequent accounting periods, even though the work might currently be under contract. For a performance obligation satisfied over time, an entity should select an appropriate measure of progress to determine how much revenue should be recognized as the performance obligation is satisfied.

Question 10

Most companies present which of the following as the first line item on the income statement?

A. Net profit
B. Net sales
C. Operating expenses
D. The cash balance

Answer 10

B. Net sales

See pages 1.109-1.110 in the Fraud Examiner’s Manual

While the balance sheet shows a company’s financial position at a specific point in time, the income statement, or statement of profit or loss and other comprehensive income, details how much profit (or loss) a company earned during a period of time, such as a quarter or a year.

Two basic types of accounts are reported on the income statement—revenues and expenses. Revenues represent amounts received from the sale of goods or services during the accounting period. Most companies present net sales or net service revenues as the first line item on the income statement. The term net means that the amount shown is the company’s total sales minus any sales refunds, returns, discounts, or allowances.

Question 11

Which of the following types of accounts are decreased by debits?

A. Liabilities
B. Owners’ equity
C. Revenue
D. All of the above

Answer 11

D. All of the above

See pages 1.102 in the Fraud Examiner’s Manual

Entries to the left side of an account are referred to as debits, and entries to the right side of an account are referred to as credits. Debits increase asset and expense accounts while credits decrease these accounts. On the other side of the equation, credits increase liabilities, revenue, and owners’ equity accounts. Conversely, debits decrease liabilities, revenues, and owners’ equity.

Question 12

U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) are considered rules-based accounting frameworks.

A. True
B. False

Answer 12

B. False

See pages 1.116 in the Fraud Examiner’s Manual

Publicly traded companies must follow the specific financial reporting practices of their jurisdiction, which differ among regions. While U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) are some of the most commonly used accounting frameworks, other countries have their own form of GAAP that might contain different standards. IFRS is considered a principle-based accounting framework, and U.S. GAAP is known to be a rules-based accounting framework. Proponents of IFRS say that a principle-based accounting system better captures an entity’s true economic situation.

Question 13

Which of the following could be used to balance the accounting equation if cash were stolen?

A. Reducing revenue
B. Increasing another asset
C. Reducing a liability
D. All of the above

Answer 13

D. All of the above

See pages 1.101-1.102 in the Fraud Examiner’s Manual

The accounting equation, Assets = Liabilities + Owners’ Equity, is the basis for all double-entry accounting. If an asset (e.g., cash) is stolen, the equation can be balanced by increasing another asset, reducing a liability, reducing an owners’ equity account, reducing revenues (and thus retained earnings), or creating an expense (and thus reducing retained earnings).

Question 14

Which of the following types of accounts are increased by credits?

A. Owners’ equity
B. Liability
C. Revenue
D. All of the above

Answer 14

D. All of the above

See pages 1.102 in the Fraud Examiner’s Manual

Entries to the left side of an account are referred to as debits, and entries to the right side of an account are referred to as credits. Debits increase asset and expense accounts while credits decrease these accounts. On the other side of the equation, credits increase liabilities, revenue, and owners’ equity accounts. Conversely, debits decrease liabilities, revenues, and owners’ equity.

Question 15

Assets, liabilities, and owners’ equity are all items that appear on a company’s balance sheet.

A. True
B. False

Answer 15

A. True

See pages 1.107 in the Fraud Examiner’s Manual

The balance sheet, or statement of financial position, provides insight into a company’s financial situation at a specific point in time, generally the last day of the accounting period. The balance sheet is an expansion of the accounting equation, Assets = Liabilities + Owners’ Equity. That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the other side.

Question 16

If compliance with generally accepted accounting principles (GAAP) would be significantly more expensive than a different method that is not GAAP, use of an alternative method is permitted.

