195accountingprinciplesqsas20answersincludedtillpagesareliked-131206072927-phpapp01 (1).pdf

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195 Accounting

Principles Questions& Answers

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198 Accounting Principles Questions &

Answers

1. What is a capital expenditure versus a revenue expenditure?

A capital expenditure is an amount spent to acquire or improve a long-term

asset such as equipment or buildings. Usually the cost is recorded in an

account classified as Property, Plant and Equipment. The cost (except for the

cost of land) will then be charged to depreciation expense over the useful life

of the asset.

A revenue expenditure is an amount that is expensed immediately—thereby

being matched with revenues of the current accounting period. Routine

repairs are revenue expenditures because they are charged directly to an

account such as Repairs and Maintenance Expense. Even significant repairs

that do not extend the life of the asset or do not improve the asset (the repairs

merely return the asset back to its previous condition) are revenue

expenditures.

2. What is owner's equity?

Owner's equity is one of the three main components of a sole proprietorship's

balance sheet and accounting equation. Owner's equity represents the

owner's investment in the business minus the owner's draws or withdrawals

from the business plus the net income (or minus the net loss) since the

business began.

Mathematically, the amount of owner's equity is the amount of assets minus

the amount of liabilities. Since the amounts must follow the cost principle (and

others) the amount of owner's equity does not represent the current fair

market value of the business.

Owner's equity is viewed as a residual claim on the business assets because

liabilities have a higher claim. Owner's equity can also be viewed (along with

liabilities) as a source of the business assets.

3. What is absorption costing?

Absorption costing means that all of the manufacturing costs are absorbed by

the units produced. In other words, the cost of a finished unit in inventory will

include direct materials, direct labour, and both variable and fixed

manufacturing overhead. As a result, absorption costing is also referred to as

full costing or the full absorption method.

Absorption costing is often contrasted with variable costing or direct costing.

Under variable or direct costing, the fixed manufacturing overhead costs are








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www.SoftSkillsExperts.co.uk not allocated or assigned to (not absorbed by) the products manufactured.

Variable costing is often useful for management's decision-making. However,

absorption costing is required for external financial reporting and for income

tax reporting.

4. What is the double declining balance method of depreciation?The double declining balance method of depreciation, also known as the

200% declining balance method of depreciation, is a common form of

accelerated depreciation. Accelerated depreciation means that an asset will

be depreciated faster than would be the case under the straight line method.

Although the depreciation will be faster, the total depreciation over the life of

the asset will not be greater than the total depreciation using the straight line

method. This means that the double declining balance method will result in

greater depreciation expense in each of the early years of an asset's life and

smaller depreciation expense in the later years of an asset's life as compared

to straight line depreciation.

Under the double declining balance method, double means twice or 200% of

the straight line depreciation rate. Declining balance refers to the asset's book

value or carrying value at the beginning of the accounting period. Book value

is an asset's cost minus its accumulated depreciation. The asset's book value

will decrease when the contra asset account Accumulated Depreciation is

credited with the depreciation expense of the accounting period.

Let's illustrate double declining balance depreciation with an asset that is

purchased on January 1 at a cost of £100,000 and is expected to have nosalvage value at the end of its useful life of 10 years. Under the straight line

method, the 10 year life means the asset's annual depreciation will be 10% of

the asset's cost. Under the double declining balance method the 10% straight

line rate is doubled to be 20%. However, the 20% is multiplied times the

asset's beginning of the year book value instead of the asset's original cost. At

the beginning of the first year, the asset's book value is £100,000 since there

has not yet been any depreciation recorded. Therefore, under the double

declining balance method the £100,000 of book value will be multiplied by

20% for depreciation in Year 1 of £20,000. The journal entry will be a debit of

£20,000 to Depreciation Expense and a credit to Accumulated Depreciation of£20,000.

At the beginning of the second year, the asset's book value will be £80,000.

This is the asset's cost of £100,000 minus its accumulated depreciation of

£20,000. The £80,000 of beginning book value multiplied by 20% results in

£16,000. The depreciation entry for Year 2 will be a debit to Depreciation

Expense for £16,000 and a credit to Accumulated Depreciation for £16,000.

At the beginning of Year 3, the asset's book value will be £64,000. This is the








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www.SoftSkillsExperts.co.uk asset's cost of £100,000 minus its accumulated depreciation of £36,000

(£20,000 + £16,000). The book value of £64,000 X 20% = £12,800 of

depreciation expense for Year 3.

At the beginning of Year 4, the asset's book value will be £51,200. This is the

asset's cost of £100,000 minus its accumulated depreciation of £48,800(£20,000 + £16,000 + £12,800). The book value of £51,200 X 20% = £10,240

of depreciation expense for Year 4.

As you can see, the amount of depreciation expense is declining each year.

Over the remaining six years there can be only £40,960 of additional

depreciation. This is the asset's cost of £100,000 minus its accumulated

depreciation of £59,040. Some people will switch to straight line at this point

and record the remaining £40,960 over the remaining 6 years in equal

amounts of £6,827 per year. Others may choose to follow the original formula.

5. What is a contingent liability?

A contingent liability is a potential liability...it depends on a future event

occurring or not occurring. For example, if a parent guarantees a daughter's

first car loan, the parent has a contingent liability. If the daughter makes her

car payments and pays off the loan, the parent will have no liability. If the

daughter fails to make the payments, the parent will have a liability.

If a company is sued by a former employee for £500,000 for age

discrimination, the company has a contingent liability. If the company is found

guilty, it will have a liability. However, if the company is not found guilty, thecompany will not have an actual liability.

In accounting, a contingent liability and the related contingent loss are

recorded with a journal entry only if the contingency is both probable and the

amount can be estimated.

If a contingent liability is only possible (not probable), or if the amount cannot

be estimated, a journal entry is not required. However, a disclosure is

required.

When a contingent liability is remote (such as a nuisance suit), then neither a

journal nor a disclosure is required.

6. What is the difference between the cash basis and the accrual basis of

accounting?

