Question

Module 1: Chapter 3: Review Questions Assignment 1. What is the difference between the cash basis and the accrual basis of accounting? 2. Why is the accrual basis of accounting generally preferred over the cash basis? 3. What is a prepaid expense and where is it reported in the financial statements? 4. What type of assets require adjusting entries to record depreciation? 5. What contra account is used when recording and reporting the effects of depreciation? Why is it used? 6. What is unearned revenue and where is it reported in the financial statements? 7. What is an accrued revenue? Give an example. 8. What is a trial balance? 9. What is a adjusted trial balance? 10. List the type of financial statements prepared at the end of the year.

Answer 1

1)

The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized. The cash method is a more immediate recognition of revenue and expenses, while the accrual method focuses on anticipated revenue and expenses.

Accrual accounting means revenue and expenses are recognized and recorded when they occur, while cash basis accounting means these line items aren't documented until cash exchanges hands.

Cash basis accounting is easier, but accrual accounting portrays a more accurate portrait of a company's health by including accounts payable and accounts receivable.

The accrual method is the most commonly used method, especially by publicly-traded companies as it smooths out earnings over time.

Accrual Accounting Method :

Revenue is accounted for when it is earned. Typically, revenue is recorded before any money changes hands. Unlike the cash method, the accrual method records revenue when a product or service is delivered to a customer with the expectation that money will be paid in the future. Expenses of goods and services are recorded despite no cash being paid out yet for those expenses.

Cash Basis Accounting :

Revenue is reported on the income statement only when cash is received. Expenses are only recorded when cash is paid out. The cash method is mostly used by small businesses and for personal finances.

2)

Accrual accounting helps a company to maximize its operational abilities by spreading out its revenue recognition and receivables. The increased efficiency advantage is one of the main reasons that generally accepted accounting principles (GAAP) requires accrual accounting; the reporting of sales is another.

In general, accrual accounting provides for a better sense of a company's overall financial health than the cash basis accounting method. That is primarily why it has been adopted as a best practice and integrated into the broad set of rules defined through generally accepted accounting principles (GAAP) and issued through the standards of the Financial Accounting Standards Board (FASB).

Accrual accounting requires companies to record sales at the time in which they occur. Unlike the cash basis method, the timing of actual payments is not important. If a company sells an item to a customer through a credit account, where payment is delayed for a short term (less than a year) or long term (more than a year), the accrual method records the revenue at the point of sale.This can be important for showing investors the sales revenue the company is generating, the sales trends of the company, and the pro-forma estimates for sales expectations. In contrast, if cash accounting was used, a transaction would not be recorded for a while after the item leaves inventory.

3)

A prepaid expense is a type of asset on the balance sheet that results from a business making advanced payments for goods or services to be received in the future. Prepaid expenses are initially recorded as assets, but their value is expensed over time onto the income statement. Unlike conventional expenses, the business will receive something of value from the prepaid expense over the course of several accounting periods.

It is recorded on asset sside in the balance sheet.

4)

Assets that require adjusting entries to record depreciation include anything that is expected to be used for longer that a year, like buildings and machinery, furniture etc with the exception of land.

5)

The Contra account that is used when recording and reporting the effects of depreciation is Amortization of asset .

It is the periodic transfer of Cost of an intangible asset to expense.

Amortization is used in the process of expensing the cost of an intangible asset over the projected life of the asset. It measures the consumption of the value of an intangible asset, such as goodwill, a patent, or a copyright.

Amortization is calculated in a similar manner to depreciation, which is used for tangible assets, and depletion, which is used for natural resources.

When businesses amortize expenses over time, they help tie the cost of using an asset to the revenues it generates in the same accounting period, in accordance with generally accepted accounting principles (GAAP). For example, a company benefits from the use of a long-term asset over a number of years. Thus, it writes off the expense incrementally over the useful life of that asset.

6)

Unearned income is income from investments and other sources unrelated to employment.

Examples of unearned income include interest from savings accounts, bond interest, alimony, and dividends from stock.Unearned income, known as a passive source of income, is income not acquired through work.

Unearned revenue is recorded on a company’s balance sheet as a liability. It is treated as a liability because the revenue has still not been earned and represents products or services owed to a customer. As the prepaid service or product is gradually delivered over time, it is recognized as revenue on the income statement.

7)

Accrued revenue is revenue that has been earned by providing a good or service, but for which no cash has been received. Accrued revenues are recorded as receivables on the balance sheet to reflect the amount of money that customers owe the business for the goods or services they purchased.

Example :

A construction company will work on one project for many months. It needs to recognize a portion of the revenue for the contract in each month as service is being rendered, rather than waiting until the very end of the contract to recognize the full contract revenue in the final month.

8)

A trial balance is a bookkeeping worksheet in which the balance of all ledgers are compiled into debit and credit account column totals that are equal. A company prepares a trial balance periodically, usually at the end of every reporting period. The general purpose of producing a trial balance is to ensure the entries in a company's bookkeeping system are mathematically correct.

9)

An adjusted trial balance is an internal document that summarizes all of the current balances available in general ledger accounting. The adjusted trial balance is prepared to show updated balances after adjusting entries have been made.

10) The types of financial statements prepared at the end of the year is :

1. Statement of Financial Position i.e Balance sheet

2.income statement I.e profit and loss account

3.cash flow statements