195 Accounting Principles Questions & Answers eBook

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195 Accounting
Principles Questions
& Answers
By: Rahat

Kazmi

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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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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 no
salvage 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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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, the
company 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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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 or
reported 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 no
explicit 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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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 proprietor
working 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 income
statement 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 hours
x £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 the
company 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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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 not
considered). 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 financial
statements 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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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 a
period 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, the
cost 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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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 expenses
payable?
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 date
of 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 accepted
accounting 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 such
as 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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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 line
on 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 yet
been 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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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 Accumulated
Depreciation 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 of
time.
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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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 likely
be 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 in
December 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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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 return
is 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 x
1% 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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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 ships
a 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 of
the 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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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 income
statements 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 financial
statements. 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 another
accounting 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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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 has
very 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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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 potentially
overstated. 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 the
time 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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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 cash
flow 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 that
a 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 income
statement 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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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 of
December 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 £10
million 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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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 plant
may 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. The
last 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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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 during
September.
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 be
matched 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 the
sales 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 expense
over 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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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 another
option 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 dollarvalue 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 cost
of 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 of
liabilities, 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 contraasset 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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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 the
related 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 of
accounting.
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 Prepaid
Insurance. 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 asset
Inventory. 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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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 disclosed
in 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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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 inventory
will 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 financial
information 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-traded
corporation's annual report to the U.S. Securities and Exchange Commission.
- Quarterly earnings reports, press releases and other communications.
The first note or footnote in a company's financial statements will disclose the
significant accounting policies such as how and when revenues are
recognized, how property is depreciated, how inventory and income taxes are
accounted for, and more.

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Other disclosures in the notes to the financial statements include the effects of
foreign currencies, contingent liabilities, leases, related-party transactions,
stock options, and much more.
Judgement is used in deciding the amount of information that is disclosed. For
example, in 1980 large U.S. corporations were required to report as
supplementary information the effects of inflation and changing prices on its
inventory and property (and cost of goods sold and depreciation expense).
After several years, the disclosure became optional since the cost of providing
the information exceeded the benefits.
53. What is the cost principle?
The cost principle is one of the basic underlying guidelines in accounting. It is
also known as the historical cost principle.
The cost principle requires that assets be recorded at the cash amount (or its
equivalent) at the time that an asset is acquired. For example, if equipment is
acquired for the cash amount of £50,000, the equipment will be recorded at
£50,000. If the equipment will be useful for 10 years with no salvage value,
the straight-line depreciation expense will be £5,000 per year (cost of £50,000
divided by 10 years). The equipment's market value, replacement cost or
inflation-adjusted cost will not affect the annual depreciation expense of
£5,000. The company's balance sheets will report the equipment's historical
cost minus the accumulated depreciation.
The cost principle also means that valuable brand names and logos that were
developed through effective advertising will not be reported as assets on the
balance sheet. This could result in a company's most valuable assets not
being included in the company's asset amounts. (On the other hand, a brand
name that is acquired through a transaction with another company will be
reported on the balance sheet at its cost.)
If a company has an asset that has a ready market with quoted prices, the
historical cost may be replaced with the current market value on each balance
sheet. An example is an investment consisting of shares of common stock
that are actively traded on a major stock exchange.
54. What is the cost of goods sold?
The cost of goods sold is the cost of the merchandise that a retailer,
distributor, or manufacturer has sold.
The cost of goods sold is reported on the income statement and can be
considered as an expense of the accounting period. By matching the cost of
the goods sold with the revenues from the goods sold, the matching principle
of accounting is achieved.