Under the cash basis of accounting...

1. Revenues are reported on the income statement in the period in which the

cash is received from customers.








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www.SoftSkillsExperts.co.uk 2. Expenses are reported on the income statement when the cash is paid out.

Under the accrual basis of accounting...

1. Revenues are reported on the income statement when they are earned---

which often occurs before the cash is received from the customers.

2. Expenses are reported on the income statement in the period when they

occur or when they expire---which is often in a period different from when the

payment is made.

The accrual basis of accounting provides a better picture of a company's

profits during an accounting period. The reason is that the income statement

prepared under the accrual basis will report all of the revenues actually

earned during the period and all of the expenses incurred in order to earn the

revenues.

The accrual basis of accounting also provides a better picture of a company's

financial position at a moment or point in time. The reason is that all assets

that were earned are reported and all liabilities that were incurred will be

reported.

The accrual basis of accounting is required because of the matching principle.

7. What is the difference between an implicit cost and an explicit cost?

An implicit cost is a cost that has occurred but it is not initially shown orreported as a separate cost. On the other hand, an explicit cost is one that

has occurred and is clearly reported as a separate cost. Below are some

examples to illustrate the difference between an implicit cost and an explicit

cost.

Let's assume that a company gives a promissory note for £10,000 to

someone in exchange for a unique used machine for which the fair value is

not known. The note will come due in three years and it does not specify any

interest. Due to the company's weak financial position it will have to pay a

high interest rate if it were to borrow money. In this example, there is noexplicit interest cost. However, due to the issuer's financial difficulty and the

seller having to wait three years to collect the money, there has to be some

interest cost. In other words, there is some interest and it is implicit. To

properly record the note and the machine, the accountant must determine the

amount of the interest, which is known as imputing the interest. In effect the

accountant must convert the implicit interest to explicit interest. This is done

by discounting the £10,000 by using the interest rate that the issuer of the

note would have to pay to another lender. If the rate is 12% per year, the

interest that was implicit in the note is £2,880 and the principal portion of the

note is the remaining £7,120.








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www.SoftSkillsExperts.co.uk If another company with the same financial condition purchased this unique

machine by issuing a £7,120 note with a stated interest rate of 12% per year,

the interest cost of £2,880 would be explicit. In this situation, there is no need

to impute the interest.

Another example of an implicit cost is the opportunity cost of a sole proprietorworking in her own business. For example, Gina works as a sole proprietor

and her business reported a net income of £30,000 for the year. Since a sole

proprietor does not receive a salary or wages, there is no explicit cost

reported for Gina's work in her business. However, if Gina is foregoing a

salary of £40,000 from another company, that is an implicit cost for her

business. After considering this implicit cost, Gina is losing £10,000 by

working in her proprietorship.

If Gina operates her business as a corporation, Gina will be an employee of

the corporation. If her annual salary is £40,000 the corporation's incomestatement would report the £40,000 salary as an explicit cost for Gina's work.

8. How do you calculate accrued vacation pay?

Accrued vacation pay is the amount of vacation pay which has been earned

by the employee but has not yet been paid to the employee.

To illustrate accrued vacation time and accrued vacation pay let's assume that

the employee's contract guarantees 120 hours of paid vacation time per year

(40 hour work week times 3 weeks). If the employee's hourly pay rate is £26

per hour, the employee is earning vacation pay of £3,120 per year (120 hoursx £26), or £60 per week (£3,120 per year divided by 52 weeks). The company

is also incurring vacation pay expense and a liability of £60 per week. In terms

of vacation time, the employee is earning 2.31 hours of vacation time each

week (120 hours per year divided by 52 weeks per year) or 2.45 hours based

on 120 hours divided by the 49 weeks not on vacation.

At December 31 the company has a liability for the vacation hours and

vacation pay that the employee has earned and is entitled to if the company

were to close. If the employee has worked 20 weeks since the employee's

anniversary date with the company and the last vacation payment, then thecompany should report a current liability of £1,200 (20 weeks x £60 per

week.)

9. What is capitalized interest?

Capitalized interest is the interest added to the cost of a self-constructed,

long-term asset. It involves the interest on debt used to finance the asset's

construction.








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www.SoftSkillsExperts.co.uk The details of capitalized interest are explained in the Financial Accounting

Standards Board's (FASB) Statement of Financial Accounting Standards No.

34, Capitalization of Interest Cost. You can find this accounting

pronouncement at www.FASB.org/st.

In short, there must be debt involved (cash and common stock are notconsidered). The interest specified by the pronouncement is added to the cost

of the project, instead of being expensed on the current period's income

statement. This capitalized interest will be part of the asset's cost reported on

the balance sheet, and will be part of the asset's depreciation expense that

will be reported in future income statements.

10. What are accrued expenses and when are they recorded?

Accrued expenses are expenses that have occurred but are not yet recorded

through the normal processing of transactions. Since these expenses are not

yet in the accountant's general ledger, they will not appear on the financialstatements unless an adjusting entry is entered prior to the preparation of the

financial statements.

Here is an example. A company borrowed £200,000 on December 1. The

agreement requires that the £200,000 be repaid on February 28 along with

£6,000 of interest for the three months of December through February. As of

December 31 the company will not have an invoice or payment for the interest

that the company is incurring. (The reason is that all of the interest will be due

on February 28.)

Without an adjusting entry to accrue the interest expense that the company

has incurred in December, the company's financial statements as of

December 31 will not be reporting the £2,000 of interest (one-third of the

£6,000) that the company has incurred in December. In order for the financial

statements to be correct on the accrual basis of accounting, the accountant

needs to record an adjusting entry dated as of December 31. The adjusting

entry will consist of a debit of £2,000 to Interest Expense (an income

statement account) and a credit of £2,000 to Interest Payable (a balance

sheet account).

