GAAP and Accrual Accounting Flashcards
Roro, Inc. paid $7,200 to renew its only insurance policy for three years on March 1, 2005, the effective date of the policy. At March 31, 2005, Roro’s unadjusted trial balance showed a balance of $300 for prepaid insurance and $7,200 for insurance expense.
What amounts should be reported for prepaid insurance and insurance expense in Roro’s financial statements for the three months ended March 31, 2005?
The $300 of prepaid insurance on March 31 before adjustment represents the remaining unexpired portion of the insurance policy before renewal. This amount must have expired by March 31 because there is only one insurance policy, and that policy was renewed March 1. The $300 is included in insurance expense for the three months ended March 31. In addition, one month of coverage has been used on the renewed policy as of March 31. Therefore $7,200/36 months or $200 is included in insurance expense for the three months ended March 31. In total, $500 of insurance expense is recognized. Prepaid insurance remaining at March 31 is $7,200 - $200 = $7,000.
At December 31, 2000, Ashe Co. had a $990,000 balance in its advertising expense account before any year-end adjustments relating to the following:
Radio advertising spots broadcast during December 2000 were billed to Ashe on January 4, 2001. The invoice cost of $50,000 was paid on January 15, 2001. Included in the $990,000 is $60,000 for newspaper advertising for a January 2001 sales promotional campaign.
Ashe’s advertising expense for the year ended December 31, 2000, should be:
Preadjusted balance
$990,000
Plus radio advertising (benefit was received in 2000;
the expense should be recognized in 2000)
50,000
Less the newspaper advertising (benefit to be received in 2001; there is no expense in 2000)
(60,000)
Equals advertising expense, 2000
$980,000
Ina Co. had the following beginning and ending balances in its prepaid expense and accrued liabilities accounts for the current year:
Prepaid expenses Accrued liabilities Beginning balance $ 5,000 $ 8,000 Ending balance 10,000 20,000
Debits to operating expenses totaled $100,000. What amount did Ina pay for operating expenses during the current year?
An increase in prepaid expenses indicates that more cash was paid than expensed (5,000). An increase in accrued liabilities indicates that more expense was accrued than paid (12,000). The reconciliation of operating expense to cash paid is: 100,000 + 5,000 - 12,000 = 93,000.
In analyzing a company’s financial statements, which financial statement would a potential investor use primarily to assess the company’s liquidity and financial flexibility?
The Balance Sheet discloses the assets and liabilities, usually classified by proximity to realization (assets) or payment (liabilities). The balance shows the relative magnitude of assets and liabilities and, therefore, the ability to pay obligations in the near and longer term. It also shows the degree of leverage and ability to adapt to changing financial conditions as well as the ability to manage future cash flows when conditions change. Much of the potential of the firm is disclosed in the Balance Sheet. It is a statement of the wealth position of the firm and allows an assessment of the relative risk of the enterprise.
Before 2001, Droit Co. used the cash basis of accounting. As of December 31, 2001, Droit changed to the accrual basis. Droit cannot determine the beginning balance of supplies inventory.
What is the effect of Droit’s inability to determine beginning supplies inventory on its 2001 accrual basis net income and December 31, 2001, accrual basis owners’ equity?
Supplies expense for 2001 under the accrual method is: supplies expense = beginning supplies + purchases - ending supplies. If beginning supplies cannot be determined, then it is assumed to be zero and supplies expense is understated, causing 2001 income to be overstated. However, total supplies expense for the entire life of the business is unaffected by the inability to determine beginning supplies for 2001. Total supplies expense for the life of the business is total purchases less ending inventory in 2001. These two amounts are determinable, and thus, owners’ equity at the end of 2001 can be determined.
On November 1, 2005, Key Co. paid $3,600 to renew its insurance policy for three years. At December 31, 2005, Key’s unadjusted trial balance showed a balance of $90 for prepaid insurance and $4,410 for insurance expense.
What amounts should be reported for prepaid insurance and insurance expense in Key’s December 31, 2005, financial statements?