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The sales revenues minus the cost of goods sold is gross profit.
Cost of goods sold is calculated in one of two ways. One way is to adjust the
cost of the goods purchased or manufactured by the change in inventory of
finished goods. For example, if 1,000 units were purchased or manufactured
but inventory increased by 100 units then the cost of 900 units will be the cost
of goods sold. If 1,000 units were purchased but the inventory decreased by
100 units then the cost of 1,100 units will be the cost of goods sold.
The second way to calculate the cost of goods sold is to use the following
costs: beginning inventory + the cost of goods purchased or manufactured =
cost of goods available - ending inventory.
When costs change during the accounting period, a cost flow will have to be
assumed. Cost flow assumptions include FIFO, LIFO, and average.
55. Why are loan costs amortized?
When loan costs are significant, they must be amortized because of the
matching principle. In other words, all of the costs of a loan must be matched
to the accounting periods when the loan is outstanding.
To clarify this, let's assume that a company incurs legal, accounting, and
registration fees of £120,000 during February in order to obtain a £4 million
loan at an annual interest rate of 9%. The loan will begin on March 1 and the
entire £4 million of principal will be due five years later. The company's cost of
the borrowed money will be £360,000 (£4 million X 9%) of interest each year
for five years plus the one-time loan costs of £120,000.
It would be misleading to report the entire £120,000 of loan costs as an
expense of one month. Hence, the matching principle requires that each
month during the life of the loan the company should report £2,000 (£120,000
divided by 60 months) of expense for the loan costs in addition to the interest
expense of £30,000 per month (£4 million X 9% per year = £360,000 per year
divided by 12 months per year). The combination of the amortization of the
loan cost plus the interest expense will mean a total monthly expense of
£32,000 for 60 months beginning on March 1.
56. What are accrued revenues and when are they recorded?
Accrued revenues are fees and interest that have been earned and sales that
occurred, but they have not yet been recorded through the normal invoicing
paperwork. Since these are not yet in the accountant's general ledger, they
will not appear on the financial statements unless an adjusting entry is
entered prior to preparing the financial statements.
Here's an example. Your company lent a supplier £100,000 on December 1.

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The agreement is for the £100,000 to be repaid on February 28 along with
£3,000 of interest for the three months of December through February. As of
December 31 your company will not have a transaction/invoice/receipt for the
interest it is earning since all of the interest is due on February 28. Without an
adjusting entry to accrue the revenue it earned in December, your company's
financial statements as of December 31 will not be reporting the £1,000 (onethird of the £3,000 of interest) that it has earned 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 £1,000 to Interest Receivable (a
balance sheet account) and a credit of £1,000 to Interest Income or Interest
Revenue (income statement accounts).
57. What is a customer deposit?
A customer deposit could be an amount paid by a customer to a company
prior to the company providing it with goods or services. In other words, the
company receives the money prior to earning it. The company receiving the
money has an obligation to provide the goods or services to the customer or
to return the money.
For example, Ace Manufacturing Co. might agree to produce an expensive,
custom-made machine for one of its customers. Ace requires that the
customer pay £50,000 before Ace begins to design and construct the
machine. The £50,000 payment is made in December 2012 and the machine
must be finished by June 30, 2013. The £50,000 is a down payment toward
the machine's price of £400,000.
In December 2012, Ace will debit Cash for £50,000 and will credit Customer
Deposits, a current liability account. (The customer will record the £50,000
payment with a debit to a long-term asset account such as Construction Work
in Progress or Down payment on New Equipment, and will credit Cash.)
58. What is a contingent asset?
A contingent asset is a potential asset associated with a contingent gain.
Unlike contingent liabilities and contingent losses, contingent assets and
contingent gains are not recorded in accounts, even when they are probable
and the amount can be estimated.
An example of a contingent gain and contingent asset might be a lawsuit filed
by Company A against Company B for infringement of Company A's patent. If
it is probable that Company A will win the lawsuit and receive an estimated
amount of money, it has a contingent asset and a contingent gain. However, it
will not report the asset and gain until the lawsuit is settled. (At most Company
A will prepare a very carefully worded disclosure stating that it possibly could

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win the case.) On the other hand, Company B will need to make an entry in its
accounts if the loss contingency is probable and the amount can be
estimated. If one of those are missing, Company B will have to disclose the
loss contingency in the notes to its financial statements.
59. How do you account for bond issue costs?
The costs associated with issuing bonds should be recorded as a deferred
charge in the long term asset section of the balance sheet under the heading
of Other Assets. The account title could be Bond Issue Costs. Over the life of
the bonds you will need to systematically move the bond issue cost from the
balance sheet to the income statement. Accountants refer to this as
amortizing the costs.
Let's illustrate the amortization of bond issue costs by assuming the total of
the bond issue costs were £24,000 and the bonds will mature in 10 years.
Each month you would debit Bond Issue Cost Expense for £200 (£24,000
divided by 120 months) and would credit Bond Issue Cost for £200. The
concept is to match the £24,000 cost to the accounting periods that are
benefiting from the bonds having been issued.
Our discussion pertains to financial statement reporting and we are not
familiar with income tax reporting. You should discuss the income tax
treatment with your tax adviser.
60. What should be the entry when goods are purchased at a discount?
If you purchase £1000 of goods having a trade discount of 20%, you can debit
Purchases (periodic system) or Inventory (perpetual system) for £800 and
Accounts Payable for £800. This is consistent with the cost principle which
means the cash or cash equivalent amount.
If the invoice allows a 1% discount for paying within 10 days, you can record
the 1% discount when you make payment within the allotted time. The entry
for paying within 10 days would be: debit Accounts Payable £800, credit Cash
for £792, and credit Purchase Discounts £8 (or Inventory £8 if perpetual).
If you are certain to always pay vendor invoices within their discount periods,
you could initially record the above invoice at £792 (instead of £800). Debit
Purchases or Inventory for £792 and credit Accounts Payable £792. When
paying the invoice within the discount period, the entry would be a debit to
Accounts Payable for £792 and a credit to Cash for £792. If you fail to pay the
invoice within the discount period, the payment will have to be £800 and will
be recorded with a debit to Accounts Payable £792, a debit to Purchase
Discounts Lost £8, and a credit to Cash for £800. Purchase Discounts Lost is
an income statement account.