11. What is the difference between product costs and period costs?

A manufacturer's product costs are the direct materials, direct labour, and

manufacturing overhead used in making its products. (Manufacturing

overhead is also referred to as factory overhead, indirect manufacturing costs,

and burden.) The product costs of direct materials, direct labour, and

manufacturing overhead are also "inventorial" costs, since these are the

necessary costs of manufacturing the products.

Period costs are not a necessary part of the manufacturing process. As a








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www.SoftSkillsExperts.co.uk result, period costs cannot be assigned to the products or to the cost of

inventory. The period costs are usually associated with the selling function of

the business or its general administration. The period costs are reported as

expenses in the accounting period in which they 1) best match with revenues,

2) when they expire, or 3) in the current accounting period. In addition to the

selling and general administrative expenses, most interest expense is aperiod expense.

12. Is there a difference between an expense and an expenditure?

An expense is reported on the income statement. An expense is a cost that

has expired, was used up, or was necessary in order to earn the revenues

during the time period indicated in the heading of the income statement. For

example, the cost of the goods that were sold during the period are

considered to be expenses along with other expenses such as advertising,

salaries, interest, commissions, rent, and so on.

An expenditure is a payment or disbursement. The expenditure may be for the

purchase of an asset, a reduction of a liability, a distribution to the owners, or

it could be an expense. For instance, an expenditure to eliminate a liability is

not an expense, while expenditures for advertising, salaries, etc. will likely be

recorded immediately as expenses.

Here's another example to illustrate the difference between an expense and

an expenditure. A company makes an expenditure of £255,500 to purchase

equipment. The expenditure occurs on a single day and the equipment is

placed in service. Assuming the equipment will be used for seven years, thecost of the equipment will be reported as depreciation expense of £100 per

day for the next 2,555 days (7 years of service with 365 days each year).

13. What are accruals?

Accruals are adjustments for 1) revenues that have been earned but are not

yet recorded in the accounts, and 2) expenses that have been incurred but

are not yet recorded in the accounts. The accruals need to be added via

adjusting entries so that the financial statements report these amounts.

An example of an accrual for revenue involves your electric utility company.The utility used coal and many employees in December to generate electricity

that customers received in December. However, the utility doesn't bill the

electric customers for the December electricity until the meters are read in

January. To have the proper amounts on the utility's financial statements,

there needs to be an adjusting entry to increase revenues that were earned in

December and the receivables that the utility has a right to as of December

31.

An example of an accrual involving an expense is an employee's bonus that








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www.SoftSkillsExperts.co.uk was earned in 2012, but will not be paid until 2013. The 2012 financial

statements need to reflect the bonus expense and the bonus liability.

Therefore, prior to issuing the 2012 financial statements an adjusting entry is

prepared to record this accrual.

14. What is the difference between accounts payable and accrued expensespayable?

I would use the liability account Accounts Payable for suppliers' invoices that

have been received and must be paid. As a result, the balance in Accounts

Payable is likely to be a precise amount that agrees with supporting

documents such as invoices, agreements, etc.

I would use the liability account Accrued Expenses Payable for the accrual

type adjusting entries made at the end of the accounting period for items such

as utilities, interest, wages, and so on. The balance in the Accrued Expenses

Payable should be the total of the expenses that were incurred as of the dateof the balance sheet, but were not entered into the accounts because an

invoice has not been received or the payroll for the hourly wages has not yet

been processed, etc. The amounts recorded in Accrued Expenses Payable

will often be estimated amounts supported by logical calculations.

15. What is the difference between financial accounting and management

accounting?

Financial accounting has its focus on the financial statements which are

distributed to stockholders, lenders, financial analysts, and others outside of

the company. Courses in financial accounting cover the generally acceptedaccounting principles which must be followed when reporting the results of a

corporation's past transactions on its balance sheet, income statement,

statement of cash flows, and statement of changes in stockholders' equity.

Managerial accounting has its focus on providing information within the

company so that its management can operate the company more effectively.

Managerial accounting and cost accounting also provide instructions on

computing the cost of products at a manufacturing enterprise. These costs will

then be used in the external financial statements. In addition to cost systems

for manufacturers, courses in managerial accounting will include topics suchas cost behaviour, break-even point, profit planning, operational budgeting,

capital budgeting, relevant costs for decision making, activity based costing,

and standard costing.

16. How do you report a write-down in inventory?

A write-down in a company's inventory is recorded by reducing the amount

reported as inventory. In other words, the asset account Inventory is reduced

by a credit. The debit in the entry to write down inventory is reported in an








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www.SoftSkillsExperts.co.uk account such as Loss on Write-Down of Inventory, an income statement

account.

If the amount of the Loss on Write-Down of Inventory is relatively small, it can

be reported as part of the cost of goods sold. If the amount of the Loss on

Write-Down of Inventory is significant, it should be reported as a separate lineon the income statement.

Since the amount of the write-down of inventory reduces net income, it will

also reduce the amount reported as owner's or stockholders' equity. Hence for

the balance sheet and in the accounting equation, the asset inventory is

reduced and the owner's or stockholders' equity is reduced.

17. What are prepaid expenses?

Prepaid expenses are future expenses that have been paid in advance. You

can think of prepaid expenses as costs that have been paid but have not yetbeen used up or have not yet expired.

The amount of prepaid expenses that have not yet expired are reported on a

company's balance sheet as an asset. As the amount expires, the asset is

reduced and an expense is recorded for the amount of the reduction. Hence,

the balance sheet reports the unexpired costs and the income statement

reports the expired costs. The amount reported on the income statement

should be the amount that pertains to the time interval shown in the

statement's heading.

A common prepaid expense is the six-month premium for insurance on a

company's vehicles. Since the insurance company requires payment in

advance, the amount paid is often recorded in the current asset account

Prepaid Insurance. If the company issues monthly financial statements, its

income statement will report Insurance Expense that is one-sixth of the

amount paid. The balance in the account Prepaid Insurance will be reduced

by the amount that was debited to Insurance Expense.

