195 Accounting Principles Questions and Answers for Accounting Exams and Job Interview

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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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be divided up and reported in quarterly financial statements. A similar
situation occurs at a company that develops complex digital systems.
Even a company that manufactures small consumer products will have
ongoing activities and costs that overlap two years or more. Again, the
accountants will assume that the revenues and costs can be assigned or
allocated to the appropriate accounting periods. Hence, the accountants will
report the company's net income and cash flows for each accounting period
(year, quarter, month, etc.) and the company's financial position at the end of
each accounting period.
Periodicity is also known as the time period assumption.
77. Is a loan payment an expense?
Often a loan payment consists of both an interest payment and a payment to
reduce the loan's principal balance. The interest portion is an expense
whereas the principal portion is a reduction of a liability such as Loans
Payable or Notes Payable.
If a company uses the accrual method of accounting, it is logical to record the
interest expense and the interest liability at the end of each accounting period
(instead of recording the interest expense when the payment is made). This is
done with an adjusting entry in order to match the interest expense to the
appropriate accounting period. It also results in the reporting of a liability for
the amount of interest that the company owes as of the date of the balance
sheet.
78. What is income smoothing?
Income smoothing refers to reducing the fluctuations in a corporation's
earnings. Income smoothing can range from good business methods to
fraudulent reporting.
Some business practices are ethical and will result in income smoothing. For
example, a corporation might have an employee bonus plan, a deferred profit
sharing plan, and a charitable giving plan that will result in expenses that total
25% of its pre-tax profits. In addition, a U.S. corporation might have a
combined federal and state income tax rate of 40% on its incremental pre-tax
profits. These examples will smooth income by causing huge expenses when
profits are huge, and will result in little expense when profits are little. (Losses
could actually result in a negative income tax expense.) In a year of low profits
a corporation might eliminate jobs and postpone maintenance expenses.
When profits are higher the corporation will add jobs and perform the
maintenance that it had avoided.

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The term income smoothing is more likely associated with the manipulation of
earnings, creative accounting and the aggressive interpretation and
application of generally accepted accounting principles. Perhaps a company
will increase its allowance for doubtful accounts with a significant charge to
bad debts expense in the years with high profits. Then in years of low profits,
the company will reduce the allowance for doubtful accounts. Perhaps a U.S.
manufacturer using LIFO will deliberately reduce its inventory quantities in low
profit years in order to liquidate the old LIFO layers containing low unit costs.
Other manufacturers might increase production when sales and profits are
low in order to have lower unit costs.
Smoothing income by abusing the leeway in accounting principles is unethical
and does a disservice to the users of the financial statements. Accountants
should follow their general guidelines such as consistency, comparability,
neutrality, full disclosure and conservatism.
79. What is accrued rent?
Accrued rent could be the rent that a landlord has earned but has not been
received from the tenant. Under the accrual method of accounting this would
be reported by the landlord on the income statement as Rent Revenue or
Accrued Rent Revenue and on the balance sheet as the asset Rent
Receivable.
Accrued rent could also refer to the rent expense that the tenant has incurred
but has not yet paid the landlord. Under the accrual method of accounting the
tenant would report the accrued rent as Rent Expense on its income
statement and on its balance sheet as the liability Accrued Expenses or Rent
Payable.
If the rent is to be paid at the beginning of each month, there would be
accrued rent only if the tenant fails to pay the rent when it was due.
80. How do you divide the cost of real estate into land and building?
We will use the following example to illustrate how to divide the cost of real
estate into the cost of the land and the cost of the building. Assume that the
entire cost of a real estate purchase is £220,000. The appraisal made at the
time of the purchase indicates that the land has a market value of £50,000
and the building has a market value of £200,000...for a total market value of
£250,000.
We can use the appraisal amounts for dividing the actual cost of £220,000
into the cost of the land and the cost of the building. There are two related
techniques which will have the same results.

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1. Since the appraisal report indicated that the land's value is £50,000 out of
the £250,000 of total appraised value, we can assign 20% (50/250) of the total
cost of £220,000 to the land, or £44,000. The building's appraised value is
£200,000 out of the £250,000 total appraised value. Therefore we can assign
80% (200/250) of the total cost of £220,000 to the building, or £176,000.
2. The real estate's total cost of £220,000 is 88% of the total appraised value
of £250,000. We can multiply the land's appraised value of £50,000 times
88% in order to get the cost of the land at £44,000. The building's appraised
value of £200,000 times the 88% cost ratio equals the cost of land at
£176,000.
A self-check of both calculations indicates the same costs: land at £44,000
plus the building at £176,000 equals the total actual cost of £220,000.
We did not deviate from the cost principle. We merely used the appraised
market values as a logical way to divide up the actual cost between the land
and building. This assignment or allocation is necessary because the cost of
the building used in a business will be depreciated, while the cost of the land
is not depreciated.
81. What is the transaction approach and balance sheet approach to
measuring net income?
The transaction approach to measuring net income is the traditional
bookkeeping and accounting method. That is, individual transactions such as
each sale, each purchase, and every expense are recorded into general
ledger accounts. At any point you can go to an account such as Salaries
Expense for Sales Staff and see the year to date amount of such an expense.
With the use of accounting software, an enormous quantity of transactions
can be recorded into many detailed accounts.
I believe that the balance sheet approach is also referred to as the capital
maintenance approach. Under the balance sheet approach one looks at the
change in stockholders' or owner's equity to determine the amount of net
income during the period between balance sheets. This approach requires
that you exclude any additional capital from the owners as well as any
dividends or withdrawals distributed to the owners. For example, if
stockholders' equity increased by £5 million with £2 million caused by the
issuance of new shares of stock, and £1 million distributed as dividends, the
net income would have been £4 million. We can verify the calculation with the
following: net income of £4 (an addition to equity) plus new investor money of
£2 (an addition to equity) = £6 of additions to equity, minus dividends of £1 (a
decrease to equity) = £5 (the net increase to equity). Under this balance sheet
approach you will not have the detailed information on revenues and
expenses that would be available under the transaction approach.

