Week 3| Accrual accounting concepts Flashcards
What are time issues for accounting?
Accounting divides the economic life of a business into artificial time periods ( a month, a quarter, a half a year, a year)
Since many business transactions affect one or more of these arbitrary time periods, it is necessary to determine the significance of these transactions on each accounting periods
e.g A company purchases a machine that will be used for many years. It doesn’t make good sense to expense the full amount of the machine at the time it is purchased as it will be used for many subsequent period
What is cash based accounting?
revenue recorded only when the cash is received
expense recorded only when cash is paid
However, this is not suitable for businesses who conduct their business mainly under credit, because the statement of profit or loss under cash based accounting wouldn’t reflect the current activities that relate to the current period
What is accrual based accounting?
Records the transactions in the current periods they occur rather than recording it when the company received the cash or when they pay the cash
What can revenue be defined as? What about the operating cycle and
Revenue: The increase of economic benefits that arise due to the ordinary activities of the business
The operating cycle is the length of time it takes for a business to acquire goods, sell them to customers and collect the cash from sales
The recognition criteria for elements of financial statements are helpful in ‘determining’ when to record amounts
When should revenue be recognised? What were financial statement users worried about?
- It is probable that any future economic benefits associated with the revenue will flow to the company
- Revenue can be measured with reliability
The probability of future economic benefit from revenue is assessed at the time that the transaction occurs
The concept of reliable estimation of the outcome of the transaction captures both the reliability of measurement of the revenue and the probability that the associated economic benefits will accrue to the entity as established in the conceptual framework
Financial statement users were concerned how there wasn’t a robust principle for when to recognise revenue
This resulted in many inconsistencies in the application of the current standards on revenue recognition
To establish a new 5 step model framework standard for the revenue recognition criteria, what were the five steps?
- Identify the contracts with a customer:
A contract must be approved by both parties consisting of their rights in regards to the goods and services as well as the terms for payments - Identify the performance obligation in the contract
It could consist of either a distinct G or S or a series of distinct G or S that are delivered overtime but are substantially the same and have the same pattern of transfer over time
e.g. magazine subscription or cleaning service - Determine the transaction price
transfer price the entity expects to receive based on past experience with the customer, net of discounts, rebates or refunds - allocate the transaction price to the performance obligation in the contract
- Recognise revenue when the entity satisfies the performance obligation
What are expenses and when do we recognise them?
Expenses are decreases in economic benefits and they arise in ordinary everyday activities of the business. The term losses refer to the expenses such as the loss from a fine flood as well as decrease in economic benefits reported on a net basis
Expense should only be recognised when:
1. There is a probable outflow of economic benefit from the business
2. The expense can be measured with high reliability
What are the adjusting entries? What are the types of adjusting entries?
Adjusting entries are needed to ensure that the recognition criteria are followed for assets, liabilities, revenues and expenses
Types of adjusting entries:
1. Prepayments (deferrals)
a) prepaid expense: Amounts paid in cash and is recorded as assets until the economic benefit is consumed or used
b) Revenue received in advance: Amounts received from customers and is recorded in liabilities until the service is performed or the good is provided
- Accruals
a) accrued revenue: Amounts not yet received and not yet recorded for which the goods or service has been acquired
b) accrued expenses: Amounts not yet paid and not yet recorded for which the consumption of economic benefit has occurred
What happens when a prepaid expense occurs?
- when this occurs an asset account is increased to show the service or benefit that will be received in the future
- prepaid expenses will expire as the service is provided with the passage of time (like rent or insurance) or by usage ( supplies)
- expirations of these benefits aren’t recorded daily, only recorded when the financial statements are prepared
- At the end of a recording period, adjusting entries are made to record the expenses applicable to the current accounting period and to show remaining amounts in the assets account
- Before adjustments, assets are overstated and expenses are understated
- Therefore, an adjusting entry for prepaid expenses will result in an increase in expenses and decrease in assets etc
What happens to the expense recognition of supplies, insurance and depreciation?
supplies expense:
- are usually recognised at the end of the reporting period
- At the end of the period, the entity counts the remaining supplies. The difference between the unadjusted supplies (assets) and the remaining supplies is recorded as the supplies expense
insurance expense:
- insurance must be paid in advance
- insurance payments made in advance are recorded as prepaid insurance as an asset account
At the end of this period:
- increase insurance expense
- Decrease prepaid expense by the amount of insurance used up in that period
Depreciation:
process of allocating the cost of an asset to expense over its useful life
depreciation is a matter of cost allocation, not valuation
according to expense recognition criteria, a portion of this cost should then be reported as expense during each period of the asset’s useful life
What would happen to revenue received in advance?
Cash received before the revenue recognition criteria has been met is recorded by increasing a liability account under the name of revenues received in advance
When payments are received for future services, a revenue received in advance account should be credited to recognise the obligation that exists
Before adjustments, liabilities are overstated and revenue is understated
Therefore, an adjusting entry for revenue received in advance will lead to a decrease in liability account and an increase in the revenue account
What would occur with adjusting entries for accruals?
Accrued revenue:
Before adjustments, both assets and revenues are understated
Accordingly, an adjusting entry for accrued revenue would result in an increase for the assets and revenue account
Accrued expense:
Expense not yet recorded or paid at the end of the reporting period are called accrued expenses
Before adjustment, both liabilities and expenses are understated
Therefore, an adjusting entry will create an increase in the liability and expense account
What is closing the books?
- since revenues, dividends and expense relate to a specific accounting period. They are considered temporary accounts
- in contrast all accounts related to the financial position statement are al permanent accounts, since their amounts are carried forward to the future accounting periods
How do you prepare closed entries?
Closing entries recorded in the ledger the transfer of profits and dividends to retained earnings
accordingly, the expense and revenue account are closed to another temporary account, profit or loss summary and only the resulting profit and loss is transferred from this account to retained earnings
How would you prepare a post-closing trial balance?
After journalising and posting, another trial balance, called a post closing trial balance, is prepared from the ledger
It is a list of all permanent accounts and their balances after closing entries are journalised and posted