18. Why is depreciation on the income statement different from the

depreciation on the balance sheet?Depreciation on the income statement is the amount of depreciation expense

that is appropriate for the period of time indicated in the heading of the income

statement. The depreciation reported on the balance sheet is the accumulated

or the cumulative total amount of depreciation that has been reported as

expense on the income statement from the time the assets were acquired

until the date of the balance sheet.

Let's illustrate the difference with an example. A company has only one

depreciable asset that was acquired three years ago at a cost of £120,000.








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www.SoftSkillsExperts.co.uk The asset is expected to have a useful life of 10 years and no salvage value.

The company uses straight-line depreciation on its monthly financial

statements. In the asset's 36th month of service, the monthly income

statement will report depreciation expense of £1,000. On the balance sheet

dated as of the last day of the 36th month, accumulated depreciation will be

reported as £36,000. In the 37th month, the income statement will report£1,000 of depreciation expense. At the end of the 37th month, the balance

sheet will report accumulated depreciation of £37,000.

19. How do I compute the units of production method of depreciation?

The units of production method of depreciation is based on an asset's usage,

activity, or parts produced instead of the passage of time. Under the units of

production method, depreciation during a given year will be very high when

many units are produced, and it will be very low when only a few units are

produced.

To illustrate the units of production method, let's assume that a production

machine has a cost of £500,000 and its useful life is expected to end after

producing 240,000 units of a component part. The salvage value at that point

is expected to be £20,000. Under the units of production method, the

machine's depreciable cost of £480,000 (£500,000 minus £20,000) is divided

by 240,000 units, resulting in depreciation of £2 per unit. If the machine

produces 10,000 parts in the first year, the depreciation for the year will be

£20,000 (£2 x 10,000 units). If the machine produces 50,000 parts in the next

year, its depreciation will be £100,000 (£2 x 50,000 units). The depreciation

will be calculated similarly each year until the asset's AccumulatedDepreciation reaches £480,000.

The units of production method is also referred to as the units of activity

method, since the method can be used for depreciating airplanes based on air

miles, cars on miles driven, photocopiers on copies made, DVDs on number

of times rented, and so on.

Depreciation is an allocation technique and the units of production method

might do a better job of allocating/matching an asset's cost to the proper

period than the straight-line method, which is based solely on the passage oftime.

20. What is the difference between stocks and bonds?

Stocks, or shares of stock, represent an ownership interest in a corporation.

Bonds are a form of long-term debt in which the issuing corporation promises

to pay the principal amount at a specific date.

Stocks pay dividends to the owners, but only if the corporation declares a








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www.SoftSkillsExperts.co.uk dividend. Dividends are a distribution of a corporation's profits. Bonds pay

interest to the bondholders. Generally, the bond contract requires that a fixed

interest payment be made every six months.

Every corporation has common stock. Some corporations issue preferred

stock in addition to its common stock. Many corporations do not issue bonds.

The stocks and bonds issued by the largest corporations are often traded on

stock and bond exchanges. Stocks and bonds of smaller corporations are

often held by investors and are never traded on an exchange.

21. What is the difference between net cash flow and net income?

Under the accrual method of accounting, net income is calculated as follows:

revenues earned minus the expenses incurred in order to earn those

revenues. If a company earns revenues in December but allows those

customers to pay in 30 days, the cash from the December revenues will likelybe received in January. In this situation the December revenues will increase

the December net income, but will not increase the company's December net

cash flow.

Under accrual accounting, expenses are matched to the accounting period

when the related revenues occur or when the costs have expired. For

example, a retailer may have purchased and paid for merchandise in October.

However, the merchandise remained in inventory until it was sold in

December. The company's net cash flow decreases in October when the

company pays for the merchandise. However, net income decreases inDecember when the cost of the goods sold is matched with the December

sales.

There are many other examples of expenses occurring in one accounting

period but the payments occur in a different accounting period.

In short, the statement of cash flows is a needed financial statement because

the income statement does not report cash flows.

22. What are the effects of depreciation?The depreciation of assets such as equipment, buildings, furnishing, trucks,

etc. causes a corporation's asset amounts, net income, and stockholders'

equity to decrease. This occurs through an accounting adjusting entry in

which the account Depreciation Expense is debited and the contra asset

account Accumulated Depreciation is credited.

The amount of the annual depreciation that is reported on the financial

statements is an estimate based on the asset's 1) cost, 2) estimated salvage








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www.SoftSkillsExperts.co.uk value, and 3) useful life. Depreciation should be thought of as an allocation of

the asset's cost to expense (and not as a valuation technique). In other words,

the accountant is matching the cost of the asset to the periods in which

revenues are generated from the asset.

The amount of the annual depreciation reported on the U.S. income tax returnis based on the tax regulations. Since depreciation is a deductible expense for

income tax purposes, the corporation's taxable income (and associated tax

payments) will be reduced by its tax depreciation expense. (In any one year,

the depreciation expense for taxes will likely be different from the amount

reported on the financial statements.)

It should be noted that depreciation is viewed as a noncash expense. That is,

the corporation's cash balance is not changed by the annual depreciation

entry. (Often the corporation's cash is reduced for the asset's entire cost at

the time the asset is acquired.)

23. What is interest expense?

Interest expense is the cost of debt that has occurred during a specified

period of time.

To illustrate interest expense under the accrual method of accounting, let's

assume that a company borrows £100,000 on December 15 and agrees to

pay the interest on the 15th of each month beginning on January 15. The loan

states that the interest is 1% per month on the loan balance. The interest

expense for the month of December will be approximately £500 (£100,000 x1% x 1/2 month). The interest expense for the month of January will be

£1,000 (£100,000 x 1%).

Since interest on debt is not paid daily, a company must record an adjusting

entry to accrue interest expense and to report interest payable. Using our

example above, at December 31 no interest was yet paid on the loan that

began on December 15. However, the company did incur one-half month of

interest expense. Therefore, the company needs to record an adjusting entry

that debits Interest Expense £500, and credits Interest Payable for £500.