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82. How do you record the interest that is unpaid on a note payable?
Interest that has occurred, but has not been paid as of a balance sheet date,
is referred to as accrued interest. Under the accrual basis of accounting, the
amount that has occurred but is unpaid should be recorded with a debit to
Interest Expense and a credit to the current liability Interest Payable.
To illustrate, let's assume that a company's December loan payment included
interest up until December 10. On the company's financial statements dated
December 31, the company will need to report the interest expense and
liability for December 10 through 31. This is done with an accrual-type
adjusting entry dated December 31.
83. Why are accruals needed every month?
Accrual adjusting entries are needed monthly only if a company issues
monthly financial statements. Two reasons for the monthly accrual adjusting
entries are:
1. To report the revenues and receivables which were earned during the
month, but the transactions had not been recorded in the accounts as of the
end of the month, and
2. To record the expenses and liabilities which were incurred during the
month, but the transactions had not been recorded in the accounts as of the
end of the month.
Monthly accrual, deferral, and other adjusting entries must be recorded prior
to issuing monthly financial statements in order to comply with the accrual
basis of accounting.
84. What is the difference between a land improvement and a leasehold
improvement?
Examples of land improvements include paved parking areas, driveways,
fences, outdoor lighting, and so on. Land improvements are recorded
separately from land, because land improvements have a limited life and are
depreciated. Land is assumed to last indefinitely and will not be depreciated.
Land improvements are recorded in a general ledger asset account entitled
Land Improvements. The depreciation of land improvements will result in
depreciation expense on the company's income tax return. This will reduce its
taxable income and will reduce a profitable company's income tax payments.
An example of a leasehold improvement is the permanent improvement to a
building that is being rented under a 10 year lease. For instance, the tenant
might construct permanent walls and offices inside of the warehouse that it
leases from the owner. The lease will likely state that all improvements to the

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building will belong to the owner of the building. The amount spent by the
tenant to improve the building will be recorded by the tenant in its asset
account Leasehold Improvements. Generally, the amount of these leasehold
improvements will be depreciated by the tenant over the useful life of the
improvements or over the life of the lease, whichever is shorter. The
depreciation expense associated with the leasehold improvements will reduce
the tenant's taxable income and its income tax payments if the company is
profitable.
85. What is the statement of activities?
The statement of activities is one of the main financial statements of a nonprofit or not-for-profit organization.
A non-profit’s statement of activities is issued instead of the income statement
which is issued by a for-profit business.
The statement of activities focuses on the total organization (as opposed to
focusing on funds within the organization) and reports the following:
1. Revenues such as contributions, program fees, membership dues, grants,
investment income, and amounts released from restrictions.
2. Expenses reported in categories such as major programs, fundraising, and
management and general.
3. The change in net assets resulting from items 1 and 2.
The statement of activities will have multiple columns in order to report the
amounts for each of the following classes of net assets: unrestricted,
temporarily restricted, permanently restricted, and total.
86. What is the monetary unit assumption?
The monetary unit assumption is that in the long run, the dollar is stable—it
does not lose its purchasing power. This assumption allows the accountant to
add the cost of a parcel of land purchased in 2013 to the cost of land
purchased in 1956. For example, if a two-acre parcel cost the company
£20,000 in 1956 and in 2013 a two-acre parcel adjacent to the original parcel
is purchased for a cost of £800,000, the accountant will add the £800,000 to
the land account and will report the land account's balance of £820,000 on the
company's balance sheet.
To say that the purchasing power of the dollar has not changed significantly
from 1956 to 2013 is quite a stretch. However, the assumption is that the
purchasing power of the dollar has not changed.

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Part of the monetary unit assumption is that accountants report assets as
dollar amounts, rather than reporting in detail all of the specific assets. If an
asset cannot be expressed as a dollar amount, it cannot be entered in the
general ledger. For example, the management team of a very successful
corporation is by far its most valuable asset. However, the accountant is not
able to objectively convert those talented people into a dollar or monetary
amount. Hence, the team will not be included in the amounts reported on the
balance sheet.
87. What is the advantage of using historical cost on the balance sheet for
property, plant and equipment?
The main advantage of using historical cost on the balance sheet for property,
plant and equipment is that historical cost can be verified. Generally, the cost
at the time of purchase is documented with contracts, invoices, payments,
transfer taxes, and so on.
The historical cost of plant and equipment (not land) is also used to determine
the amount of depreciation expense reported on the income statement. The
accumulated amount of depreciation is also reported as a deduction from the
assets' historical costs reported on the balance sheet. (In the case of
impairment, some assets might be reported at less than the amounts based
on historical cost.)
The use of historical cost is also a disadvantage to those users of the financial
statements who want to know the current values.
88. Why are debt issue costs classified as an asset?
Debt issue costs are classified as assets because of the matching principle.
The idea is to match the cost of issuing debt to the periods that benefit from
the debt. For example, if a corporation incurs £500,000 of issue costs
associated with its 10 year bonds, it should expense £50,000 per year
(£500,000 divided by 10 years).
To achieve the matching principle, the corporation must initially defer the
issue costs. Deferred expenses or deferred costs or prepaid costs are
reported as assets on the balance sheet. In the bond example above, at the
time that the corporation pays for its bond issue costs, it will debit Deferred
Issue Costs for £500,000 and will credit Cash for £500,000. Then in each of
the 10 years of the bond's life it will credit Deferred Issue Costs for £50,000
and will debit Bond Issue Costs Expense for £50,000.
If the amount of the bond issue costs is not significant, the materiality concept
allows the corporation to expense the entire amount of issue costs at the time
that the bonds are issued.

