Chapter 4: Income measurement and accrual accounting Flashcards
What is the meaning of the following statement? The choice between historical cost and current value is a good example of the trade-offs in accounting that must sometimes be made.
As an example, in deciding whether or not an asset that a company pledges as collateral for a loan is sufficient, a banker may be most interested in the current value of the asset. The accountant, however, may be reluctant to present the current value of the asset on the balance sheet because of the difficulty in measuring the value of the asset. Because of its objective nature, historical cost is the attribute used to measure many of the assets recognized on the balance sheet.
A realtor earns a 10% commission on the sale of a $150,000 home. The realtor lists the home on June 5, the sale occurs on June 12, and the seller pays the realtor the $15,000 commission on July 8. When should the realtor recognize revenue from the sale assuming (a) the cash basis of accounting and (b) the accrual basis of accounting?
The realtor will recognize revenue from the sale of the home on July 8 if the cash basis is used because this is the date cash is received. Revenue will be recognized on June 12 if the accrual basis is used because this is the date the sale takes place and the realtor has performed his or her obligation.
Is it necessary for an asset to be acquired when revenue is recognized? Explain your answer.
No, the recognition of revenue is not always the result of the acquisition of an asset. For instance, assume that a publisher sells a magazine subscription and collects cash from the customer in advance. At the time cash is collected, the publisher incurs a liability. As each month’s magazine is mailed to the customer, a portion of the liability is satisfied and revenue is recognized.
A friend says to you: “I just don’t get it. Assets cost money. Expenses reduce income. There must be some relationship among assets, costs, and expenses—I’m just not sure what it is!” What is the relationship? Can you give an example of it?
A company incurs a cost when it acquires an asset. For example, assume that a retailer buys office supplies for $100 on October 21. On this date, it has incurred a cost of $100 to acquire an asset, namely office supplies. The asset will be removed from the records and an expense recognized, namely office supplies expense, when the supplies are used up.
Give the two possible attributes to be measured when an item is to be included in financial statements? What unit of money is used to measure items in the United States?
The two possible attributes are historical cost and current value. The simplest approach is to show an item such as an asset at its original cost, thus the designation historical cost. An alternative to historical cost as the attribute to be measured is current value. Current value is the amount of cash or its equivalent that could be received currently from the sale of the asset. Current value is not as simple and often not as easy to get agreement upon. The dollar is the unit of money used in the United States to measure items.
Explain whether a company must have an inflow of an asset to be able to recognize revenue. Give two examples of situations in which revenue is recognized continuously over a period of time.
It is not necessary for there to be an inflow of an asset in order to recognize revenue. For example, revenue can be recognized when a company provides a service for which it had earlier received a deposit. The deposit represents a liability, and it is satisfied when the service is provided. Revenue is recognized continuously over a period of time for both rent and interest.
Assume that a company purchases merchandise for resale on December 20, 2016. The merchandise is still on hand on December 31, the company’s year-end. On January 12, 2017, the merchandise is sold to a customer. Explain how the merchandise will be treated on any of the financial statements at year-end. In which year will revenue from the sale be recorded? In which year will cost of goods sold expense be recorded?
The merchandise will be reported on the December 31, 2016, balance sheet as a current asset. Revenue from the sale, along with cost of goods sold expense, will be recorded in 2017, the year in which the merchandise is sold.
Give an example of each of the four basic types of adjusting entries.
To recognize the expired portion of a prepaid expense. For example, an adjusting entry is needed at the end of each month to recognize insurance expense for the portion of an insurance policy that has expired during the period.
To recognize a portion of a deferred revenue or liability. For example, a publisher has to make an adjusting entry at the end of each period to recognize the expired portion of a subscription.
To recognize expense at the end of the period before cash is paid. For example, an adjusting entry is made at the end of the year to recognize income tax expense, even though the taxes will not be paid until early in the following year.
To recognize revenue at the end of the period before cash is received. For example, a landlord will need to make an adjusting entry at the end of the month for the rent owed by a tenant but not payable until some time during the following month.
What are the rules of debit and credit as they apply to the contra-asset account Accumulated Depreciation?
An asset account is increased with a debit. Accumulated Depreciation is a contra-asset account. Therefore, it is increased with a credit.
Which of the following steps in the accounting cycle requires the most thought and judgment by the accountant: (a) preparing a trial balance, (b) posting adjusting and closing entries, or (c) analyzing and recording transactions? Explain your answer.
The preparation of a trial balance and the posting of adjusting and closing entries are purely mechanical in nature. In fact, these steps are normally performed by the computer. On the other hand, the analysis of transactions requires analytical skill. The accountant must consider all the available evidence and make a determination as to which accounts should be debited and credited and what amounts to use in recording a transaction. As is the case with posting, the actual recording of the transaction can be performed by the computer.
What two purposes are served in making closing entries?
Closing entries are made at the end of an accounting period. They have two important purposes: (1) to return the balance in all temporary or nominal accounts (revenues, expenses, and dividends) to zero to start the next accounting period and (2) to transfer the net income (or net loss) and the dividends of the period to Retained Earnings.
Why is the Dividends account closed directly to Retained Earnings rather than to the Income Summary account?
The Dividends account is closed directly to Retained Earnings because it is not an expense and therefore is not an income statement account. Because it does not appear on an income statement, it is not closed through the Income Summary account, but instead directly to Retained Earnings.
One asset account will always be carried over from the unadjusted trial balance columns of a work sheet to the balance sheet columns of the work sheet without any adjustment. What account is this?
Cash is always carried over from the unadjusted trial balance columns of the work sheet to the balance sheet columns without any adjustment. This is simply because Cash is never debited or credited in an adjusting entry.