A. True
B. False

Answer 16

B. False

See pages 1.123-1.124 in the Fraud Examiner’s Manual

The question of when it is appropriate to deviate from generally accepted accounting principles (GAAP) is a matter of professional judgment; there is not a precise set of circumstances that justifies such a departure. However, the fact that complying with GAAP would be more expensive or would make the financial statements look weaker is not a reason to use a non-GAAP method of accounting for a transaction.

Question 17

The assumption that a business will continue indefinitely is reflected in the accounting concept of:

A. Comparability
B. Objective evidence
C. Going concern
D. Relevance

Answer 17

C. Going concern

See pages 1.118-1.119 in the Fraud Examiner’s Manual

A company’s management is required to provide disclosures when existing events or conditions indicate that it is more likely than not that the entity might be unable to meet its obligations within a reasonable period of time after the financial statements are issued. There is an underlying assumption that an entity will continue as a going concern; that is, the life of the entity will be long enough to fulfill its financial and legal obligations. Any evidence to the contrary must be reported in the entity’s financial statements.

Question 18

The ________________ details how much profit (or loss) a company earned over a particular period of time.

A. Balance sheet
B. Income statement
C. Statement of changes in owners’ equity
D. Statement of cash flows

Answer 18

B. Income statement

See pages 1.109, 1.111-1.112 in the Fraud Examiner’s Manual

While the balance sheet shows a company’s financial position at a specific point in time, the income statement, or statement of profit or loss and other comprehensive income, details how much profit (or loss) a company earned during a period of time, such as a quarter or a year.

The statement of changes in owners’ equity details the changes in the total owners’ equity amount listed on the balance sheet.

The statement of cash flows reports a company’s sources and uses of cash during a particular period of time.

Question 19

The qualitative financial reporting characteristic of comparability prohibits any change in an accounting principle previously employed.

A. True
B. False

Answer 19

B. False

See pages 1.117-1.118 in the Fraud Examiner’s Manual

Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items. Information about a company is more useful if it can be compared with similar information about other entities and with similar information about the same entity for another period or another date. Although a single economic occurrence can be faithfully represented in multiple ways, permitting alternative accounting methods for the same economic occurrence diminishes comparability.

Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal.

However, both comparability and consistency do not prohibit a change in an accounting principle previously employed. An entity’s management is permitted to change an accounting policy if one of the following circumstances applies:

The change is required by a standard or interpretation.
The change would result in the financial statements providing more reliable and relevant information about the effects of transactions; other events; or conditions on the entity’s financial position, financial performance, or cash flows.
The entity’s financial statements must include full disclosure of any such changes. Examples of changes in accounting principles include a change in the method of inventory pricing, a change in the depreciation method for previously recorded assets, and a change in the method of accounting for long-term construction contracts. The disclosure for a change in accounting principles should include the justification for the change and should explain why the newly adopted principle is preferable.

Question 20

The statement of cash flows includes the following categories: cash flows from strategic activities, cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

A. True
B. False

Answer 20

B. False

See pages 1.112 in the Fraud Examiner’s Manual

The statement of cash flows reports a company’s sources and uses of cash during the accounting period. This statement is often used by potential investors and other interested parties in tandem with the income statement to determine a company’s true financial performance during the period being reported.

The statement of cash flows has three sections:

Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities

Question 21

Which of the following statements is TRUE regarding the balance sheet?

A. Assets are generally presented on the balance sheet in order of liquidity.
B. The balance sheet shows the financial performance of a company over a certain period of time, such as a quarter or a year.
C. Balance sheets are usually manipulated by understating assets or overstating liabilities.
D. The accounts that appear on the balance sheet include revenues and expenses.

Answer 21

A. Assets are generally presented on the balance sheet in order of liquidity.

See pages 1.107-1.108 in the Fraud Examiner’s Manual

The balance sheet, or statement of financial position, provides insight into a company’s financial situation at a specific point in time, generally the last day of the accounting period. The balance sheet is an expansion of the accounting equation, Assets = Liabilities + Owners’ Equity. That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the other side.