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89. Why do purchases appear as expenses on an income statement?
Generally, the purchases of merchandise are sold in the year they are
acquired. Hence, it is logical to match the current period's purchases as
expenses on the same income statement that reports the current period's
sales revenues.
If some of the purchases are not sold in the same period, there will be a
change in inventory. An increase in the amount of inventory will appear on the
income statement as a deduction to the current period's purchases. It is a
deduction because some of the costs of the current period's purchases are
not associated with the sales shown on the income statement. The deduction
is reporting that some of the costs of purchases are being deferred to a later
period when they will be sold. The deduction is necessary in order to achieve
the matching principle: matching the proper amount of the costs of the goods
sold with the sales revenues of the accounting period.
A decrease in the amount of inventory will appear on the income statement as
an addition to the cost of the purchases. This recognizes that some of the
sales included some costs of purchases that were made in an earlier
accounting period.
90. What is the difference between Rent Receivable and Rent Payable?
The asset account Rent Receivable is used by the landlord to report the
amount of rent that has been earned by the landlord but has not been
received from the tenant as of the balance sheet date. The liability account
Rent Payable is used by the tenant to report the amount of rent that the tenant
owes for rent but has not been paid as of the balance sheet date.
If the rent is to be paid on the first day of each month, and if the rent is paid on
time, the landlord will have a zero balance in Rent Receivable. Similarly, the
tenant will have a zero balance in Rent Payable. It is only if the tenant falls
behind in making the rent payments that amounts will be entered into the Rent
Receivable and Rent Payable accounts.
91. What is prepaid insurance?
Prepaid insurance is the portion of an insurance premium that has been paid
in advance and has not expired as of the date of the balance sheet. This
unexpired cost is reported in the current asset account Prepaid Insurance.
As the amount of prepaid insurance expires, the expired cost is moved from
the asset account Prepaid Insurance to the income statement account
Insurance Expense. This is usually done at the end of each accounting period
through an adjusting entry.
To illustrate prepaid insurance, let's assume that on November 20 a company

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pays an insurance premium of £2,400 for the six-month period of December 1
through May 31. On November 20, the payment is entered with a debit of
£2,400 to Prepaid Insurance and a credit of £2,400 to Cash. As of November
30 none of the £2,400 has expired and the entire £2,400 will be reported as
Prepaid Insurance. On December 31, an adjusting entry will debit Insurance
Expense for £400 (the amount that expired: 1/6 of £2,400) and will credit
Prepaid Insurance for £400. This means that the debit balance in Prepaid
Insurance at December 31 will be £2,000 (5 months of insurance that has not
yet expired times £400 per month; or 5/6 of the £2,400 insurance premium
cost).
92. Is the installation labour for a new asset expensed or included in the
cost of the asset?
The cost of installation is part of the cost of the asset. An asset's cost is
considered to be all of the costs of getting an asset in place and ready for use.
Therefore, the labour cost of installing a new machine is considered to be part
of the asset's cost and not an immediate expense of the period.
The cost of the installation labour will include the workers' wages and the
fringe benefits applicable to those wages.
The total cost of the asset, including installation costs, will be depreciated
over the useful life of the asset.
The concept of materiality does allow you to expense the installation cost
immediately if the amount is insignificant.
93. Why is interest expense a no operating expense?
Interest expense is a no operating expense when it is not part of a company's
main operations. For example, a retailer's main operations are the purchasing
and sale of merchandise, and a manufacturer's main operations are the
production and sale of goods. Neither the retailer nor the manufacturer has
as its main operations the borrowing and lending of money. (On the other
hand, a bank's main operations involves interest expense on its depositors'
savings accounts and interest revenues on its loans and bond investments.)
By reporting interest expense as a no operating expense, it also allows for a
better comparison between the operating income of a retailer that has little
debt with a retailer that has a significant amount of debt.
94. Why are the amounts on the financial statements rounded to thousands
or millions?
Amounts on financial statements are often rounded in order to emphasize the
important digits. As a result of rounding, the financial statements are more
attractive in appearance which in turn makes them more inviting to read.

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Rounding is important because corporations must present three years of
figures on their income statements and cash flow statements and two years of
figures on the balance sheet. For example, imagine looking at the income
statement with the following sales amounts over the past three years:
£1,512,989.63 £1,321,026.98 £1,265,876.22. Now look at the amounts
rounded to the nearest thousand: £1,513 £1,321 £1,266. The rounded figures
allow you to focus on the relevant digits. The rounded amounts also makes it
easier for us to see the trend. Of course, you must label the financial
statement with words such as "Amounts rounded to 000's" so that the reader
understands the amounts shown.
Rounding of the less important digits is acceptable because of accountants'
materiality principle or guideline. The rounding is acceptable so long as the
rounded amounts will not mislead a current or potential investor, lender, or
other person making a decision from the reported information.
95. Does collecting a customer's accounts receivable affect net income?
Collecting accounts receivable that are in a company's accounting records will
not affect the company's net income. (Generally speaking, net income is
revenues minus expenses.)
Under the accrual basis of accounting, revenues and accounts receivable are
recorded when a company sells products or earns fees by providing services
on credit. At the point of delivering the goods or services, the company debits
Accounts Receivable and credits Sales Revenues or Service Revenues.
When an account receivable is collected 30 days later, the asset account
Accounts Receivable is reduced and the asset account Cash is increased. No
revenue account is involved at the time of collection.
Your question brings to light the difference between a receipt and a revenue.
Cash receipts from collecting accounts receivable or from the proceeds of a
bank loan are not revenues. Revenues are amounts that companies earn
through their operations by selling products or providing services (whether or
not cash is received at the time of the sale or service).
96. What is the difference between a note payable and a bond payable?
For accounting purposes, a note payable and a bond payable are similar.
That is, both are 1) written promises to pay interest and to repay the principal
amount or maturity amount on specified future dates, 2) both are reported as
liabilities, and 3) interest is accrued as a current liability.
If the bond or the note has its principal or maturity due within one year of the
balance sheet date and the payment will cause a reduction in working capital,
the bond or note will be reported as a current liability. If the bond or note will
not be due within one year of the balance sheet date or if the maturity date is

