Basic Concepts and Accrual Accounting

Question 1

What are the five different attributes used to measure assets and liabilities?

Answer 1

SFAC5 discusses these attributes:
Historical cost
Current cost
Current market value
Net realizable (settlement) value
Amortized cost
Present (or discounted) value of future cash flows

Question 2

Explain historical cost and provide examples of assets/liabilities measured at historical cost.

Answer 2

Historical cost is the amount of cash or cash equivalents paid to acquire an asset. Liabilities are reported at historical proceeds. Ex. - PPE, Inventory

Question 3

Explain current cost and provide examples of assets/liabilities measured at current cost.

Answer 3

Current (or replacement) cost is the amount of cash or its equivalent, that would have to be paid if the same or equivalent assets were acquired currently. Ex. - Inventory

Question 4

Explain current market value and provide examples of assets/liabilities measured at current market value.

Answer 4

The amount of cash or its equivalent that could be obtained by selling an asset in an orderly liquidation. Also known as fair value. Ex. - Investments in marketable securities

Question 5

Explain net realizable (settlement) value and provide examples of assets/liabilities measured at net realizable value.

Answer 5

The non discounted amount of cash, or cash equivalent, into which an asset is expected to be converted in due course of business less direct costs. Also, liabilities that involve known estimated amounts of monies payable at a future date. Ex. - Short-term receivables, trade payables, warranty obligations

Question 6

Explain present (or discounted) value of future cash flows and provide examples of assets/liabilities measured at present value of future cash flows.

Answer 6

Long-term receivables are reported at their present or discounted value of their future cash inflows. Long-term payables are reported at their present or discounted value of their future cash outflows.

Question 7

What are the key components of the external financial report?

Answer 7

Income statement
Statement of comprehensive income
Balance sheet
Statement of changes in owners' equity
Statement of cash flows
Footnote disclosures and supplementary schedules
Auditor's opinion

Question 8

What is a deferred revenue? Give an example of a deferred revenue. Is this an asset or liability?

Answer 8

Cash is received before revenue is earned.

Prepaid Rent, Prepaid subscriptions, Gift certificates.

Liability

Question 9

In a revenue transaction, what is an accrued asset? Give an example of an accrued asset.

Answer 9

Revenue is earned before cash is received.

Sales on account (A/R), Interest, Rent

Question 10

What is the formula for converting accrual basis to cash basis?

Answer 10

Δ cash = Δ liabilities + Δ equity - Δ other assets

Question 11

What is the formula for converting cash basis to accrual basis?

Answer 11

Δ cash = - Δ liabilities + Δ equity + Δ other assets

Question 12

What is the going concern assumption? When is the assumption inapplicable? What implications does this have?

Answer 12

The going concern assumption means that a company will have a long life. A company is in imminent failure. The historical cost principle would be of little usefulness. Depreciation, amortization, current /noncurrent assets all lose their significance. Net realizable value should be used.

Question 13

What is the fundamental quality of relevance? What are the ingredients of relevance?

Answer 13

Relevant accounting information must be capable of making a difference in a decision. Relevant information has both predictive value (provide information about the future) and confirmatory value (confirm or correct expectations).

Question 14

What is the fundamental quality of faithful representation? What are the ingredients of faithful representation?

Answer 14

Faithful representation means that the numbers and descriptions match what really existed or happened. Faithful representation has information that is complete (all information is provided), neutral (information is unbiased), and free from error (information is accurate).

Question 15

What are the enhancing qualitative characteristics of accounting information that distinguish more-useful information from less useful information?

Answer 15

Comparability (information that is reported in a similar manner for different companies), Verifiability (independent measurers obtain similar results), Timeliness (having information available to decision-makers), and Understandability (quality of information that allows reasonably informed users see the significance).

Question 16

What is the difference between real and nominal accounts? Give examples of real accounts and nominal accounts.

Answer 16

A real account is a permanent account that is never closed. Real accounts show on the balance sheet. Examples include assets, liabilities, equity accounts. A nominal account is a temporary account. Companies periodically close nominal accounts. Examples include revenue, expenses, and dividend accounts.

Question 17

What is the difference between the general ledger and the subsidiary ledger?