24. Where does revenue received in advance go on a balance sheet?

Revenues received in advance are reported as a current liability if they will be

earned within one year. The accounting entry is a debit to the asset Cash for

the amount received and a credit to the liability account such as Customer

Advances or Unearned Revenues.

As the amount received in advance is earned, the current liability account will

be debited for the amount earned and the Revenues account reported on the

income statement will be credited. This is done through an adjusting entry.








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www.SoftSkillsExperts.co.uk 25. What is the deferred revenue?

Deferred revenue is not yet revenue. It is an amount that was received by a

company in advance of earning it. The amount unearned (and therefore

deferred) as of the date of the financial statements should be reported as a

liability. The title of the liability account might be Unearned Revenues or

Deferred Revenues.

When the deferred revenue becomes earned, an adjusting entry is prepared

that will debit the Unearned Revenues or Deferred Revenues account and will

credit Sales Revenues or Service Revenues.

26. What are goods in transit?

Goods in transit refers to merchandise and other inventory items that have

been shipped by the seller, but have not yet been received by the purchaser.

To illustrate goods in transit, let's use the following example. Company J shipsa truckload of merchandise on December 30 to Customer K, which is located

2,000 miles away. The truckload of merchandise arrives at Customer K on

January 2. Between December 30 and January 2, the truckload of

merchandise is goods in transit. The goods in transit requires special attention

if the companies issue financial statements as of December 31. The reason is

that the merchandise is the inventory of one of the two companies, but the

merchandise is not physically present at either company. One of the two

companies must add the cost of the goods in transit to the cost of the

inventory that it has in its possession.

The terms of the sale will indicate which company should report the goods in

transit as its inventory as of December 31. If the terms are FOB shipping

point, the seller (Company J) will record a December sale and receivable, and

will not include the goods in transit as its inventory. On December 31,

Customer K is the owner of the goods in transit and will need to report a

purchase, a payable, and must add the cost of the goods in transit to the cost

of the inventory which is in its possession.

If the terms of the sale are FOB destination, Company J will not have a sale

and receivable until January 2. This means Company J must report the cost ofthe goods in transit in its inventory on December 31. (Customer K will not

have a purchase, payable, or inventory of these goods until January 2.)

27. What is the accrual basis of accounting?

Under the accrual basis of accounting, revenues are reported on the income

statement when they are earned. (Under the cash basis of accounting,

revenues are reported on the income statement when the cash is received.)

Under the accrual basis of accounting, expenses are matched with the related

revenues and/or are reported when the expense occurs, not when the cash is








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www.SoftSkillsExperts.co.uk paid. The result of accrual accounting is an income statement that better

measures the profitability of a company during a specific time period.

For example, if I begin an accounting service in December and provide

£10,000 of accounting services in December, but don't receive any of the

money from the clients until January, there will be a difference in the incomestatements for December and January under the accrual and cash bases of

accounting. Under the accrual basis, my income statements will show

£10,000 of revenues in December and none of those services will be reported

as revenues in January. Under the cash basis, my December income

statement will show no revenues. Instead, the December services will be

reported as January revenues under the cash method.

There will be a difference on the balance sheet, too. Under the accrual basis,

the December balance sheet will report accounts receivable of £10,000 and

the estimated true profit will be added to owner's equity or retained earnings.Under the cash basis, the £10,000 of accounts receivable will not be reported

as an asset, and the true profit will not be included in owner's equity or

retained earnings.

To illustrate a difference in expenses, we will assume that the heat and light

expense that I used in my accounting service is metered by the utility on the

last day of the month. The utilities that I used in December will appear on a bill

that I receive in January and will pay on February 1. Under the accrual basis

of accounting, the utilities that I used in December will be estimated and will

be reported as an expense and a liability on the December financialstatements. Under the cash basis of accounting, the utilities used in

December will be recorded as an expense on February 1, when the utility bills

are paid.

For financial statements prepared in accordance with generally accepted

accounting principles, the accrual method is required because of the matching

principle.

28. What is materiality?

In accounting, the concept of materiality allows you to violate anotheraccounting principle if the amount is so small that the reader of the financial

statements will not be misled.

A classic example of the materiality concept or the materiality principle is the

immediate expensing of a £10 wastebasket that has a useful life of 10 years.

The matching principle directs you to record the wastebasket as an asset and

then depreciate its cost over its useful life of 10 years. The materiality

principle allows you to expense the entire £10 in the year it is acquired instead

of recording depreciation expense of £1 per year for 10 years. The reason is








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www.SoftSkillsExperts.co.uk that no investor, creditor, or other interested party would be misled by not

depreciating the wastebasket over a 10-year period.

Determining what is a material or significant amount can require professional

judgment. For example, £5,000 might be immaterial for a large, profitable

corporation, but it will be material or significant for a small company that hasvery little profit.

29. What is the conservatism principle?

The conservatism principle helps an accountant decide between two

alternatives. For example, if an item in inventory has a cost of £20, but it can

be replaced for £15, the conservatism principle directs the account to report

the item in inventory at £15 and to immediately report the loss of £5. For an

asset such as inventory it means reporting the lower asset amount on the

balance sheet and the lower net income amount on the income statement.From the conservatism principle comes the accountants' the lower of cost or

market rule for inventory valuation.

The conservatism principle does not say that accountants are to be

conservative. Accountants should be fair and objective. The conservatism

principle is used to "break a tie" between two reasonable options. It is not

intended to motivate accountants to beat down a company's earnings and

assets.

30. What are adjusting entries? Adjusting entries are usually made on the last day of an accounting period

(year, quarter, and month) so that the financial statements reflect the

revenues that have been earned and the expenses that were incurred during

the accounting period.

Sometimes an adjusting entry is needed because:

Revenue has been earned, but it has not yet been recorded.

An expense may have been incurred, but it hasn't yet been recorded.

A company may have paid for six-months of insurance coverage, but the

accounting period is only one month. (This means that five months of

insurance expense is prepaid and should not be reported as an expense on

the current income statement.)