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within one year but will not cause a reduction in working capital when it
becomes due, it will be reported as a long-term liability. (For example, there
may be a bond sinking fund or a formal agreement for refinancing the debt
with new long-term debt or stock.)
Outside of accounting, I am certain there are differences. For example, debt
with an original maturity date of less than a year is likely to be a note.
However, some notes can be longer than one year. Government debt
securities might be bills, notes, or bonds depending on the original maturity
date of the debt security. Perhaps some notes do not specify interest.
97. What is the entry when merchandise has been received but not the
vendor's invoice?
If you received merchandise, but have not received the vendor's invoice by
the end of the accounting period, you need to 1) debit Purchases (periodic
method) or debit Inventory (perpetual method) for the cost of the goods or
merchandise received, and 2) credit Accounts Payable. You also need to
include the merchandise in your physical inventory.
When the vendor's invoice is received and processed, be sure to reverse
(remove) the above entry.
98. What is meant by the term going concern?
Going concern is a basic underlying assumption in accounting. The
assumption is that a company or other entity will be able to continue operating
for a period of time that is sufficient to carry out its commitments, obligations,
objectives, and so on. In other words, the company will not have to liquidate
or be forced out of business in the foreseeable future.
The going concern provides some logic for the cost principle: If a company is
a going concern, it is not planning to liquidate, so why report the current value
of its long term assets? However, if an asset's value has been impaired, the
asset's carrying amount might be reduced to an amount lower than its
carrying value.
99. What is a deferred asset?
I assume that the term deferred asset refers to a deferred charge or a
deferred debit. A deferred charge is reported on the balance sheet in the longterm asset section other assets.
An example of a deferred charge is bond issue costs. These costs include all
of the fees that a corporation incurs in order to register and issue bonds. The
fees are paid near the time that the bonds are issued but they will not be
expensed at that time. Rather, the bond issue costs are initially deferred to the
long-term asset section of the balance sheet. Then in each year of the life of

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the bonds, a portion of the bond issue costs will be systematically moved from
the balance sheet and will appear as an expense on the income statement.
The process of systematically reducing this deferred charge is known as
amortizing the bond issue costs.
100.

What is the difference between the terms capitalize and
depreciate?
Capitalize refers to adding an amount to the balance sheet. For
example, certain interest from loans to self-construct a building will be
added to the cost of the building. The buildings cost including the
capitalized interest will be recorded as an asset on the balance sheet.
Depreciate refers to reducing an amount reported on the balance
sheet. Depreciation is defined as systematically allocating the cost of a
plant asset from the balance sheet and reporting it as depreciation
expense on the income statement. If the building has a cost of
£600,000 and a useful life of 30 years, then each year £20,000 of cost
is removed from the asset section of the balance sheet and will appear
on the income statement as depreciation expense. (This in turn
reduces owner's equity and keeps the balance sheet in balance.)
The interest on debt that is capitalized will not be expensed during the
year of construction. Instead, it is added to the cost of the building
(capitalized) and will be part of the annual depreciation expense
occurring during the building's 30-year life.
In summary, capitalize means to add an amount to the balance sheet.
Depreciate means to systematically remove an amount from the
balance sheet during the asset's useful life.

101.

What is the journal entry to record a one-year subscription for a
magazine?
Let's assume that the cost of the one-year subscription for a monthly
magazine is £24. Let's also assume the payment is made at the start of
the subscription period, and that your company prepares monthly
One way to enter the transaction is to debit the current asset Prepaid
Subscriptions for £24 and to credit Cash for £24. At the end of each
month you would make an adjusting entry to debit Subscriptions
Expense for £2 and to credit Prepaid Subscriptions for £2. This
approach would obviously match the annual cost to each of the 12
periods benefiting from the subscription. However, this is not practical
given the small amount involved.

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Thanks to the accounting concept of materiality, accountants can
ignore the matching principle when the amount is insignificant in
relationship to the company's size. Since no investor or lender would
be misled if the entire £24 appeared as an expense in one month and
£0 appeared in the other 11 months, the following entry would be more
practical: debit Subscriptions Expense for £24 and credit Cash for £24
at the time of entering the invoice into the accounting records.
If the annual subscription was £8,400 for a trade journal and other
membership services, a small company will likely find that amount to be
significant and should not expense the entire amount in one month.
102.

How can working capital be improved?
Working capital can be improved by 1) earning profits, 2) issuing
common stock or preferred stock for cash, 3) replacing short-term debt
with long-term debt, 4) selling long-term assets for cash, 5) settling
short-term debts for less than the stated amounts, and 6) collecting
more of the accounts receivables than was anticipated and then
reducing the balance required in the current asset account Allowance
for Doubtful Accounts.
I am sure there are additional ways to increase working capital. The
concept is to increase the amount of current assets and/or to decrease
the amount of current liabilities.

103.

What is GAAP?
GAAP is the acronym for generally accepted accounting principles. In
the U.S. that means
1) The basic accounting principles and guidelines such as the cost
principle, matching principle, full disclosure, etc.
2) The detailed standards and other rules issued by the Financial
Accounting Standards Board (FASB) and its predecessor the
Accounting Principles Board, and
3) Generally accepted industry practices.
GAAP must be adhered to when a company distributes its financial
statements outside of the company. If a corporation's stock is publicly
traded, the financial statements must also adhere to rules established
by the U.S. Securities and Exchange Commission (SEC). This includes
having its financial statements audited by an independent CPA firm.

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104.

When do you adjust the amount of prepaid expenses?
The balance in the current asset account Prepaid Expenses should be
adjusted prior to issuing a company's financial statements. If the
company issues financial statements for each calendar month, you will
need to adjust the balance in Prepaid Expenses as of the end of each
month. If your company issues only quarterly financial statements, you
will need to adjust the balance at the end of each quarter.
The goal is to have the balance in Prepaid Expenses be equal to the
amount of the unexpired costs as of the end of the accounting period
(which is also the date appearing in the heading of the balance sheet).
Usually the adjusting entry for prepaid expenses will be a credit to
Prepaid Expenses and a debit to the appropriate expense account(s).
For instance, if Prepaid Expenses involve the prepayment of insurance
premiums the adjusting entry will include a debit to Insurance Expense.

105.

At what point are revenues considered to be earned?
Revenues, which are derived from an entity's main activities such as
the sale of merchandise or the performance of service, are considered
to be earned when the earning process has been substantially
completed.
For example, a merchandiser's sales revenues are considered earned
when the goods have been shipped or delivered to the customers and
the merchandiser has a right to a collectible accounts receivable.
(Under accrual accounting it is not necessary to have received the cash
in order to have earned the revenues.) The reason is that the
substantial and difficult parts of the selling process (having the
merchandise, finding customers, getting customers to place orders, and
delivering the merchandise to customers) have been completed.
Collecting the accounts receivable is usually an automatic process
which requires little or no effort.
General guidance for determining when revenues are earned can be
found in paragraphs 83 and 84 of the FASB's Statement of Financial
Accounting Concepts No. 5, Recognition and Measurement in Financial
Statements of Business Enterprises and in an Intermediate Accounting
textbook.

