Chapter 3 Flashcards
Explain the sequence of financial transactions that occur continuously during an accounting time period. What is this sequence of activities called?
The sequence of financial transactions that occurs continuously during an accounting time period is called the operating cycle. OperaƟons begin with some cash on hand. The cash is
used to purchase supplies and pay expenses while revenue is being generated. When revenue is earned, cash is collected, beginning the cycle over again. While some transacƟons
are being completed, others are only beginning.
Do you have to wait until the operating cycle is complete before you can measure income using the accrual basis of accounting?
No, the operating cycle does not have to be complete before income can be measured. Revenue can be recorded as earned when the product is sold or the service performed regardless of whether cash is collected. To measure income, expenses must be matched to revenues or the relevant time period. This usually can be done whether or not the operating cycle is complete.
What is the relationship between the matching concept and accrual accounting? Are revenues matched to expenses, or are expenses matched to revenues? Does it matter one way or the other?
Accrual accounting matches expenses to revenues for a particular time period. The accrual method is the basis on which accounts are adjusted to reach this objective. Under this method, expenses are matched to the revenues during the period that the revenues are generated. The revenue recognition assumption helps determine when revenues are earned, thus allowing expenses to be matched to these revenues. Revenues are not generally matched to expenses by convention. The rationale is that revenues are recognized before expenses; therefore expenses should be matched to revenues.
What is the impact of the going concern concept on accrual accounting?
Under the going concern concept, it is assumed that operating cycles that are incomplete at the end of financial periods will be completed during the (assumed) unlimited life of the entity. Since accountants must prepare financial statements even though operating cycles are incomplete, accrual accounting techniques are employed to more accurately measure economic activity during a given time period.
Identify three different categories of expenses
5.
a. The cost of goods that are transferred to customers (such as items sold); these expenses can be matched to revenue generated relatively easily.
b. The cost of assets only partially consumed during the time period like trucks and equipment; these expenses are as easily matched with revenue.
c. Some expenses incurred during the accounting period are not easily identified with revenue generated, such as salaries of administrative staff.
These are matched to the period in which they are incurred, rather than to related revenue.
What are adjusting entries and why are they required?
Adjusting entries are changes made at the end of an operating cycle to more accurately reflect economic activity during the period. For instance, depreciation is calculated on plant and equipment assets and charged to the income statement.
Why are asset accounts like Prepaid Insurance adjusted? How are they adjusted?
At the end of the accounting period, an accountant must determine the amount of future benefits (assets like Prepaid Insurance) that belong on the balance sheet and how much should be recorded in the income statement (as Insurance Expense, in this example). The appropriate amounts must be transferred by means of adjusting entries.
What is a contra account and why is it used?
A contra account is used to reduce the value of a related balance sheet item. For instance, the account Accumulated Depreciation-Equipment is credited by the amount of depreciation expense recorded each year. The balance in this account is netted against the related account (Equipment, in this example) so that the asset is shown at carrying amount on the balance sheet.
How are plant and equipment asset accounts adjusted? Is the procedure similar to the adjustment of other asset and liability accounts at the end of an accounting period?
Plant and equipment accounts and are handled differently than other asset accounts. The expired portion of the cost of such an asset is estimated based on its useful life and recorded as depreciation expense. This requires no cash outlay, despite being an expense. Plant and equipment asset accounts themselves are not reduced by the depreciation expense; rather, a contra asset account is set up in order to show a reduced balance on the balance sheet.
How are liability accounts like Unearned Repair Revenue adjusted?
At the end of the accounting period, the amount of the liability that belongs on the balance sheet must be determined. The account balance is adjusted through the use of an adjusting entry to the related revenue account (Repair Revenue, in this example).
The expense recognition principle (also referred to as the matching principle)
The expense recognition principle (also referred to as the matching principle) states that we must match expenses with associated revenues in the period in which the revenues were earned. A mismatch in expenses and revenues could be an understated net income in one period with an overstated net income in another period. There would be no reliability in statements if expenses were recorded separately from the revenues generated.
For example, if Lynn earned printing revenue in April, then any associated expenses to the revenue generation (such as paying an employee) should be recorded on the same income statement. The employee worked for Lynn in April, helping her earn revenue in April, so Lynn must match the expense with the revenue by showing both on the April income statement.
The _______________________ is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (GAAP), for both public- and private-sector businesses in the United States.
The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (GAAP), for both public- and private-sector businesses in the United States.
Cost Principal
The cost principle, also known as the historical cost principle, states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition. For most assets, this value is easy to determine as it is the price agreed to when buying the asset from the vendor. There are some exceptions to this rule, but always apply the cost principle unless FASB has specifically stated that a different valuation method should be used in a given circumstance.
Full disclosure principle
The full disclosure principle states that a business must report any business activities that could affect what is reported on the financial statements. These activities could be nonfinancial in nature or be supplemental details not readily available on the main financial statement.
Example of full disclosure principal?
Some examples of this include any pending litigation, acquisition information, methods used to calculate certain figures, or stock options. These disclosures are usually recorded in footnotes on the statements, or in addenda to the statements.
Separate Entity Concept
**The separate entity concept prescribes that a business may only report activities on financial statements that are specifically related to company operations, not those activities that affect the owner personally. This concept is called the separate entity concept because the business is considered an entity separate and apart from its owner(s).
For example, Lynn Sanders purchases two cars; one is used for personal use only, and the other is used for business use only. According to the separate entity concept, Lynn may record the purchase of the car used by the company in the company’s accounting records, but not the car for personal use.**
Conservatism
**This concept is important when valuing a transaction for which the dollar value cannot be as clearly determined, as when using the cost principle.
Conservatism states that if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount. This would mean that any uncertain or estimated expenses/losses should be recorded, but uncertain or estimated revenues/gains should not.
This understates net income, therefore reducing profit. This gives stakeholders a more reliable view of the company’s financial position and does not overstate income.**