Answer 17

The general ledger is a collection of all the asset, liability, owners’ equity, revenue, and expenses accounts. A subsidiary ledger contains the details related to a given general ledger account. For example, Accounts Receivable shows the account balance in the general ledger. The Accounts Receivable subsidiary ledger shows all of the individual transactions for each customer that leads to the A/R balance in the general ledger.

Question 18

What is the difference between the adjusted trial balance and the post-closing trial balance?

Answer 18

The trial balance taken immediately after all adjustments have been posted is called an adjusted trial balance. A trial balance taken immediately after closing entries have been posted is called a post-closing trial balance.

Question 19

What are adjusting entries?

Answer 19

Adjusting entries are made at the end of an accounting period to bring all accounts up to date on an accrual basis. Adjusting entries are either deferrals or accruals.

Question 20

What are closing entries?

Answer 20

The process where nominal accounts are reduced to zero and the net income or net loss is determined and transferred to the owners’ equity account.

Question 21

What are the normal balances for asset accounts, expense accounts, liability accounts, stockholder equity accounts, and revenue accounts? How are each increased and decreased?

Answer 21

Normal balance debit accounts include asset and expense accounts. Normal balance credit accounts include liability, equity accounts, and revenue accounts. Increases for normal balance debit accounts occur on the debit side, decreases on the credit side. Increases for normal balance credit accounts occur on the credit side, decreases on the debit side. A company increases stockholders’ equity accounts, such as Common Stock and Retained Earnings on the credit side, but increases Dividends on the debit side.

Question 22

What is the expanded basic accounting equation?

Answer 22

Assets = Liabilities + Stockholders’ Equity (Common Stock + Retained Earnings - Dividends) + Net Income ( Revenues - Expenses)

Question 23

List the different effects of the following transactions on owners’ equity accounts for proprietorships/partnerships and corporations. Investments, revenues earned, expenses incurred, and withdrawals by owners.

Answer 23

Investment: Increases capital account or common stock
Revenue: Increases capital account or retained earnings
Expense: Decreases capital account or retained earnings
Withdrawal: Decreases capital account or retained earnings

The nominal accounts (revenue, expense, drawing or dividends) are closed to capital or retained earnings.

Question 24

Why does a trial balance not prove that a company recorded all transactions or that the ledger is correct?

Answer 24

Numerous errors may exist even though the trial balance may agree. For example, a transaction may not have been journalized, a journal entry may not have been posted, a journal entry may have been posted twice, incorrect amounts may have been used in journaling or posting, or making offsetting errors in recording the amount of the transaction.

Question 25

What are the two types of deferral adjusting entries? What happens if a company does not make adjustments for these deferrals?

Answer 25

Prepaid expenses - expenses paid in cash and recorded as assets before they are used or consumed. Without adjusting entries, the asset, stockholders’ equity, and net income are overstated and expenses are understated.

Unearned revenues - revenues received in cash and recorded as liabilities before they are earned. Without adjusting entries, the liability is overstated, stockholders’ equity, net income, and revenues are understated.

An adjusting entry for a deferral will decrease a balance sheet account and increase an income statement account.

Question 26

What are the two types of accrual adjusting entries? What happens if a company does not make adjusting entries for these accruals?

Answer 26

Companies make adjusting entries for accruals to record unrecognized revenues earned and unrecognized expenses incurred.

Accrued revenues - revenues earned but not yet received in cash or recorded. Without adjusting entries, assets, stockholders’ equity, net income and revenues are understated.

Accrued expenses - expenses incurred but not yet paid in cash or recorded. Without adjusting liabilities and expenses are understated and stockholders’ equity and net income are overstated.

Adjusting entries for accruals will increase a balance sheet account and an income statement account.

Question 27

What is a contra-asset account. Give two examples with the related expense accounts and the related asset accounts.

Answer 27

A contra-asset account offsets an asset account on the balance sheet.

Accumulated depreciation is a contra-asset account which offsets the Equipment account on the balance sheet. Its normal balance is a credit. The related expense account is depreciation expense.

Allowance for doubtful accounts is a contra-asset account which offsets the Accounts Receivable account on the balance sheet. Its normal balance is a credit. The related expense account is Bad debt expense.