106.

How do you write off a bad account?
There are two ways to write off a bad account receivable. One is the
direct write-off method and the other occurs under the allowance
method.

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Under the direct write-off method a company writes off a bad account
receivable after the specific account is found to be uncollectible. This
write off usually occurs many months after the account receivable and
the credit sale were recorded. The entry to write off the bad account will
consist of 1) a credit to Accounts Receivable in order to remove the
amount that will not be collected, and 2) a debit to Bad Debts Expense
to report the amount of the loss on the company's income statement.
Under the allowance method a company anticipates that some of its
credit sales and accounts receivable will not be collected. In other
words, without knowing the specific accounts that will become
uncollectible, the company debits Bad Debts Expense and credits
Allowance for Doubtful Accounts. This Allowance account is a contra
receivable account and it allows the company to report the net amount
of the receivables that it expects will be turning to cash prior to
identifying and removing a specific account receivable. When a specific
customer's account does present itself as uncollectible, the customer's
account will be written off by crediting Accounts Receivable and
debiting Allowance for Doubtful Accounts.
In the U.S. the direct write-off method is required for income tax
purposes. However, for financial reporting purposes the allowance
method means recognizing the loss (the bad debts expense) closer to
the time of the credit sales. As a result, the allowance method is more
in line with the accountants' concept of conservatism and may result in
a better matching of the bad debt expense with the credit sales.
107.

What is the difference between unearned revenue and unrecorded
revenue?
In financial accounting, unearned revenue refers to amounts received
prior to being earned. For example, if ABC Service Co. receives
£24,000 on December 31, 2012 for a one-year service agreement
covering January 1 through December 31, 2013, the entire £24,000 is
unearned as of December 31, 2012. On the December 31, 2012
balance sheet ABC should report a liability such as Unearned
Revenues for £24,000. During 2013 ABC should move £2,000 per
month from the liability account on its balance sheet to a revenue
account on its income statement.
I associate unrecorded revenue with revenues that were earned, but
not yet recorded in a company's accounting records. For example, an
electric utility will provide electricity to customers for up to one month
before it reads the customers' meters, calculates the bills and records
the billings as revenues and accounts receivable. As a result, the
electric utility will have up to one month of unrecorded revenue. At each

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balance sheet date, the utility should accrue for the revenues it earned
but had not yet recorded. This is done through an adjusting entry that
debits a balance sheet receivable account and credits an income
statement revenue account.
108.

How do you account for a project under construction?
I will assume that the project under construction is a major rebuilding of
equipment or an addition to a building. The amounts spent on these
projects would be debited to a long term asset account such as
Construction Work in Progress. This account is often reported as the
last line within the balance sheet classification Property, Plant and
Equipment.
There will be no depreciation until the project is completed and the
asset is placed into service. When the completed asset is placed into
service, the project's cost will be removed from the account
Construction Work in Progress and will be debited to the appropriate
plant asset account.

109.

What is the entry when a contract is signed?
Signing a contract will not require a journal entry unless cash, a
promissory note, or another asset is exchanged at the time. Signing a
contract causes a commitment but does not necessarily create a
liability or asset at the time of signing.
For example, an electric utility may sign a contract with a coal producer
for 100 million tons of coal to be delivered over a one-year period
beginning in three months. On the day the two parties sign the contract,
the electric utility does not own any of the coal specified in the contract
and does not have a liability to the coal producer. Likewise, on the day
of signing the contract, the coal producer does not have a sale of any of
the coal specified in the contract nor does it have an account receivable
from the electric utility. In three months, when the first trainload of coal
arrives at the electric utility, the utility will record the purchase of that
trainload of coal and the related account payable to the producer. Also
at that time, the coal producer will record the sale of that trainload of
coal and an account receivable.

110.

Why does commitment and contingencies appear on the balance
sheet without an amount?
The term or caption commitment and contingencies appears near the
end of a balance sheet without an amount in order to direct a reader's
attention to the disclosures included in the notes to the financial
statements.

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An amount is not shown for a variety of reasons. For example, a chain
of retail stores may have signed five-year, non-cancellable leases to
rent retail space for £1 million per year. This commitment needs to be
disclosed to the readers of the balance sheet. However, if none of the
£5 million is actually due as of the balance sheet date, there is no
liability amount to be recorded in a liability account.
Another example of a commitment is an electric utility which has signed
a non-cancellable contract to purchase 100 million tons of coal during
the following 10 years. This commitment also needs to be disclosed to
the readers of the balance sheet. However, if none of the coal has been
delivered as of the balance sheet date, the utility company will not
report a liability since nothing is due as of the balance sheet date.
There are also some loss contingencies which are not recorded with
amounts in the general ledger, but must be disclosed in the notes to the
111.

What does it mean to report expenses by function?
To report expenses by function means to report them according to the
activity for which the expenses were incurred.
For a business, the reporting of expenses by function means the
income statement will report expenses according to the following
functional classifications: manufacturing, selling, general administrative,
and financing.
For a not-for-profit organization, the reporting of expenses by function
means the statement of activities will report expenses according to the
following functional classifications: 1) each of its major programs, and
2) the supporting services which are a) management and general, b)
fund-raising, and c) membership development.
(Classifying expenses according to salaries, electricity, repairs, etc. is
referred to as natural classifications, or classifying expenses by their
nature.)

112.

