Question

***Please Answer Quickly***

Info:

Scenario A:

Daniel bought a brand-new truck for his landscaping business. He paid $30,000, the full amount up front. Assuming there is no salvage value, he plans to use it for 10 consecutive years. His assistant records this transaction on the balance sheet as equipment for $30,000 on the day of the purchase. He had expensed the whole amount on the day of purchase.

After two years of owning his truck, Daniel decided to apply for a loan and met with Mr. Thompkins, the bank loan officer. A few minutes into the appointment, Daniel gave him his company's balance sheet. Mr. Thompkins asked Daniel several questions about how the information was provided. Daniel said he would contact him in a few days with the requested information. Daniel claimed that he was using GAAP. Help Daniel to answer the loan officer's questions.

QUESTIONS:

Scenario A

What is the effect of this transaction on the related equipment accounts in year one and year two?

Does he need to make any adjusting entries? Explain why or why not.

What would be the effect of making adjusting entries on the financial statements?

Why do you think GAAP recognizes accrual-based accounting and not cash based accounting? What are its benefits?

How would accrual-based accounting help them better manage their business?

If you set up your own small business, should you use cash accounting or accrual accounting? Why?

Answer 1

As per GAAP and accrual basis of accounting in simple there can be two type of expenditure viz. Revenue expenditure and Capital Expenditure. Those expenses who's economic benefit is not long term i.e. it does not flow to subsequent accounting periods can be expensed out in Profit and loss fully in the same year, however for other expenditure who's economic benefit can be dervied in later years as well, expenditure is recognized as asset in balance sheet and subsequently the asset is charged to expense based on its useful life or any other basis.

In the given case daniel bought a brand new truck and is willing to use it for next 10 years, hence as per GAAP the cost paid to acquire truck i.e. $ 30K can not be recognized in first year as it will lead to incorrect reporting of profits as expenditure being capital in nature.

Truck must be recognized as an asset and must be depreciaated over 10 years.

Below are the answers to specific questions asked above :-

Equipment cost in year one will be reflect huge amount i.e. $ 30k, where as equipment cost in year 2 will be reflected as "0" which will show incorrect picture of profit and loss account.

Yes, Daniel shall reclassify the truck as asset, and should make calculations from retrospective effect and must give effect in current year so that books will show correct figures from current year onward. Example of above working is as below:-

Reverse the entry in which asset is expensed out, by doing so profit will increase by $ 30K after which calculate and pass below journals

Amount of asset = 30K, Useful life = 10 years, Salvage value =0, hence depreciation per year = 3000 (30k/10years)

Therefore he must recognize asset in third year at $ 24K, and must show depreciation as $ 6K as expense and in each subsequent accounting period must expense out $ 3K.

By making this adjustment entries, assets in the books will be recognized correctly And also accurate profits will be reflected in financial statements.

Accrual Based accounting appropriately recognizes expense in the period to which the same relates irrespective of actual incurring of those expeneses. Accrual basis ensures Consistancy and correct reporting, it restricts manipulation of financial statements and also its helps in arriving on True and Fair view of statements of accounts.

However, in case of small business where there are not much transactions and transactions happen on cash only i.e. pre recognition of income and expense is not possible then only cash accounting is recommended. However in all other cases where it is possible to seggregate and relate transactions with accounting periods, accrual method of accounting to be followed.