Question 28

What is the formula for determining accrued interest?

Answer 28

Face value of note x annual interest rate x time in terms of one year = interest

Question 29

What three aspects of financial reporting does GAAP address?

Answer 29

Recognition - A recognized item is recorded in an account and eventually affects the financial statements.

Measurement - Concerns the dollar amount assigned to an item.

Disclosure - Many unrecognized amounts are reported in the footnotes to complete the portrayal of the firm’s financial position and performance.

Question 30

What do financial statements help users assess about a company?

Answer 30

Financial statements help users assess an entity’s liquidity, financial flexibility, profitability, and risk.

Question 31

What do the following terms mean?
Realization
Recognition
Allocation
Matching

Answer 31

Realization - process of converting non cash resources and rights into money; refers to sales of assets for cash or claims to cash. (Realized - identifies revenues or gains or losses on assets sold; Unrealized - identifies revenues or gains or losses on assets unsold).

Recognition - process of formally recording an item in the financial statements.

Allocation - process of assigning or distributing an amount according to a plan or formula.

Matching - simultaneous recognition of revenues with expenses which are related directly or jointly to the same transaction or events.

Question 32

What is comprehensive income?

Answer 32

The change in equity of an entity during a period from transactions and other events of non-owner sources (i.e.: all equity amount changes except investment and distributions). In other words, comprehensive income excludes changes in equity resulting from investments and distributions.

Question 33

Name the first five elements from SFAC 6 that are directly related to measuring performance and status of an entity.

Answer 33

Assets - Probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.

Liabilities - Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

Equity or net assets - is the residual interests in the assets of an entity that remains after deducting its liabilities. In a business enterprise the equity is the ownership interest.

Investments - by owners are increases in equity of a particular business enterprise resulting from transfers to it from other entities of something valuable to obtain or increase ownership interests (or equity) in it.

Distributions - to owners are decreases in equity of a particular business enterprise resulting from transferring assets, rendering services, or incurring liabilities by the enterprise to owners.

Question 34

Name the second five elements from SFAC 6 that are directly related to measuring performance and status of an entity.

Answer 34

Comprehensive income - is the change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.

Revenues - are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.

Expenses - are outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.

Gains - are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.

Losses - are decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners.

Question 35

What does realization mean?

Answer 35

The process of converting non cash resources and rights into money; refers to sales of assets for cash or claims to cash.

Question 36

What does recognition mean? What criteria should be met?

Answer 36

The process of formally recording an item in financial statements. It should be an element as defined in SFAC 6, item can be measured, the item is relevant in that it has the capacity to make a difference in users’ decisions, and reliability - the item is representationally faithful, verifiable, and neutral.

Question 37

What does SFAC 5 say a full set of financial statements should include?

Answer 37

Financial position at end of period
Earnings for period
Comprehensive income for period
Cash flows for period
Investments by and distributions to owners during period

Question 38

According to SFAC 5, what do the financial statements help users’ assess about an entity?

Answer 38

The entity’s liquidity, financial flexibility, profitability, and risk.

Question 39

What is the financial capital maintenance concept?

Answer 39

The objective is to maintain purchasing power. A return is achieved only after capital has been maintained or recovered.

Question 40

When are revenues and gains recognized?

Answer 40

Generally not recognized until realizable (readily convertible to known amounts of cash or claims to cash) and earned.

Question 41

What are the four accounting assumptions?

Answer 41

Entity assumption - There is a separate accounting entity for each business unit.

Going concern assumption - A business is assumed to have an indefinite life.

Unit of measure assumption - Monetary unit measurement basis, price level changes are not accounted for. Financial capital maintenance is assumed (return of capital and return on capital).

Time period assumption - Breaking the indefinite life of an entity into smaller reporting periods (timeliness is emphasized over reliability).

Question 42

What are the four accounting principles?

Answer 42

Measurement - There are multiple ways in which assets and liabilities are valued including historical cost, net realizable value, current replacement cost, fair value, amortized cost, and net present value.

Revenue recognition - Revenue is recognized when it is earned and realizable.

Expense recognition - Recognize expenses only when expenditures help to produce revenues. Some are directly matched, while others are allocated (depreciation and amortization) or recognized during the period incurred (SG&A).