Assets are the resources owned by a company. Generally, assets are presented on the balance sheet in order of liquidity (i.e., how soon they are expected to be converted to cash).

Generally, in a financial statement fraud scheme, the balance sheet is manipulated to appear stronger by overstating assets and/or understating liabilities.

Question 22

The accounting framework that an entity follows depends on the rules of the jurisdiction(s) in which the entity operates.

A. True
B. False

Answer 22

A. True

See pages 1.115-1.116 in the Fraud Examiner’s Manual

Historically, each country has enacted its own generally accepted accounting principles (GAAP), which has led to a worldwide divergence of accounting practices. It has also contributed to some difficulties in comparing the financial performance of companies in different countries, as well as financial reporting challenges for multinational entities. Consequently, accounting standard-setters have been working toward a uniform set of accounting standards to enhance the transparency and comparability of financial reporting, facilitate cross-border commerce, and encourage international investment. The resulting International Financial Reporting Standards (IFRS) has been adopted as the source of GAAP for reporting companies in many countries. However, some countries, such as the United States, have retained their own set of accounting standards that form GAAP for reporting companies in those jurisdictions. Currently, there is not a universally accepted accounting recording and reporting system in existence. Publicly traded companies must follow the specific financial reporting practices of their jurisdiction, which differ among regions.

Question 23

Which accounting principle requires corresponding expenses and revenue to be recorded in the same accounting period?

A. Going concern
B. Faithful representation
C. Comparability
D. Matching

Answer 23

D. Matching

See pages 1.121 in the Fraud Examiner’s Manual

Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching principle, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognized at the same time as the income derived from the sale of the goods.

Question 24

Which of the following is the CORRECT accounting model?

A. Assets = Liabilities – Owners’ Equity
B. Assets + Liabilities = Owners’ Equity
C. Assets = Liabilities + Owners’ Equity
D. None of the above

Answer 24

C. Assets = Liabilities + Owners’ Equity

See pages 1.101 in the Fraud Examiner’s Manual

Accounting is based on the following model or accounting equation: Assets = Liabilities + Owners’ Equity.

Question 25

Julia runs a printing company and has an antique printing press that she uses in her business. She purchased the press from a friend for $5,000. Similar presses are selling on the market today for about $8,000. Julia has a colleague who recently paid $9,000 for an antique printing press. According to the historical cost basis of asset measurement, how much should Julia initially record the printing press for on her books?

A. $8,000
B. $5,000
C. $3,000
D. $9,000

Answer 25

B. $5,000

See pages 1.122 in the Fraud Examiner’s Manual

According to the historical cost basis of asset measurement, assets are recorded at the amount of cash or cash equivalents paid or the fair value of the consideration given to acquire them at the time of their acquisition. This basis is the one most commonly adopted by entities in preparing their financial statements. In this example, Julia should list the printing press on her balance sheet for the amount she originally purchased it for—$5,000.

Question 26

When looking at a set of financial statements, on which statement would you find notes payable, current assets, retained earnings, and accumulated depreciation?

A. Statement of changes in owners’ equity
B. Statement of cash flows
C. Income statement
D. Balance sheet

Answer 26

D. Balance sheet

See pages 1.107-1.108 in the Fraud Examiner’s Manual

Notes payable, current assets, retained earnings, and accumulated depreciation can all be found on the balance sheet. The balance sheet is an expansion of the accounting equation, Assets = Liabilities + Owners’ Equity. That is, it lists a company’s assets on one side and its liabilities and owners’ equity on the other side. Assets are classified as either current or noncurrent. Current assets consist of cash or other liquid assets that are expected to be converted to cash, sold, or used up, usually within a year or less. Current assets listed on the balance sheet include cash, accounts receivable, inventory, supplies, and prepaid expenses. Following the current assets are the long-term assets, or those assets that will likely not be converted to cash within one year, such as fixed assets and intangible assets. A company’s fixed assets are presented net of accumulated depreciation, an amount that represents the cumulative expense recorded to reflect the expected decline of a company’s property from normal use.