A customer paid a company in advance of receiving goods or services. Until

the goods or services are delivered, the amount is reported as a liability. After

the goods or services are delivered, an entry is needed to reduce the liability

and to report the revenues.








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www.SoftSkillsExperts.co.uk A common characteristic of an adjusting entry is that it will involve one income

statement account and one balance sheet account. (The purpose of each

adjusting entry is to get both the income statement and the balance sheet to

be accurate.)

31. How do you amortize goodwill?Prior to 2001, the U.S. accounting rules required goodwill to be amortized to

expense over a period not to exceed 40 years. However, in June 2001 the

Financial Accounting Standards Board issued its Statement of Financial

Accounting Standards No. 142, Goodwill and Other Intangible Assets. This

accounting pronouncement ended the automatic amortization of goodwill to

expense for U.S. financial reporting.

While goodwill is no longer amortized to expense in uniform increments,

goodwill is to be measured annually to determine if there is an impairment

loss.

32. Why isn't the direct write off method of uncollectible accounts

receivable the preferred method?

Under the direct write off method, a company does not anticipate bad debt

expense. Rather, it waits until an account is actually written off as

uncollectible before recording bad debt expense. This means its accounts

receivable will be reported on the balance sheet at their full amounts—

implying that all of the accounts receivable will be turning to cash. If there is

some doubt concerning the collectability of some of the receivables, the

assets are potentially overstated and the company's profit is potentiallyoverstated. Since there is usually a significant amount of time between a

credit sale and the write off of a bad account, the bad debt expense will occur

in a much later period than the revenue from the sale. This is a problem under

the matching principle.

The accounting profession prefers the allowance method over the direct write

off method because the accounts receivable will be presented on the balance

sheet with a reduction called the allowance for doubtful accounts. This means

the net amount of the accounts receivable will be lower and closer to the

amount that will actually be collected. Bad debt expense is reported at thetime that the allowance for doubtful accounts is created and adjusted. Hence,

the bad debt expense is reported closer to the time of the credit sale.

It should be noted that the Internal Revenue Service requires the direct write

off method. They prefer to see the tax deduction for bad debt expense only

when an account receivable is actually written off —as opposed to allowing a

deduction for an anticipated potential loss.








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www.SoftSkillsExperts.co.uk 33. What is the difference between the Cash Flow and Funds Flow

statements?

The cash flow statement, known formally as the Statement of Cash Flows,

reports a company's change in cash and cash equivalents from one balance

sheet date to another. The cash flow statement classifies the amount of the

change according to operating, investing, and financing activities. The cashflow statement has been required by the Financial Accounting Standards

Board since 1988, when it issued its Statement No. 95.

Prior to 1988, accountants prepared a funds flow statement. Generally, the

funds flow statement reported on the change in working capital from one

balance sheet date to another.

34. Where are accruals reflected on the balance sheet?

Accrued expenses are reported in the current liabilities section of the balance

sheet. Accrued expenses reported as current liabilities are the expenses thata company has incurred as of the balance sheet date, but have not yet been

recorded or paid. Typical accrued expenses include wages, interest, utilities,

repairs, bonuses, and taxes.

Accrued revenues are reported in the current assets section of the balance

sheet. The accrued revenues reported on the balance sheet are the amounts

earned by the company as of the balance sheet date that have not yet been

recorded and the customers have not yet paid the company.

Accrued expenses and accrued revenues are also reflected in the incomestatement and in the statement of cash flows prepared under the indirect

method. However, these financial statements reflect a time period instead of a

point in time.

35. What is accrued income?

Accrued income is an amount that has been 1) earned, 2) there is a right to

receive the amount, and 3) it has not yet been recorded in the general ledger

accounts. One example of accrued income is the interest earned on a bond

investment.

To illustrate, let's assume that a company invested £100,000 on December 1

in a 6% £100,000 bond that pays £3,000 of interest on each June 1 and

December 1. On December 31, the company will have earned one month's

interest amounting to £500 (£100,000 x 6% per year x 1/12 of a year, or 1/6 of

the semi-annual £3,000). No interest will be received in December since it will

be part of the £3,000 to be received on June 1. The £500 of interest earned

during December, but not yet received or recorded as of December 31 is

known as accrued income.








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www.SoftSkillsExperts.co.uk Under the accrual basis of accounting, accrued income is recorded with an

adjusting entry prior to issuing the financial statements. In our example, there

will need to be an adjusting entry dated December 31 that debits Interest

Receivable (a balance sheet account) for £500, and credits Interest Income

(an income statement account) for £500.

36. When should costs be expensed and when should costs be capitalized?

Costs should be expensed when they are used up or have expired and when

they have no future economic value which can be measured. For example,

the August salaries of a company's marketing team should be charged to

expense in August since the future economic value of their August salaries

cannot be determined.

Costs should be capitalized or recorded as assets when the costs have not

expired and they have future economic value. For example, on November 25

a company pays £12,000 for property insurance covering the six months ofDecember through May. The £12,000 is initially recorded as the current asset

Prepaid Insurance. On November 30 the company will report this asset at

£12,000 since the £12,000 has a future economic value. (It will save making

future payments of cash for insurance coverage.) On December 31 the asset

will be reported as £10,000---the unexpired cost. It will also report Insurance

Expense for the month of December as £2,000---the cost that has expired

during December. On January 31 the asset will be reported at the unexpired

cost of £8,000. January's insurance expense will be £2,000---the amount that

has expired during January.

37. What does the cost principle mean for a company's income statement?

If a company has buildings, equipment and inventory, the cost principle will

mean that the amount of depreciation expense and the cost of goods sold

expense will be based on the costs when the assets were acquired. If these

assets have increased in value, the depreciation and cost of goods sold

reported on the income statement will be less than the value of the economic

capacity being used up. As a result, the reported net income will be greater

than the economic reality.

