Chapter 15 Flashcards
Accrual Accounting
determining pro t by recognising revenues as earned when the good/ service is provided, and expenses as incurred when the bene t is consumed
Balance day adjustment
a change made to a revenue or expense on balance day to show revenues earned and expenses incurred in a particular reporting period
Prepaid expense
an expense that has been paid but is yet to be consumed
How are prepaid expenses classified
Yet at the time the rent (or insurance, advertising, rates etc) is paid, none has been consumed. In fact, it will not be consumed until some time in the future, so it is not a consumption of an economic bene t, but rather a future economic bene t. In other words, at the time the rent is paid, it is actually for the puchase of an asset.
What is the need for balance day adjustments
to ensure that profit can be calculated accurately, by comparing revenues earned against expenses incurred in the current reporting period.
Use an accounting principle and qualitative characteristic to show why balance day adjustments are necessary
Balance day adjustments apply the Reporting Period principle to ensure Relevance in the accounting reports. That is, by adjusting the gures so that they show revenue earned and expenses incurred in the current reporting period, we are ensuring that the Income Statement (and for that matter, the Balance Sheet) includes all information which is useful for decision making, while excluding information which is not (such as revenue or expenses which were earned or incurred outside the current period).
4 common balance day adjustments and when are they made
• • • •
stock losses and gains
prepaid expenses
accrued expenses
depreciation expense.
These balance day adjustments must be made before the reports are prepared.
Accrued expenses
an expense that has been incurred but not yet paid
Finite life
the limited period of time (usually measured in years) for which a non-current asset will exist
Depreciable asset
a non-current asset which has a finite life, and thus must be depreciated over that life
Depreciation
the allocation of the cost of a non-current asset over its useful life.
Depreciation expense
that part of the cost of a non-current asset which has been consumed in the current reporting period.
Depreciation expense formula
Depreciation expense ($ per annum) =
(HC less RV)/Life
Historical cost
the original purchase price of the non-current asset
Residual value
the estimated value of the non-current asset at the end of its useful life
Useful life
the estimated period of time for which the non-current asset will be used (by the current entity) to earn revenue. (This is usually measured in years)
Depreciable value
the total value of the asset that will be consumed by the current entity, and so must be allocated over its useful life
Depreciable expense
the value of a non-current asset which has been consumed in the current reporting period
Accumulated depreciation
the value of a non- current asset that has been consumed over its life so far
Carrying value
the value of a non- current asset that is yet to be consumed/
allocated as an expense, plus any residual value
Use a qualitative characteristic to show why the carrying value is necessary
The carrying value is calculated by deducting any accumulated depreciation from the
Historical Cost of the asset. It represents the value of the asset that is yet to be consumed – and thus yet to be allocated as depreciation expense – plus any residual value. Once the asset is depreciated the Historical Cost of the asset is less useful for decision-making than the carrying value: the carrying value is thus a more Relevant valuation to report in the Balance Sheet.
Relevance vs reliability in regards to estimating residual and carrying values.
One of the key issues in calculating depreciation is estimating the asset’s residual value and useful life; without these estimates, depreciation cannot be calculated. However, because the residual value and useful life are estimates, using them in the calculation of depreciation means that the reports will not be free from bias, and to some extent this will undermine the Reliability of the accounting reports.
The obvious question then arises: why depreciate non-current assets if we are undermining a key Qualitative Characteristic? The answer lies in a different Qualitative Characteristic: Relevance. Depreciation ensures that the Income Statement includes all information that is useful for decision-making (about pro t) by showing the consumption of non-current assets in the current reporting period. Similarly, by showing accumulated depreciation in the Balance Sheet, it ensures that assets are shown at their carrying value, which is more useful for decision-making about their replacement. In this sense, Relevance overrides Reliability so that the accounting reports ful l their function of providing useful nancial information.
