Accrual-Basis Accounting and Financial Statements

Comprehensive practice flashcards covering LO1 through LO7 and common accounting mistakes from the lecture notes.

What does the revenue recognition principle state?

It states that revenue should be recorded in the period in which it is earned, not necessarily in the period in which cash is received.

What does the matching principle state?

It states that expenses are recognized in the same period as the revenues they help to generate.

What type of relationship between revenue and expense recognition is implicit in the matching principle?

A cause-and-effect relationship.

How are revenues and expenses recorded under accrual-basis accounting?

Revenues are recorded when earned (revenue recognition principle) and expenses are recorded with related revenues (matching principle), regardless of when cash is received or paid.

How are revenues and expenses recorded under cash-basis accounting?

Revenues are recorded at the time cash is received and expenses are recorded at the time cash is paid.

Why is cash-basis accounting generally not accepted in preparing financial statements?

Because cash-basis accounting violates both the revenue recognition principle and the matching principle.

What is the purpose of adjusting entries in accrual-basis accounting?

They update account balances at the end of the period to record unrecorded events, ensuring revenues are recorded when earned, expenses are recorded when incurred, and assets and liabilities are correctly stated.

In which two cases are adjusting entries unnecessary?

(1) For transactions that do not involve revenue or expense activities, and (2) for transactions that result in revenues or expenses being recorded at the same time as the cash flow.

What is a prepaid expense and how is its adjusting entry recorded?

A prepaid expense is the cost of an asset acquired in one period that will be expensed in a future period. Its adjusting entry always includes a debit to an expense account and a credit to an asset account.

What is the financial statement effect of an adjusting entry for a prepaid expense?

It decreases assets and increases expenses, which decreases both net income and retained earnings.

What is unearned revenue and how is its adjusting entry recorded?

Unearned revenue occurs when a company receives cash in advance from a customer for products or services to be provided in the future. Its adjusting entry always includes a debit to a liability account and a credit to a revenue account.

What is the financial statement effect of an adjusting entry for unearned revenue?

It decreases liabilities and increases revenues, which increases both net income and retained earnings.

What is an accrued expense and how is its adjusting entry recorded?

An accrued expense occurs when a company incurs an expense but has not yet paid for it. Its adjusting entry always includes a debit to an expense account and a credit to a liability account.

What is the financial statement effect of an adjusting entry for an accrued expense?

It increases liabilities and increases expenses, which decreases both net income and retained earnings.

What is an accrued revenue and how is its adjusting entry recorded?

An accrued revenue occurs when a company has earned revenue but has not yet received cash. Its adjusting entry always includes a debit to an asset account and a credit to a revenue account.

What is the financial statement effect of an adjusting entry for an accrued revenue?

It increases assets and increases revenues, which increases both net income and retained earnings.

What is an adjusted trial balance?

A list of all accounts and their balances at a particular date after account balances have been updated for adjusting entries.

Which financial statements are prepared using the adjusted trial balance?

The income statement, statement of stockholders' equity, and balance sheet.

How is net income calculated on the income statement?

Revenues minus expenses.

How is the change in retained earnings calculated on the statement of stockholders' equity?

Net income (from the income statement) less dividends for the period.

On a classified balance sheet, how are current assets distinguished from long-term assets?

Current assets provide a benefit over the next year, while long-term assets provide a benefit for more than one year.

On a classified balance sheet, how are current liabilities distinguished from long-term liabilities?

Current liabilities are due over the next year, while long-term liabilities are due in more than one year.

What are the two main purposes of closing entries?

(1) To transfer the balances of temporary accounts (revenues, expenses, and dividends) to the retained earnings account, and (2) to reduce the balances of these temporary accounts to zero to prepare them for measuring activity in the next period.

How are revenue, expense, and dividend accounts closed?

Revenue accounts are closed by debiting their balances and crediting retained earnings. Expense accounts and the dividends account are closed by crediting their balances and debiting retained earnings.

What is a post-closing trial balance?

A list of all accounts and their balances at a particular date immediately after temporary account balances have been updated for closing entries.

What are the balances of temporary accounts after closing entries are posted?

The balances of all revenue, expense, and dividend accounts are zero.

Why is interest payable recorded in a separate account from notes payable?

To keep the balance owed for principal separate from the balance owed for interest.

Why will an adjusting entry never include the cash account?

Adjusting entries are made at the end of the period to update balances for prepayments or accruals where cash has either already been exchanged or will be exchanged in a future period.

Why is it incorrect to assume that closing entries reduce retained earnings to zero?

Retained earnings is a permanent account representing the cumulative accumulation of all revenues, expenses, and dividends over the life of the company; only temporary accounts are reduced to zero.