What is the matching principle?
The matching principle is one of the basic underlying guidelines in
accounting. The matching principle directs a company to report an
expense on its income statement in the same period as the related
revenues.
To illustrate the matching principle, let's assume that all of a company's
sales are made through sales representatives (reps) who earn a 10%

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commission. The commissions for each calendar month's sales are
paid to the reps on the 15th day of the following month. For example, if
the company has £60,000 of sales in December, the company will pay
commissions of £6,000 on January 15. The matching principle requires
that £6,000 of commission expense be reported on the December
income statement along with the related December sales of £60,000.
This is likely to be carried out through an adjusting entry on December
31 that debits Commission Expense and credits Commissions Payable
for £6,000.
The matching principle is associated with the accrual method of
accounting and adjusting entries. Without the matching principle, the
company might report the £6,000 of commission expense in January
(when it is paid) instead of December (when the expense and the
liability are incurred).
A retailer's or a manufacturer's cost of goods sold is another example
of an expense that is matched with sales through a cause and effect
relationship. However, not all costs and expenses have a cause and
effect relationship with sales or revenues. Hence, the matching
principle may require a systematic allocation of a cost to the accounting
periods in which the cost is used up. For example, if a company
purchases an elaborate office system for £252,000 that will be useful
for 84 months, the company will match £3,000 of expense each month
to its monthly income statement.
If the future benefit of a cost cannot be determined, it should be
charged to expense immediately. For example, the entire cost of a
television advertisement that is shown during the Olympics will be
charged to advertising expense in the year it is shown.
113.

Does paying an accounts payable affect net income?
Paying accounts payable that are already included in a company's
accounting records will not affect the company's net income. (Generally
speaking, net income is revenues minus expenses.)
Under the accrual basis of accounting, if an expense is associated with
an accounts payable, the expense will be recorded at the time the
accounts payable is recorded—not at the time of the payment. For
example, on January 2 a company has its office copier repaired. The
cost of the repair is £300 and is to be paid by January 31. On January
2, the invoice for the repair is recorded with a £300 debit to Repairs and
Maintenance Expense-Office Equipment and a £300 credit to Accounts
Payable. On January 31 when the invoice is paid, the company will
debit Accounts Payable and will credit Cash for £300. As you see, the

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January 31 transaction affects two balance sheet accounts; no expense
account or other income statement account is involved.
The January 31 transaction also illustrates that an expenditure is not
necessarily an expense. Here are two additional examples: (1) A
company pays cash to purchase an asset that will be used in the
business. At the time of the purchase, an expenditure takes place, but
not an expense. The expense will occur later when the asset is
depreciated. (2) A company repays £50,000 of principal owed on its
bank loan. The £50,000 is an expenditure, but it is not an expense.
Expenses are costs that are used up in order for the company to earn
revenues. Expenses are also costs that expired during an accounting
period. Under accrual accounting, expenses can occur before or after a
cash expenditure is made.
114.

What is meant by events after the balance sheet date?
Events after the balance sheet date are significant financial events that
occur after the date of the balance sheet, but prior to the date that the
financial statements are issued. For example, a company's balance
sheet that has the heading of December 31, 2012 might not be finalized
and distributed until February 1, 2013. During January new information
may arise that has financial significance. Perhaps there is an event that
provides more information about the conditions actually existing on
December 31. The second type of event would be a new January event
that does not change the December 31 amounts, but needs to be
disclosed to the readers of the December 31 financial statements.
An example of the first situation might be that a customer owes Jay
Company £200,000 on December 31 and Jay Company assumed that
the customer was financially sound. As a result Jay Company did not
provide any allowance for the customer's account being uncollectible.
Then on January 28, the customer filed for bankruptcy and Jay
Company learns that none of the £200,000 receivable will be collected.
If the customer's financial condition on December 31 was already in
bankruptcy condition, Jay Company will need to adjust its December 31
balance sheet and its income statement for the year 2012 for this
£200,000 of bad debts expense.
An example of the second situation might be a loss arising from a
catastrophe occurring on January 16, 2013. The amounts reported as
of December 31, 2012 will not be adjusted since those amounts were
correct as of December 31. However, the readers of the December 31
balance sheet and the 2012 income statement should be informed

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through a disclosure that something significant has occurred to the
company's financial position since December 31.
The events after the balance sheet date are often referred to as
subsequent events or post balance sheet events.
115.

How do you calculate the payroll accrual?
The payroll accrual is the amount that needs to be entered into a
liability account in order for the credit balance in the liability account to
be the amount owed to employees. The amount owed is the amount
the employees have earned from working, but as of the date of the
balance sheet this amount has not been paid to the employees.
To illustrate the payroll accrual, assume that a company's employees
were paid on September 30 for their work through September 25. The
credit balance needed in the liability account as of September 30 is the
amount that the employees earned for the days of September 26
through September 30.

116.

Can a fully depreciated asset be revalued?
No. A fully depreciated asset cannot be revalued because of
accounting's cost principle, matching principle, and going concern
assumption.
For instance, let's assume that a company purchased a building 30
years ago at a cost of £600,000. The company then depreciated the
building at a rate of £20,000 per year for 30 years. Today the building
continues to be used by the company and it plans to continue using it
for many more years. The company's current balance sheet will report
the building at its cost of £600,000 minus its accumulated depreciation
of £600,000. In other words, the building will be reported at its book
value of £0.
The cost principle prevents the company from recording and reporting
more than its actual cost of £600,000. The matching principle requires
that only the actual cost of £600,000 can be allocated or matched to the
years in which the company benefits from the use of the building.
Lastly, the company is assumed to be a going concern and therefore it
is not liquidating. Hence the amount that the company would receive if
it sold the building is not appropriate for its financial statements.
Even if the building's current value is estimated to be £2 million, the
financial statements must report the actual cost and the depreciation
based on that cost---even if this means reporting a book value of £0. It

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also means there will be no additional depreciation expense reported
after the £600,000 of actual cost has been reported as depreciation
expense.
117.

What does arm’s length transaction mean?
An arm’s length transaction involves two independent parties and each
is attempting to get the best deal possible.
For example, if your mother is selling her two-year old car to you for
£7,000 and the blue book wholesale value is £14,000 that is NOT an
arm’s length transaction. Your mother is giving you a very good deal
instead of attempting to get the fair market value of the car.
In an arm’s length transaction, the seller of a car attempts to get as
much as possible for the car from an independent person who is
striving to get the car for the lowest possible price. Both parties
probably know the retail value and the wholesale value of the car and
both want the best price: the seller is attempting to sell the car at a
price that is close to the retail value and the buyer is attempting to buy
the car for the wholesale value or less.

118.