Liabilities are presented in order of maturity. Like current assets, current liabilities are those obligations that are expected to be paid within one year, such as accounts payable (the amount owed to vendors by a company for purchases on credit), accrued expenses (e.g., taxes payable or salaries payable), and the portion of long-term debts that will come due within the next year. Those liabilities that are not due for more than a year are listed under the heading long-term liabilities. The most common liabilities in this group are bonds, notes, and mortgages payable.

Question 27

The management at a publicly traded company may choose which set of financial reporting practices it wants its company to follow.

A. True
B. False

Answer 27

B. False

See pages 1.116 in the Fraud Examiner’s Manual

Publicly traded companies must follow the specific financial reporting practices of their jurisdiction, which differ among regions. While U.S. generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS) are some of the most commonly used accounting frameworks, other countries have their own form of GAAP that might contain different standards. IFRS is considered a principle-based accounting framework, and U.S. GAAP is known to be a rules-based accounting framework. Proponents of IFRS say that a principle-based accounting system better captures an entity’s true economic situation.

Question 28

Which of the following statements is TRUE regarding gross profit?

A. Gross profit is another term for net income.
B. Gross profit is equal to net sales minus cost of goods sold.
C. Gross profit is equal to revenues minus operating expenses.
D. Gross profit is the top line of the income statement.

Answer 28

B. Gross profit is equal to net sales minus cost of goods sold.

See pages 1.109-1.110 in the Fraud Examiner’s Manual

Two basic types of accounts are reported on the income statement—revenues and expenses. Revenues represent amounts received from the sale of goods or services during the accounting period. Most companies present net sales as the first line item on the income statement. The term net means that the amount shown is the company’s total sales minus any sales refunds, returns, discounts, or allowances.

From net sales, an expense called cost of goods sold or cost of sales is deducted. Regardless of the industry, this expense indicates the amount a company spent (in past, present, and/or future accounting periods) to produce the goods or services that were sold during the current period. The difference between net sales and cost of goods sold is called gross profit or gross margin, which represents the leftover amount from sales to pay the company’s operating expenses.

Question 29

Delta, a Certified Fraud Examiner (CFE), was hired to serve as an expert accounting witness in a case of alleged financial statement fraud. As part of her expert testimony, Delta explained how, under International Financial Reporting Standards (IFRS), management must make every effort to ensure that the company’s financial statements are complete, neutral, and free from error. Delta was explaining the concept of:

A. Going concern
B. Comparability
C. Faithful representation
D. None of the above

Answer 29

C. Faithful representation

See pages 1.117 in the Fraud Examiner’s Manual

Financial information must faithfully represent the economic data of the enterprise that it purports to represent. Every effort shall be made to maximize the qualities of perfectly faithful representation: complete, neutral, and free from error. A complete representation includes all information necessary to understand the data presented. A neutral representation is without bias in the selection or presentation of financial information. Free from error means there are no material errors or omissions in the financial reporting data and that the process used to produce the reported information has been selected and applied with no errors.

Question 30

Entries to the left side of an account are referred to as credits while entries to the right side of an account are referred to as debits.

A. True
B. False

Answer 30

B. False

See pages 1.102 in the Fraud Examiner’s Manual

Entries to the left side of an account are referred to as debits, and entries to the right side of an account are referred to as credits. Asset and expense accounts are increased with debits and decreased with credits while liabilities, owners’ equity, and revenue accounts are increased with credits and decreased with debits.

Question 31

If a fraudster wants to conceal the misappropriation of cash, which of the following actions will NOT result in a balanced accounting equation?