To illustrate this point let's assume that the cost of a bank building was £10million and was fully depreciated during its first 30 years of use. The cost

principle requires the depreciation expense on the bank's income statement

for year 31 (and each year thereafter) to be £0 even if the bank building's

market value has doubled. Similarly, a manufacturer using equipment that is

fully depreciated will have lower manufacturing overhead and lower cost of

goods sold because the current year's depreciation for the equipment is £0.

Generally, the cost principle requires that only the verifiable, historical costs

recorded at the time of transactions will appear as expenses on the income








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www.SoftSkillsExperts.co.uk statement. Unfortunately those recorded costs may not measure the

economic reality that is occurring in the period of the income statement.

38. What is an impairment?

The term impairment is usually associated with a long-lived asset that has a

market which has decreased significantly. For example, a meat packing plantmay have recently spent large amounts for capital expenditures and then

experienced a dramatic drop in the plant's value due to business and

community conditions.

If the undiscounted future cash flows from the asset (including the sale

amount) are less than the asset's carrying amount, an impairment loss must

be reported.

If the impairment loss must be reported, the amount of the impairment loss is

measured by subtracting the asset's fair value from its carrying value.

39. What is historical cost?

Historical cost is a term used instead of the term cost. Cost and historical cost

usually mean the original cost at the time of a transaction. The term historical

cost helps to distinguish an asset's original cost from its replacement cost,

current cost, or inflation-adjusted cost. For example, land purchased in 1992

at cost of £80,000 and still owned by the buyer will be reported on the buyer's

balance sheet at its cost or historical cost of £80,000 even though it’s current

cost, replacement cost, and inflation-adjusted cost is much higher today.

The cost principle or historical cost principle states that an asset should be

reported at its cost (cash or cash equivalent amount) at the time of the

exchange transaction and should include all costs necessary to get the asset

in place and ready for use.

40. What are the accounting principles, assumptions, and concepts?

The basic or fundamental principles in accounting are the cost principle, full

disclosure principle, matching principle, revenue recognition principle,

economic entity assumption, monetary unit assumption, time period

assumption, going concern assumption, materiality, and conservatism. Thelast two are sometimes referred to as constraints. Rather than distinguishing

between a principle or an assumption, I prefer to simply say that these ten

items are the basic principles or the underlying guidelines of accounting. (My

reason is that accounting principles also include the statements of financial

accounting standards and the interpretations issued by the Financial

Accounting Standards Board and its predecessors, as well as industry

practices.)

There are also "qualities" of accounting information such as reliability,

relevance, consistency, comparability, and cost/benefit.








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www.SoftSkillsExperts.co.uk 41. What is cost incurred?

Cost incurred is a cost that a company has become liable for.

To illustrate, let's assume that a new retailer opens on September 1 and its

electric meter will be read by the utility on the last day of every month. During

September the retailer has incurred the cost of the electricity it used duringSeptember.

Under accrual accounting the retailer needs to report a liability on September

30 for the amount owed to the utility at that point. On its income statement for

September, the retailer needs to report electricity expense equal to the cost of

the electricity used during September. (The fact that the utility will not bill the

retailer until October and will allow the retailer until November to make

payment is not pertinent under accrual accounting.)

The matching principle requires that the costs incurred in September bematched with the revenues in September.

42. Is sales tax an expense or a liability?

If a company sells £100,000 of product that is subject to a state sales tax of

7%, the company will collect £107,000. It will record sales of merchandise of

£100,000 and will record a liability for sales tax of £7,000. In this situation the

company is acting as a collection agent for the state by charging the £7,000 in

sales tax. The company will have to remit the £7,000 to the state shortly after

collecting the money. When the company remits the £7,000 to the state, the

company will reduce its cash and its sales tax liability. In this situation thesales tax is not an expense and it is not part of the company's sales revenues.

If a company purchases a new delivery van for £30,000 plus £2,100 of sales

tax, the company will record the truck as an asset at its total cost of £32,100.

In this situation, the sales tax of £2,100 is considered to be a necessary cost

of the truck and will be part of the depreciation expense recorded during the

useful life of the truck.

43. What is depreciation?

Depreciation is the assigning or allocating of a plant asset's cost to expenseover the accounting periods that the asset is likely to be used. For example, if

a business purchases a delivery truck with a cost of £100,000 and it is

expected to be used for 5 years, the business might have depreciation

expense of £20,000 in each of the five years. (The amounts can vary

depending on the method and assumptions.)

In our example, each year there will be an adjusting entry with a debit to

Depreciation Expense for £20,000 and a credit to Accumulated Depreciation

for £20,000. Since the adjusting entries do not involve cash, depreciation

expense is referred to as a noncash expense.








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www.SoftSkillsExperts.co.uk 44. What are the ways to value inventory?

Generally, the balance sheet of a U.S. company must value inventory at cost.

In other words, a company's inventory is not reported at the sales value. (An

exception occurs when a company's inventory consists of readily sellable

commodities that have quoted market prices.)

Since the costs of products may change during an accounting year, a

company must select a cost flow assumption that it will use consistently. For

instance, should the oldest cost be removed from inventory when an item is

sold? If so, the company will select the cost flow assumption known as first-in,

first out (FIFO). In the U.S. an alternative is to remove the period's most

recent cost when an item is sold. This is known as last-in, first-out (LIFO).

Another option is to use an average method such as the weighted-average

method or the moving-average method. Both the LIFO method and the

average methods will result in different values depending on whether a

company uses the perpetual method or the periodic method. Still anotheroption is to use the specific identification method.

The LIFO cost flow assumption can be achieved by tracking the units in

inventory or by using price indexes. When price indexes are used, it is

referred to as dollar-value LIFO. (Retailers often use a technique called dollar-

value retail LIFO.)

The accountants' concept of conservatism can result in some inventories

being valued at less than cost. Hence, an additional method for valuing

inventory is the lower of cost or market. For example, if the replacement costof a company's inventory has declined to an amount that is less than cost, the

company may be required to reduce its inventory cost. The amount of that

adjustment will also reduce the current period's net income.