How much do you depreciate an asset and when?
Depreciation begins when you place an asset in service and it ends
when you take an asset out of service or when you have expensed its
cost, whichever comes first.
For financial statements, you are guided by the matching principle. The
objective is to match the cost of the asset to the accounting periods in
which revenues were earned by using the asset. There are two
estimates needed: 1) the number of years that the asset will be used,
and 2) the salvage value at the end of the asset's use. If an asset has a
cost of £100,000 and is expected to be used for 10 years and then
have no salvage value, most companies will depreciate the asset at the
rate of £10,000 per year. This is known as the straight line method of
depreciation.
For income tax purposes in the U.S., the Internal Revenue Service has
determined the number of years that various assets will be useful and it
assumes there will be no salvage value. The IRS also allows
companies to take larger depreciation deductions in the earlier years
and smaller deductions in the later years of the assets' lives. This is
known as accelerated depreciation.
As you probably noted from the above information, in any one year the

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depreciation expense on the financial statements will be different from
the depreciation expense on the income tax return. However, over the
life of an asset, the total depreciation expense will be the same.
Accountants refer to this as a timing difference.
119.

What is the meaning of systematic and rational allocation?
Systematic and rational allocation is a phrase often cited in the
definition of depreciation. In that context it means that the annual
depreciation expense should be based on a formula that is logical and
acceptable to other unbiased accountants.
For example, depreciating an asset over a 10-year period with the
same amount of depreciation expense each year is systematic and
rational. Depreciating the asset on the basis of the number of parts it
produces is also systematic and rational. However, determining the
annual depreciation expense based on each year's profits is not
systematic and rational.
Systematic and rational allocations provide for objectivity and
consistency, which are important characteristics of accounting.

120.

Which financial statement shows a corporation's worth?
Not one of the financial statements will show a corporation's worth. The
balance sheet, income statement, statement of cash flows, and
stockholders' equity statement merely provide information to assist
financial experts in forming an opinion of a corporation's worth.
In the past, some people mistakenly thought that a corporation's
stockholders' equity was the corporation's worth. However,
stockholders' equity (or the owner's equity of a proprietorship) is merely
the result of subtracting the reported amount of liabilities from the
reported amount of assets. Since the reported amounts reflect the cost
principle and other accounting principles, the net result cannot be
assumed to be the company's worth.

121.

Is standard costing GAAP?
Standard costing was developed to assist a manufacturer plan and
control its operations. Generally accepted accounting principles or
GAAP require that a manufacturer's financial statements comply with
the cost principle. This means that the inventories, the cost of goods
sold, and the resulting net income must reflect the manufacturer's
actual costs.
Standard costing will meet the GAAP requirements if the variances
between the standard costs and the actual costs are properly prorated

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to the inventories and to the cost of goods sold prior to issuing the
122.

How does the purchase of a new machine affect the profit and
loss statement?
The purchase of a new machine that will be used in a business will
affect the profit and loss statement, or income statement, when the
machine is placed into service. At that point, depreciation expense will
begin and there will likely be other expenses such as wages,
maintenance, electricity, and so on.
Since the income statement reports only the expenses that match the
revenues during the accounting period, the depreciation expense might
be very small in the first accounting period compared to the amount
spent for the machine. For example, if the machine is purchased half
way into the accounting year and its cost was £300,000, the
depreciation for that first accounting period might be only £15,000—
assuming it has a 10 year life and no salvage value. In the next
accounting period the depreciation expense will be £30,000 under the
straight-line method.
If the machine is used by a manufacturer, the depreciation, electricity,
and maintenance of the machine will be recorded as manufacturing
overhead. This overhead is then assigned to the products and will be
held in inventory until the goods are sold. When the products are sold,
these overhead costs will be reported on the income statement as part
of the cost of goods sold.

123.

Should trademarks be included on the balance sheet?
A trademark should be reported on the balance sheet as an intangible
asset. However, the cost principle prevents the reported amount from
being more than the cost of acquiring and defending the trademark. A
trademark that was developed internally (rather than purchased) might
have a cost of £0, and therefore it will not be listed on the balance
sheet.
For example, Company X, a consumer products company, introduced a
new product in 1960. It registered the trademark in 1960 for a small fee
that was immediately expensed. Since then Company X has been very
effective in promoting this trademarked brand. Consumers now pay a
premium price for this recognized and superior product. A competitor
offers to purchase the trademark from Company X for £300 million in
cash. If Company X does not sell the trademark, Company X will not list
the trademark as an asset. (Recall that the trademark's cost was £0.)

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If Company X were to sell the trademark to Company Y for £300
million, Company Y will report the trademark on its balance sheet at
£300 million. The reason is that there was a transaction for £300 million
and Company Y's cost of the trademark was indeed £300 million.
124.

Why are the issue costs of bonds reported as an asset?
The costs associated with issuing bonds should be matched to the
accounting periods that will benefit from the bonds. For example, if a
corporation incurs bond issue costs of £150,000 in order to issue
£5,000,000 of bonds maturing in 15 years, the corporation should
report an annual Bond Issue Costs Expense of £10,000 (£150,000
divided by 15 years).
Since the corporation must pay the bond issue costs of £150,000 when
the bonds are issued, but can expense only £10,000 per year, the bond
issue costs need to be deferred to a long-term asset account. In effect
the bond issue costs are prepaid expenses, which are part of the
definition of assets. (Recall, that the payment of a 6-month or 12-month
insurance premium is reported as a current asset until it expires and is
then expensed.)
The journal entry for the bond issue costs will initially be a debit of
£150,000 to Bond Issue Costs and a credit to Cash or Accounts
Payable. Then each year that the bonds are outstanding there needs to
be an accounting entry to credit Bond Issue Costs for £10,000 and to
debit Bond Issue Costs Expense. This is referred to as amortization
and it results in the balance in the long-term asset account Bond Issue
Costs being reduced to £0 by the time the bonds mature.

125.

What is a natural business year?
A natural business year is the period of 12 consecutive months (or 5253 consecutive weeks) ending at a low point of an organization's
activities. For example, a school district will have a natural business
year of July 1 through June 30, since classes for the school year end in
early June.
A retailer's natural business year might be the 52-53 consecutive
weeks ending on the Saturday closest to each February 1. This is a low
point of activity as it follows the retailer's holiday season and its
January clearance sales. The 52-53 week periods (instead of 12 month
periods) will result in an equal number of Saturdays in most of the
natural business years (as well as in the 13-week quarters and in the 45 week months).