A. Reducing owners’ equity
B. Decreasing another asset
C. Creating an expense
D. Decreasing a liability

Answer 31

B. Decreasing another asset

See pages 1.101-1.102 in the Fraud Examiner’s Manual

The accounting equation, Assets = Liabilities + Owners’ Equity, is the basis for all double-entry accounting. If an asset (e.g., cash) is stolen, the equation can be balanced by increasing another asset, reducing a liability, reducing an owners’ equity account, reducing revenues (and thus retained earnings), or creating an expense (and thus reducing retained earnings).

Question 32

Calculating _____________ determines a company’s earnings for an accounting period by deducting its operating expenses from gross profit.

A. Gross revenues
B. Cost of goods sold
C. Net profit
D. Net sales

Answer 32

C. Net profit

See pages 1.110 in the Fraud Examiner’s Manual

A company’s net profit (also known as net income or net earnings) for the period is determined after subtracting operating expenses from gross profit. If a company’s total expenses were greater than its total revenues and the bottom line is negative, then it had a net loss for the period.

Question 33

Which of the following is FALSE regarding cash-basis accounting?

A. Revenues are recorded in the accounting system when a company receives cash.
B. Expenses are recorded in the accounting system as soon as they are paid.
C. Cash-basis accounting focuses on tracking a company’s future cash flow.
D. Cash-basis accounting is simpler to use than accrual-basis accounting.

Answer 33

C. Cash-basis accounting focuses on tracking a company’s future cash flow.

See pages 1.104-1.105 in the Fraud Examiner’s Manual

There are two primary methods of accounting: cash basis and accrual basis. The main difference between the two methods is the timing in which revenue and expenses are recognized.

Cash-basis accounting involves recording revenues and expenses based on when a company receives or pays cash. For example, sales are recorded when a company receives cash payment for goods, regardless of when the goods are delivered. If a customer purchases goods on credit, the company does not record the sale until the cash is received for the sale. Likewise, if a customer prepays for a sale, the company records the sales revenue immediately, rather than when the goods are given to the customer. The process is the same with expenses: The expenses are recorded when paid, without consideration to the accounting period in which they were incurred. The advantage of cash-basis accounting is its simplicity—the only thing its accounting system must track is cash being received or paid. Using this method makes it easier for companies to track their cash flow.

Accrual-basis accounting requires revenues to be recorded when they are earned (generally, when goods are delivered or services are provided to a customer), without regard to when cash is exchanged. Expenses are recorded in the same period as the revenues to which they relate. For example, employee wages are expensed in the period during which the employees provided services, which might not necessarily be the same period in which they are paid.

Accrual-basis accounting records accounts receivable for money that has yet to be received from customers and records accounts payable for purchases made on credit. This accounting method provides immediate feedback to companies on their expected cash inflows and outflows, which makes it easier for them to manage their current resources and efficiently plan for the future. When companies recognize economic events by matching their revenues with the expenses that directly relate to those revenues, it provides a more accurate representation of their financial situation.

Question 34

Gross revenues refer to the total amount of sales made by a company during an accounting period after deductions are made.

A. True
B. False

Answer 34

B. False

See pages 1.109-1.110 in the Fraud Examiner’s Manual

Two basic types of accounts are reported on the income statement—revenues and expenses. Revenues represent amounts received from the sale of goods or services during the accounting period. Most companies present net sales or net service revenues as the first line item on the income statement. The term net means that the amount shown is the company’s total sales minus any sales refunds, returns, discounts, or allowances. Conversely, gross revenues refer to the company’s total sales during the accounting period before any deductions are made.

Question 35

Which of the following statements is FALSE regarding the statement of cash flows?

A. The statement of cash flows is often used in tandem with the income statement to determine a company’s true financial performance.
B. The statement of cash flows shows a company’s financial position at a specific point in time.
C. There are three types of cash flows: cash flows from operating activities, from investing activities, and from financing activities.
D. The statement of cash flows reports a company’s sources and uses of cash during the accounting period.

