Adjusting the Accounts and Preparing Financial Statements

Question 1

cash basis

Answer 1

income is recorded when cash is received

expenses are recorded when cash is paid

it does not recognise income when goods are sold, or services are performed on credit

it is simple to operate

Question 2

accrual basis: income including revenue

Answer 2

income is recognised in the period in which the expected inflow of economic benefit can be reliably measured

increases in economic benefits during the period in the form of inflows or enhancements of assets or decreases in liabilities

result in increases in equity

not contribution by the owners

income = revenue + gains

gains are the profits made on the sale of long term assets

recognised at the fair value of assets received

Question 3

accrual basis: expenses

Answer 3

expenses recognised when the consumption of benefits can be reliably measured

decreases in economic benefits during the period in the form of outflows or depletions of assets or incurrences of liabilities

result in decreases in equity

not distributions to the owners = dividends and drawings are not an expense

expenses are recognised in the period in which the consumption of costs can be measured = only costs that relate to this period i.e. not prepaid expenses (they are classified as assets)

Question 4

temporary/nominal accounts

Answer 4

income and expense accounts are reduced to a zero balance at the end of the accounting period

close at the end of a period

income, expenses, drawings etc.

Question 5

permanent/real accounts

Answer 5

accounts in the balance sheet are not closed

ending balances of one period are carried forward and become the beginning balances of the next period

assets, liabilities and equity

Question 6

the need for adjusting entries

Answer 6

period in which cash is paid or received does not coincide with period in which expense and income are recognised

some accounts must be adjusted on the last day of the accounting period to correctly recognise income and expenses not reflected in cash receipts or payments

won’t be able to match the expenses and revenues to the correct period

Question 7

deferals

Answer 7

the expenses paid in advance, called prepaid expenses = asset

revenues received in advance, called unearned revenues = liability

Question 8

accruals

Answer 8

the recognition of expenses incurred but not yet paid for, called ‘accrued expenses’ = liability

Question 9

rules for adjusting entries (summary of adjustments format)

Answer 9

one side of the entry affects an income statement account = that is revenue or expense

the other side of the entry affects an account reported in the balance sheet, that is asset or liability

the cash account is never adjusted as the cash flow occurs either before or after the end of the reporting period

Question 10

adjusted trial balance

Answer 10

same accounting process applied

unadjusted trial balance used as starting point

adjusting entries are posted to the general ledger

an adjusted trial balance can then be prepared

debits must still equal credits

adjusting entries always affect an income statement and a balance sheet account

Question 11

income statement

Answer 11

prepared first to determine profit or loss

reflects entity’s performance for the period

Question 12

statement of changes in equity

Answer 12

profit (loss) must be added to (subtracted from) equity

capital contributions and drawings/dividends also recorded

shows details of movements in equity

equity balance is reported in balance sheet

Question 13

balance sheet

Answer 13

reflects entity’s financial position as at the end of the period

three major categories of accounts

• assets
• liabilities
• equity

statement users find it useful if assets and liabilities are further classified

Question 14

current assets

Answer 14

cash and other types of assets that are held

primarily for the purpose of sale or trading

will be used up/paid off within a single operating cycle = usually 12 months

the operating cycle is the average length of time it takes to acquire inventory

Question 15

non-current assets

Answer 15

will not be used up/paid off within a single operating cycle = usually 12 months

property, plant and equipment are expected to be used by the business entity for a number of years and are not held for resale

an intangible asset is one that usually does not have a physical substance

Question 16

current liabilities

Answer 16

entity that are reasonably expected to be settled in

the entity’s normal operating cycle

it will require payment in the short-term accounts payable, interest payable and other accrued liabilities

Question 17

non-current or long-term liabilities

Answer 17

entity that do not require payment within the entity’s operating cycle or within 12 months

long-term debt is that portion of the mortgage due after 1 year

the interest accrued on both the long-term and short-term portion of the debt is reported as a current liability

Question 18

the worksheet

Answer 18

assembles all information needed to adjust the accounts and prepare financial statements

aids in the preparation of interim financial statements when adjusting and closing entries are not required

contains information needed to close off profit and loss accounts for the period if required

Question 19

preparation of the worksheet

Answer 19

enter ledger account titles and balances in the account title and unadjusted trial balance columns = columns 1 and 2

enter the necessary adjusting entries in the adjustment columns = columns 3 and 4

prepare an adjusted trial balance

extend every account balance listed in the columns to its proper financial statement column = columns 5 and 6

total the two income statement columns and the two balance sheet columns = columns 7 and 8

calculate the difference between the totals of the two income statement columns and enter this as a balancing amount in both the income statement and balance sheet = columns 9 and 10

calculate the four column totals again with the balancing amount included

Question 20

completed worksheet

Answer 20

used to prepare the financial statements

can be used as a basis for journalising adjusting and closing entries