Prepaid insurance at year end is $3,400, which is the portion of the prepayment on November 1 that continues to the next three years. Of the 36 months of coverage purchased, 34 months remain at December 31: $3,400 = (34/36)($3,600). Insurance expense includes three items: (1) the $90 of prepaid insurance remaining in the trial balance that has expired, (2) the $200 of insurance expense related to the November 1 purchase above ($3,600-$3,400 remaining prepaid), and (3) the expense portion of the $4,410 insurance expense amount in the unadjusted trial balance ($4,410-$3,600) = $810. This firm must have expensed the entire $3,600 November 1 purchase because it was not reflected in prepaid insurance. The difference of $810 reflects actual expense. Therefore, total insurance expense equals $1,100 = $90 + $200 + $810.
Bird Corp.’s trademark was licensed to Brian Co. for royalties of 15% of the sales of the trademarked items. Royalties are payable semiannually on March 15 for sales in July through December of the prior year, and on September 15 for sales in January through June of the same year.
Bird received the following royalties from Brian:
March 15 September 15 2004 $5,000 $7,500 2005 6,000 8,500
Brian estimated that the sales of the trademarked items would total $30,000 for July through December 2005.
In Bird’s 2005 Income Statement, the royalty revenue should be:
2005 royalty revenue is the amount earned in 2005, regardless of when it is received. The September receipt of $8,500 accounts for the royalties earned the first half of 2005. Royalties for the second half are estimated to be .15($30,000) = $4,500. Although this is an estimate, if reliable, it provides relevant information. Waiting for the exact amount is not justified in this case. The small increase in reliability does not justify postponing recognition in 2005. Thus, total royalty revenue for 2005 is $13,000, which equals $8,500 + $4,500.
Compared to the accrual basis of accounting, the cash basis of accounting overstates income by the net increase during the accounting period of the
An increase in accounts receivable reflects recognized but uncollected sales. The accrual method recognizes these sales as earnings, causing income to exceed cash-basis income for such sales. Thus cash-basis income is understated relative to accrual-basis accounting. The opposite is true for an increase in accrued expenses. The increase in the liability reflects recognized but unpaid expenses. The accrual method recognizes these expenses in earnings, causing income to decrease relative to cash-basis income. Thus, cash-basis income is overstated, relative to accrual-basis accounting.
Reid Partners, Ltd., which began operations on January 1, 2003, has elected to use cash-basis accounting for tax purposes and accrual-basis accounting for its financial statements.
Reid reported sales of $175,000 and $80,000 in its tax returns for the years ended December 31, 2004 and 2003, respectively. Reid reported accounts receivable of $30,000 and $50,000 in its Balance Sheets as of December 31, 2004 and 2003, respectively.
What amount should Reid report as sales in its Income Statement for the year ended December 31, 2004?
When converting from cash-basis sales to accrual-basis sales, sales must be adjusted for the net change in accounts receivable. There has been a net decrease in receivables of $20,000 over the course of the year from $50,000 to $30,000. Thus, accrual sales would decline by $20,000 as compared to cash sales (which included the additional receivables collected). Therefore, this response of $155,000 ($175,000-$20,000) is correct.
In financial statements prepared on the income-tax basis, how should the nondeductible portion of expenses, such as meals and entertainment, be reported?
Despite the fact that these expenses are not deductible for tax purposes, they are still business expenses and need to be included in the determination of income on the financial statements. In addition, the income tax return requires information on the total meals and entertainment expense in order to calculate the deductible amount.
A company has the following accrual-basis balances at the end of its first year of operation:
Unearned consulting fees $2,000
Consulting fees receivable 3,500
Consulting fee revenue 25,000
The company’s cash-basis consulting revenue is what amount?
Cash-basis revenue is the amount of cash collected for the period. $25,000 of accrual-basis revenue was recognized for the period. Start with the $25,000 amount, and add the $2,000 unearned fees. This amount is not included in the $25,000 because it is not earned but was collected during the period. Subtract the $3,500 receivable, which is included in the $25,000 but was not collected. The result is that $23,500 in cash was collected ($25,000 + $2,000 - $3,500).