Full disclosure - Financial statements should present all information needed by an informed reader to make an economic decision.

Question 43

What is the equation for accounts receivable?

Answer 43

Beginning A/R Balance + Sales - Collections - Write-offs = Ending A/R Balance

Question 44

What is the equation for inventory?

Answer 44

Beginning Inventory + Purchases - Ending Inventory = Cost of Goods Sold

Question 45

What is the equation for supplies?

Answer 45

Beginning Supplies + Purchases - Ending Inventory = Supplies Expense

Question 46

What is the equation for accounts payable?

Answer 46

Beginning A/P Balance + Purchases on Account - Payments on Account = Ending A/P Balance

Question 47

What is the order of classification of accounts on the statements of financial position (balance sheet)?

Answer 47

Assets - Order of decreasing liquidity
Liabilities - Order of maturity
Owners’ Equity - Order of permanence

Question 48

What are current assets?

Answer 48

Assets that are in the form of cash or will be converted to cash or consumed within one year or the operating cycle of the business, whichever is longer. Examples:
Cash, Cash Equivalents, Accounts Receivable, Short-term Investments, Inventory, and Prepaid Assets

Question 49

What are current liabilities?

Answer 49

Liabilities that are due in the upcoming year or in the operating cycle of the business, whichever is longer, and that will be met through the transfer of a current asset or the creating of another current liability. Examples: Accounts Payable, Wages Payable, Income Tax Payable, Unearned Revenues, Warranty Liability, Current Portion of Long-Term Debt

Question 50

What are long-term assets and liabilities?

Answer 50

These are determined by exclusion, essentially assets or liabilities that do not meet the criteria for current assets or current liabilities. Examples: Long-Term Investments, Plant Assets, Deferred Charges, Intangible Assets, Notes and Bonds Payable, Mortgages Payable

Question 51

What are cash equivalents?

Answer 51

Cash equivalents are short-term investments that are convertible into a known and fixed amount of cash; and have an original maturity to the purchaser of three months or less.

Question 52

What are the three categories of cash flows on the Statement of Cash Flows?

Answer 52

Operating - Those cash flows related to transactions that flow through the income statement. Cash inflows include receipts from customers and interest. Cash outflows include payments to suppliers, to employers, and to taxing authorities.

Investing - Those cash flows related to the acquisition and disposal of long-term assets and investments (other than cash equivalents and trading securities – these are operating). Investing cash outflows include purchases of plant assets and investments. Cash inflows include proceeds from the sale of these items.

Financing - Cash flows related to the liabilities and owners’ equity sections of the balance sheet. Financing cash inflows include issuing debt and equity securities. Cash outflows include retirement of debt and equity securities, and dividend payments.

Question 53

How are installment sales recognized? When can installment sales accounting be used?

Answer 53

Revenue is recognized as cash is collected. Installment sales accounting can only be used where “collection of the sale price is not reasonably assured”.

Gross profit is deferred to future periods and recognized proportionately to collection of the receivables.

Installment receivables and deferred gross profit accounts must be kept separate by year, because the gross profit rate usually varies from year to year.

Question 54

What is the cost-recovery method of revenue recognition? When is it used?

Answer 54

The cost recovery method is similar to the installment sales method in that gross profit on the sale is deferred. The difference is that no profit is recognized until the cumulative receipts exceed the cost of the asset sold.

If interest revenue was to be earned by the seller, it would likewise be deferred until the entire cost was recovered.

The cost recovery method is used when the uncertainty of collection is so great that even use of the installment method is precluded.

Question 55

How are the following items measured?:
Long-term receivables
Available for sale securities
Equipment
Warranty obligations
Short-term payables
Accounts receivable
Bonds-payable, due in 10 years
Trading securities

Answer 55

Long-term receivables:
present value of future cash flows

Available for sale securities:
Current market value

Equipment:
Historical cost or historical proceeds

Warranty Obligations:
Net realizable value or settlement rate

Short-term payables:
Historical cost or historical proceeds

Accounts receivable:
Net realizable value or settlement rate

Bonds payable, due in ten years:
Present value of future cash flows

Trading securities:
Current market value