A company's inventory must be measured and reviewed very carefully as it is

an important amount for determining a company's financial position and

profitability.

45. How does an expense affect the balance sheet?

An expense will decrease the amount of assets or increase the amount ofliabilities, and will reduce the amount of owner's or stockholders' equity.

For example an expense might 1) reduce a company's assets such as Cash,

Prepaid Expenses, or Inventory, 2) increase the credit balance in a contra-

asset account such as Allowance for Doubtful Accounts or Accumulated

Depreciation, 3) increase the balance in the liability account Accounts

Payable, or increase the amount of accrued expenses payable such as

Wages Payable, Interest Payable, and so on.








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www.SoftSkillsExperts.co.uk In addition to the change in the assets or liabilities, an expense will reduce the

credit balance in the Owner Capital account of a sole proprietorship, or will

reduce the credit balance in the Retained Earnings account of a corporation.

46. What is accrued payroll?

Accrued payroll would be wages, salaries, commissions, bonuses, and therelated payroll taxes and benefits that have been earned by a company's

employees, but have not yet been paid or recorded in the company's

accounts.

For example, the accrued payroll as of December 31 would include all of the

wages that the hourly-paid employees have earned as of December 31, but

will not be paid until the following pay day (perhaps January 5). The

employer's portion of the FICA, unemployment taxes, worker compensation

insurance, and other benefits pertaining to those wages should also be

included as accrued payroll in order to achieve the matching principle ofaccounting.

47. What is the difference between cost and expense?

A cost might be an expense or it might be an asset. An expense is a cost that

has expired or was necessary in order to earn revenues. We hope the

following three examples will illustrate the difference between a cost and an

expense.

A company has a cost of £6,000 for property insurance covering the next six

months. Initially the cost of £6,000 is reported as the current asset PrepaidInsurance. However, in each of the following six months, the company will

report Insurance Expense of £1,000—the amount that is expiring each month.

The unexpired portion of the cost will continue to be reported as the asset

Prepaid Insurance.

The cost of equipment used in manufacturing is initially reported as the long

lived asset Equipment. However, in each accounting period the company will

report part of the asset's cost as Depreciation Expense.

A retailer's purchase of merchandise is initially reported as the current assetInventory. When the merchandise is sold, the cost of the merchandise sold is

removed from Inventory and is reported on the income statement as the

expense entitled Cost of Goods Sold.

The matching principle guides accountants as to when a cost will be reported

as an expense.








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www.SoftSkillsExperts.co.uk 48. How do you record a payment for insurance?

Since insurance premiums are usually paid prior to the period covered by the

payment, it is common to debit Prepaid Insurance and to credit Cash for the

amount paid. (Prepaid Insurance is a current asset and is reported on the

balance sheet after inventory.)

As the prepaid amount expires, the balance in Prepaid Insurance is reduced

by a credit to Prepaid Insurance and a debit to Insurance Expense. This is

done with an adjusting entry at the end of each accounting period (e.g.

monthly). One objective of the adjusting entry is to match the proper amount

of insurance expense to the period indicated on the income statement. (The

income statement should report the amount of insurance that has expired

during the period indicated in the income statement's heading.) Another

objective is to report on the balance sheet the unexpired amount of insurance

as the asset Prepaid Insurance.

If you can arrange for your insurance payments to be the amount applicable

to each accounting period, you can simply debit Insurance Expense and credit

Cash. For example, if the insurance premiums for one year amount to

£12,000 and you can pay the insurance company £1,000 per month, then

each monthly payment will be recorded with a debit to Insurance Expense and

a credit to Cash. In this case £1,000 per month will be matched on the income

statement and there will be no prepaid amount to be reported on the balance

sheet.

49. Where is a contingent liability recorded? A contingent liability that is both probable and the amount can be estimated is

recorded as 1) an expense or loss on the income statement, and 2) a liability

on the balance sheet. As a result, a contingent liability is also referred to as a

loss contingency. Warranties are cited as a contingent liability that meets both

of the required conditions (probable and the amount can be estimated).

Warranties will be recorded at the time of a product's sale with a debit to

Warranty Expense and a credit to Warranty Liability.

A loss contingency which is possible but not probable, or the amount cannot

be estimated, will not be recorded in the accounts. Rather, it will be disclosedin the notes to the financial statements.

A loss contingency that is remote will not be recorded and will not have to be

disclosed in the notes to the financial statements.

50. Why isn't land depreciated?

Land is not depreciated because land is assumed to have an unlimited useful

life.








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www.SoftSkillsExperts.co.uk Other long-lived assets such as land improvements, buildings, furnishings,

equipment, etc. have limited useful lives. Therefore, the costs of those assets

must be allocated to those limited accounting periods. Since land's life is not

limited, there is no need to allocate the cost of land to any accounting periods.

51. What are inventorial costs?Inventorial costs are 1) the costs to purchase or manufacture products which

will be resold, plus 2) the costs to get those products in place and ready for

sale. Inventorial costs are also known as product costs.

To illustrate, let's assume that a retailer purchases an item for resale by

paying £20 to the supplier. The item is purchased FOB shipping point, which

means that the retailer must pay the freight from the supplier to its location. If

that freight cost is £1, then the retailer's inventorial cost is £21. Assuming this

is the only item in the retailer's inventory, the retailer's balance sheet will

report inventory at a cost of £21. When the item is sold, the retailer's inventorywill decrease by £21 and the £21 will be reported on the income statement as

the cost of goods sold.

In the case of a manufacturer, a product's inventorial costs are the costs of

the direct materials, direct labour and manufacturing overhead incurred in

manufacturing the product.

52. What is the full disclosure principle?

For a business, the full disclosure principle requires a company to provide the

necessary information so that people who are accustomed to reading financialinformation can make informed decisions concerning the company.

The required disclosures can be found in a number of places including the

following:

- the company's financial statements including any supplementary schedules

and notes (or footnotes).

- Management's Discussion and Analysis that is included in a publicly-tra

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