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61. How should the sale of gift certificates be recorded in the general
ledger?
The sale of a gift certificate should be recorded with a debit to the asset
account Cash and a credit to the liability account Gift Certificates Outstanding.
(Revenue is not recorded until merchandise or services are provided to the
customer.)
When a customer presents the gift certificate for merchandise or for services,
the liability account Gift Certificates Outstanding will be reduced with a debit
and a revenue account will be credited. If the revenue is a sale of
merchandise, the income statement will match the cost of goods sold and
other expenses with the revenue.
62. Where does accrued interest on notes receivable get reported on the
balance sheet?
Accrued interest on notes receivable is likely to be reported as a current asset
such as Accrued Interest Receivable or Interest Receivable. The accrued
interest receivable is a current asset if the interest amount is expected to be
collected within one year of the balance sheet date.
I would expect that even a long-term note receivable that is due in five years
will require that the interest on the note be paid quarterly, semi-annually or
annually. Hence the accrued interest will be a current asset.
If the interest on the note is not expected to be received within one year of the
balance sheet date, then the accrued interest receivable should be reported
as a long-term asset.
63. Why would a company use double-declining depreciation on its financial
statements?
Most companies will not use the double-declining balance method of
depreciation on their financial statements. The reason is that it causes the
company's net income in the early years of an asset's life to be lower than it
would be under the straight-line method.
One reason for using double-declining balance depreciation on the financial
statements is to have a consistent combination of depreciation expense and
repairs and maintenance expense during the life of the asset. In other words,
in the early years of the asset's life, when the repairs and maintenance
expenses are low, the depreciation expense will be high. In the later years of
the asset's life, when the repairs and maintenance expenses are high, the
depreciation expense will be low. While this seems logical, the company will
end up reporting lower net income in the early years of the asset's life (as
compared to the use of straight-line depreciation). Most managers will not
accept reporting lower net income sooner than required.

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64. What is inventory valuation?
Inventory valuation is the dollar amount associated with the items contained in
a company's inventory. Initially the amount is the cost of those items.
However, under certain situations the cost could be replaced with a lower
dollar amount.
The inventory valuation includes all of the costs to get the inventory items in
place and ready for sale. The inventory valuation excludes the costs of selling
and administration.
Since the inventory items are constantly being sold and restocked and since
the costs of the items are constantly changing, a company must select a cost
flow assumption. Cost flow assumptions include first-in, first-out; weighted
average; and last-in, first out. The company must consistently follow its stated
cost flow assumption.
A manufacturer's inventory valuation will include the costs of production,
namely direct materials, direct labour, and manufacturing overhead.
Manufacturers are also required to consistently follow their cost flow
assumptions.
Inventory valuation is important in that it affects the cost of goods sold
reported on the company's income statement. Inventory is also an important
component of a company's current assets, working capital, and current ratio.
65. Where in the chart of accounts is a suspense account located?
A suspense account could be located in any part of an organization's chart of
accounts. In other words, a suspense account could be located in any of
these sections: asset, liability, revenue, expense.
Let's illustrate why any or all four of these sections of the chart of accounts
might contain a suspense account. Assume that a company receives cash of
£500 but is not able to determine the reason for the receipt. Because of
double-entry accounting or bookkeeping, the company's asset account Cash
is debited for £500 and there needs to be at least one other account credited
and the total of the credits must be £500. Without knowing exactly the nature
of the £500 receipt, the best location of a suspense account could be any of
the following:
1. The unknown credit might involve an asset account if the cash was from
the sale of another asset or the collection of an asset. In this example, the
best suspense account location would be in the asset section.
2. The unknown credit could involve a liability account if the cash was a
deposit for future work to be done. Given these facts, the best suspense
account location is the liability section.

