Question

Chapter Four: Accrual Accounting Concepts

1. What is the difference between the cash basis of accounting and the accrual basis of accounting?

2. What kinds of companies use the accrual basis of accounting?

3. What is the revenue recognition principle?

4. What is the expense recognition principle?

5. Why are adjusting journal entries (adjustments) made?

6. What are unexpired costs? What are expired costs? What causes a cost to become expired?

7. On which financial statement does one find unexpired costs? On which financial statements does one find expired costs?

8. Describe the (1) two categories of and (2) four types of adjusting journal entries. What is one example of each?

9. What is the specific impact on the financial statement account categories (assets, liabilities, equity, revenues, and expenses) if the corporate accountant does not prepare adjusting journal entries for depreciation and amortization?

10. What happens to the financial statements when corporations engage in earnings management?

11. What is the process of “closing the books”?

12. What are the differences between temporary (nominal) and permanent accounts?

13. What is the difference between (1) Revenues and Gains; between (2) Expenses and losses?

14. Which of the trial balances is used to prepare the financial statements?

Answer 1

1. The cash basis and accrual basis of accounting are two different methods used to record accounting transactions. The key difference between the two methods is in the timing of recognition of transactions.

• Cash basis: Revenue is recorded when cash is received from customers, and expenses are recorded when cash is paid to suppliers and employees. If goods are sold on account, revenue would be recognized only once collections are made. Therefore, the concept of Bad Debt Expense is alien to the cash method. If a payment of $ 2,400 is made for an insurance coverage for the next 12 months, the entire amount of $ 2,400 would be recognized as a insurance expense in the period the payment is made. Therefore, the concept of Prepaid Expense is also not there in the cash basis.
• Accrual basis: Revenue is recorded when earned, and expenses are recorded when costs are consumed. When goods are sold on account, revenue would be recorded as soon as the invoice is made, regardless of when the proceeds are actually collected. If a payment of $ 2,400 is made for insurance coverage for the next 12 months, the amount would be initially recorded as a Prepaid Expense.

2. According to the Internal Revenue Service, to be eligible for the cash method, a C corporation or partnership must have average annual gross receipts no greater than $5 million for every year of business.The average annual amount is computed by adding the gross receipts for the current and previous two years, then dividing by three.For proprietorships and S corporations, the maximum average gross receipts cannot exceed $1 million in order to qualify for cash method of accounting. Certain exceptions apply. For example, a family-owned farm can use cash accounting if gross receipts were no greater than $25 million for each prior tax year after 1985. Additionally, several types of closely held personal service corporations can use cash accounting regardless of size.

All other businesses are required to use the accrual method of accounting.

3. Th revenue recognition principle states that revenue should be recognized and recorded only when it is earned, and not when the related cash is received. Revenue is earned when the significant risks and rewards of ownership to the goods have passed from the seller to the buyer, or when the services have been performed, and no uncertainty exists as to the future realization of the proceeds.

4. As per the expense recognition principle, expenses should be recorded when they are incurred, and in the same period as the revenues to which they relate.

5. The adjusting entries are required to be made at the end of each accounting period in order to convert cash method of accounting to accrual method of accounting. If the adjustments were not recorded, profits would either be overstated or understated, and assets and liabilities would also be either overstated or understated.

6. Unexpired cost is any cost that has not yet been charged to expense because it still represents some residual value. This cost is frequently associated with revenue that has not yet been recognized; under the matching principle, an unexpired cost is maintained on the books as an asset until the associated revenue is recognized, at which point the asset is charged to expense. Examples of unexpired costs are: Prepaid Expenses, Book Values of Tangible and Intangible Assets, Deferred Revenue Expenses, Ending Balances of Inventories etc.

An expired cost is a cost that has been recognized as an expense. This happens when the business consumes or receives benefit from a cost in the course of generating revenues. Examples: Insurance Expense, Salaries Expense, Advertising Expense, Depreciation Expense.

7. Unexpired costs are found on the Balance Sheet, while expired costs would be found on the Income Statement.