Answer 35

B. The statement of cash flows shows a company’s financial position at a specific point in time.

See pages 1.109, 1.112-1.113 in the Fraud Examiner’s Manual

The statement of cash flows reports a company’s sources and uses of cash during the accounting period. This statement is often used by potential investors and other interested parties in tandem with the income statement to determine a company’s true financial performance during the period being reported. The statement of cash flows has three sections: cash flows from operating activities, cash flows from investing activities, and cash flows from financing activities.

The balance sheet shows a company’s financial position at a specific point in time.

Question 36

If a fraudster wants to conceal the removal of a liability from the books, which of the following actions will NOT balance the accounting equation?

A. Increasing an asset
B. Increasing revenue
C. Increasing a different liability
D. Increasing owners’ equity

Answer 36

A. Increasing an asset

See pages 1.101-1.102 in the Fraud Examiner’s Manual

The accounting equation, Assets = Liabilities + Owners’ Equity, is the basis for all double-entry accounting. Suppose that in order to make an organization appear that it has less debt, an accountant fraudulently removes a liability. This would leave the accounting equation unbalanced since the assets side would be greater than liabilities plus owners’ equity. In this particular case, the equation can be balanced by decreasing an asset, increasing a different liability, increasing an owners’ equity account, increasing revenues (and thus retained earnings), or reducing an expense (and thus increasing retained earnings). Increasing an asset would only make the equation further out of balance.

Question 37

In accrual-basis accounting, revenues are generally recognized when goods are delivered or services are provided to a customer.

A. True
B. False

Answer 37

A. True

See pages 1.105 in the Fraud Examiner’s Manual

Accrual-basis accounting requires revenues to be recorded when they are earned (generally, when goods are delivered or services are provided to a customer), without regard to when cash is exchanged. Expenses are recorded in the same period as the revenues to which they relate. For example, employee wages are expensed in the period during which the employees provided services, which might not necessarily be the same period in which they are paid.

Question 38

David runs a local catering company. He keeps his books on a calendar year and uses the accrual basis of accounting. In December of Year 1, a customer placed an order with him to cater the food for a party that would take place in February of Year 2. The contract was signed and the balance was paid in full when the order was placed in December. When should David report the revenue from this party and the associated expenses of catering it?

A. It does not matter because it is up to David to decide whether he reports the revenue and expenses in December or February.
B. Both the revenue and expenses should be recorded in February.
C. The revenue should be recorded in December when David received the cash, and the expenses should be recorded in February after the party takes place.
D. Both the revenue and expenses should be recorded in December.

Answer 38

B. Both the revenue and expenses should be recorded in February.

See pages 1.121 in the Fraud Examiner’s Manual

Expenses are recognized in the income statement on the basis of a direct association between the costs incurred and the earning of specific items of income. This process, commonly referred to as the matching principle, involves the simultaneous or combined recognition of revenues and expenses that result directly and jointly from the same transactions or other events; for example, the various components of expense making up the cost of goods sold are recognized at the same time as the income derived from the sale of the goods. In this example, since the expenses will not be incurred until David caters the event in February, the revenue David received should not be recorded until February as well.

Question 39

The statement of changes in owners’ equity acts as the connecting link between which two financial statements?

A. Balance sheet and statement of retained earnings
B. Income statement and balance sheet
C. Statement of cash flows and balance sheet
D. Income statement and statement of cash flows

Answer 39

B. Income statement and balance sheet

See pages 1.111 in the Fraud Examiner’s Manual

The statement of changes in owners’ equity details the changes in the total owners’ equity amount listed on the balance sheet. Because it shows how the amounts on the income statement flow through to the balance sheet, it acts as the connecting link between the two statements. The balance of the owners’ equity at the beginning of the year is the starting point for the statement. The transactions that affect owners’ equity are listed next and are added together. The result is added to (or subtracted from, if negative) the beginning-of-the-year balance, which provides the end-of-the-year balance for total owners’ equity.