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3. The unknown credit might involve a revenue account if the cash was
received for work that was recently earned, but not yet billed. In this situation
the best suspense account location would be the revenue section.
4. The unknown credit might involve an expense account if the cash was
received as a refund of an earlier expense. In this case the best suspense
account location is the expense section of the chart of accounts.
Unfortunately the best location is not known at the time of the receipt, and it is
hard to say where you will find the suspense account in your own general
ledger.
Be aware that if the unknown account is a revenue or expense account and
the amount is reported in a suspense account in your current liability section
of the balance sheet, your company's net income is incorrect and all of the
financial statements are incorrect. If the amount is insignificant, the problem is
very small. If the amount is significant, you should find out the proper account
before issuing the financial statements.
66. What are cost flow assumptions?
The phrase cost flow assumptions often refers to the methods available for
moving the costs of a company's products from its inventory to its cost of
goods sold. In the U.S. the cost flow assumptions include FIFO, LIFO, and
average. (If specific identification is used, there is no need to make an
assumption.)
FIFO, LIFO, and average are cost flow assumptions because the costs
flowing out of inventory do not have to match the specific physical units being
shipped. Let's illustrate this important point with a company that has four units
of the same product in its inventory. The units were purchased at increasing
costs and in the following sequence: £40, £41, £43, and £44. If the company
ships the oldest unit (the unit with a cost of £40), it will expense via the cost of
goods sold: £40 under FIFO, £44 under LIFO, or £42 under the average
method. If the company ships the most recently purchased unit (the physical
unit having a cost of £44), the inventory will be reduced and the cost of goods
sold will be increased by: £40 under FIFO, £44 under LIFO, or the average of
£42. In other words, the cost used to reduce the inventory and to increase the
cost of goods sold was based on an assumed cost flow without regard to
which physical unit was actually shipped.
Other than a one-time change to a better cost flow assumption, the company
must consistently use the same cost flow assumption.

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67. Are bonds payable reported as a current liability if they mature in six
months?
Bonds payable that mature (or come due) within one year of the balance
sheet date will be reported as a current liability if the issuer of the bonds must
use a current asset or will create a current liability in order to pay the
bondholders when the bonds mature.
However, the bonds could be reported as a long-term liability right up to the
maturity date if:
1. The company has a sufficient, long-term investment that is restricted for the
purpose of paying the bondholders when the bonds mature. This type of
investment is known as a bond sinking fund.
2. The company has a binding agreement that guarantees that the existing
bonds will be refinanced by issuing new bonds or by issuing shares of stock.
68. What is the consistency principle?
The consistency principle requires accountants to be consistent from one
accounting period to another in applying accounting principles, methods,
practices, and procedures. In other words, the readers of a company's
financial statements can presume that the same rules and measurements
were followed in all of the years being reported. If a change is made to a more
preferred accounting method, the effects of the change must be clearly
disclosed.
The Financial Accounting Standards Board refers to consistency as one of the
characteristics or qualities that makes accounting information useful.
69. What is meant by the term relevance in accounting?
In accounting, the term relevance means it will make a difference to a
decision maker.
For example, in the decision to replace equipment that has been used for the
past six years, the original cost of the equipment does not have relevance. In
other words, the original cost is irrelevant or is not relevant in the decision to
replace the equipment. What will have relevance are the future amounts, such
as the cost of the new equipment, and the savings that will occur when the old
equipment is replaced.
Here's another expression of relevance: Costs that will differ among
alternatives. Costs that will not differ among alternatives do not have
relevance.
In order to have relevance, accounting information must be timely. Financial

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statements issued three weeks after the accounting period ends will have
more relevance than financial statements issued several months after the
period ends. Having timeliness and relevance may mean sacrificing some
precision or reliability.
70. What are the limitations of the balance sheet?
One limitation of the balance sheet is that only the assets acquired in
transactions can be included. Therefore, some of a company's most valuable
assets will not be reported on the balance sheet. For example, assume that a
company developed an internet business that now attracts millions of visitors
each day and has £10 million in annual revenues. Since the internet business
was not purchased from another company and its cost to develop was not
significant, the company's balance sheet will include the business's cash,
receivables and some related payables. However, the company's balance
sheet will not be reporting the internet business at anywhere near the £30
million that the company was offered for the internet business.
Similarly, the immensely talented designers and content writers employed by
an internet business cannot be reported as assets on the company's balance
sheet since they were not acquired (and accountants are not able to compute
a precise amount for these human resources). This is also the case for a
company's reputation, its brand names that were developed through years of
effective marketing, its customers' future demand for its unique services, etc.
Another limitation of the balance sheet pertains to a company's long-term (or
noncurrent) assets which have increased in value since the time they were
purchased in a transaction. For instance, a company's land will be reported at
an amount no greater than its cost (due to the accountant's cost principle). Its
buildings will be reported at their cost minus their accumulated depreciation
(due to the cost principle and the matching principle). Hence, the amounts
reported on the balance sheet for a company's land and buildings could be
much lower than their market value.
71. Is advertising an asset or an expense?
Accountants record advertising expenditures as expenses when the ads are
run. (A prepayment of a future ad would be recorded as an asset until the ad
is run.)
The reason advertising is recorded as an expense and not an asset is the
problem of measuring the future value of an ad. What amount would the
accountant use for recording the advertising expenditure as an asset? (You
may recall a very entertaining and memorable ad by an automobile
manufacturer during a Super Bowl. Viewers ranked it as one of the best.
However, a later analysis showed that the ad did not result in additional sales
for the car company.)

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Advertising may be valuable, even crucial for some businesses and will lead
to additional assets, but accountants and others are unable to quantify the
future economic value necessary for reporting it as an asset. As a result,
advertising expenditures will be reported as expenses in the accounting
period in which the ads are run.
72. What is carriage inwards?
Carriage inwards refers to the transportation costs associated with the
purchase of merchandise or other assets. The buyer is responsible for the
cost of carriage inwards when it buys items and the prices are stated as being
FOB shipping point. Carriage inwards is also known as freight-in or
transportation-in.
When goods or merchandise are purchased FOB shipping point and the
periodic inventory method is used, the buyer will likely record the cost of the
carriage inwards in the general ledger account Carriage Inwards (or Freight-in
or Transportation-in). The carriage inwards costs are considered to be part of
the cost of items purchased. In other words, part of the costs of carriage
inwards should be assigned to the units in inventory and some should be
assigned to the units that have been sold.
In the case of assets other than inventory items that are purchased FOB
shipping point, the buyer should add the carriage inwards cost to the asset's
cost. This is necessary because accountants define an asset's cost as all of
the costs that are necessary to get an asset in place and ready for use.
73. What is principles of accounting?
Three meanings come to mind when you ask about principles of accounting...
1. Principles of Accounting was often the title of the introductory course in
accounting. It was also common for the textbook used in the course to be
entitled Principles of Accounting.
2. Principles of accounting can also refer to the basic or fundamental
accounting principles: cost, matching, full disclosure, materiality, going
concern, economic entity, and so on. In this context, principles of accounting
refers to the broad underlying concepts which guide accountants when
preparing financial statements.
3. Principles of accounting can also mean generally accepted accounting
principles (GAAP). When used in this context, principles of accounting will
include both the underlying basic accounting principles and the official
accounting pronouncements issued by the Financial Accounting Standards
Board (FASB) and its predecessor organizations. The official pronouncements
are detailed rules or standards for specific topics.

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74. How do you record money from an insurance claim involving property?
I would use a separate general ledger account such as Loss from Property
Damage to record all costs incurred to get the property back to its previous
condition. The costs incurred will be debited to Loss from Property Damage.
The amount received from your insurance claim would be credited to the
same account. Other money received, such as the salvaging of materials,
would also be credited to Loss from Property Damage.
If the account Loss from Property Damage ends up with a debit balance, that
will be the amount of the loss. If the account has a credit balance, there is
actually a gain on the property damage.
75. What does a balance sheet tell us?
A balance sheet reports the dollar amounts of a company's assets, liabilities,
and owner’s equity (or stockholders' equity) as of a previous date.
Assets include cash, accounts receivable, inventory, investments, land,
buildings, equipment, some intangible assets, and others. Generally assets
are reported at their cost or a lower amount due to depreciation, the cost
principle, and conservatism. The cost principle also means that some very
valuable aspects of the company are not listed as assets. For example, a
company's outstanding reputation, its effective management team, and its
amazing brand recognition are not reported as assets if they were not
acquired in a transaction involving another party or entity.
Liabilities are obligations of a company as of the balance sheet date. These
include loans payable, accounts payable, warranty obligations, taxes payable,
and more.
The stockholders' equity or owner's equity report the amount of the assets
that came from the owners and not from its creditors.
The balance sheet allows you to easily determine the amount of a company's
working capital and whether the company is highly leveraged.
With every balance sheet distributed by a company there should be notes or
footnotes. These notes provide important additional information about the
company's financial position including potential liabilities not yet appearing as
amounts on the balance sheet.
76. What is periodicity in accounting?
In accounting, periodicity means that accountants will assume that a
company's complex and ongoing activities can be divided up and reported in
annual, quarterly and monthly financial statements. For example, some earthmoving equipment may require two years to manufacture but the activities will

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