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Many companies have a natural business year of January 1 through
December 31. On the other hand, some companies are required by
government regulations to end their accounting years on December 31,
even though it is not the end of their natural business year.
The term fiscal year is associated with companies having financial
reporting years that do not end on December 31.
126.

Why would Prepaid Insurance have a credit balance?
Several situations could cause a credit balance in the asset account
Prepaid Insurance. For example, let's assume a company's insurance
has a cost of £600 every six months. As a result, the company decides
to debit Prepaid Insurance when the amount is paid semi-annually. It
also prepares an automatic monthly adjusting entry to debit Insurance
Expense £100 and to credit Prepaid Insurance for £100. If one of the
£600 payments is debited to Insurance Expense (or another account)
instead of Prepaid Insurance, the monthly adjusting entries will cause
the balance in the Prepaid Insurance account to become a credit
balance.
Another possibility is that the company simply failed to pay the
insurance company and the monthly adjusting entries caused the
balance in Prepaid Insurance to become a credit balance. Whatever
the cause of the credit balance in Prepaid Insurance, the account
balance needs to be adjusted before issuing a balance sheet. The
Prepaid Insurance account must report the true amount that is prepaid
(paid but not yet expired) as of the date of the balance sheet. If nothing
is prepaid then the Prepaid Insurance account must show a zero
balance. If an amount is owed to the insurance company, there should
be a liability account with a credit balance for the amount owed as of
the balance sheet date.
Because adjusting entries involve a balance sheet account and an
income statement account, it is wise to also look at the amount being
reported in the income statement account Insurance Expense. You
should monitor both the Insurance Expense account balance and the
Prepaid Insurance account balance throughout the year. The amount
paid to the insurance company that has expired needs to be reported
as an expense and the amount that has not yet expired needs to be
reported as the asset Prepaid Insurance.

127.

What is the difference between assessed value and appraised
value?
Assessed value pertains to the amount that a local or state government
has designated for specific property. This assessed value will be used

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when a property tax is levied by the government. For example, a city
tax assessor is responsible for determining the assessed value for
every parcel of land and every building within the city. The city
government then establishes a real estate tax rate (or rates) that will be
applied to the assessed values. Some local and state governments will
also determine assessed values for personal property. The assessed
value of real or personal property is not necessarily equal to the
property's market value.
Appraised value pertains to the amounts contained in an appraisal
report for specific property. The appraisal report is generally prepared
by a professional appraiser who looks at the property's features
including size, type of construction, location, condition, and recent sales
of comparable property in the vicinity. The appraised value is an
attempt to determine the property's market value. The appraisal report
for real estate is likely to report the appraised value of the land
separate from the appraised value of the buildings. Hence, accountants
might use the relationship of these values in order to allocate the cost
of real estate into the cost of the land and the cost of the buildings.
Appraised values have relevance because a company's balance sheet
will report land and buildings at the cost when they were acquired. (The
balance sheet will also report the accumulated depreciation of the
buildings.)
128.

What is the effect on financial ratios when using LIFO instead of
FIFO?
During periods of significantly increasing costs, LIFO when compared
to FIFO will cause lower inventory costs on the balance sheet and a
higher cost of goods sold on the income statement.
This will mean that the profitability ratios will be smaller under LIFO
than FIFO. The profitability ratios include profit margin, return on
assets, and return on stockholders' equity.
The inventory turnover ratio will be higher when LIFO is used during
periods of increasing costs. The reason is that the cost of goods sold
will be higher and the inventory costs will be lower under LIFO than
under FIFO.

129.

What causes a corporation's market value to be greater than its
book value?
One cause of a corporation's market value being greater than its book
value is the accountant's cost principle. In order for an item to be listed
as an asset on a corporation's balance sheet, the item must have been

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purchased (or donated). If an item is not listed on the balance sheet as
an asset, it will not be included in a corporation's book value. (A
corporation's book value is the amount of stockholders' equity reported
on the balance sheet, which is the amount of assets reported minus the
amount of liabilities reported.)
Often a corporation's most valuable assets were not purchased and,
therefore, will not be reported as assets and will not be included in the
corporation's book value. Think of the late Steve Jobs and the culture
he developed at Apple. He and his team, the innovative culture, the
wildly successful brand names, etc. could never be listed on the
balance sheet as assets nor directly included in the corporation's book
value.
On the other hand, the market does recognize those attributes as being
immensely valuable. Hence the corporation's market value was and is
greater than its book value.
130.

Is a post-dated check considered to be currency?
A post-dated check---a check with a date that is later than the current
date---is not considered to be currency. Further, the post-dated check
should not be reported as part of the Cash account balance until the
date of the check.
If the post-dated check was received as payment on accounts
receivable, the accounts receivable balance is not reduced until the
date of the check.
To illustrate this, let's assume that on August 20 a company receives a
£1,000 post-dated check. The check is dated September 5 and
represents the full payment on one of the company's accounts
receivable. Since the post-dated check is not considered to be money
until the date of the check, the accounts receivable should not be
reduced and cash should not be increased until September 5.
Therefore, the company's August 31 balance sheet will report that the
customer's £1,000 accounts receivable is still due.

131.

What if a company's Allowance for Doubtful Accounts is
understated?
When a company's Allowance for Doubtful Accounts is understated, the
credit balance in this account is too small. This indicates that the
company has reported too little of Bad Debts Expense and therefore
too much net income.

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Having a credit balance in the Allowance for Doubtful Accounts that is
too small also means that the company is reporting too much for the
following balance sheet items: net receivables, total current assets,
working capital, total assets, and owner's equity.
132.

How can I determine the inventory methods used by other
companies in my industry?
You can find the inventory methods used by the companies in your
industry whose stock is publicly traded by reading the Summary of
Significant Accounting Policies contained in each company's Form 10K. The Form 10-K is the annual report to the Securities and Exchange
Commission or SEC.
The Summary of Significant Accounting Policies will appear as the first
or second item in the Notes to the Financial Statements.
Most publicly traded corporations will have an Investors Relations link
at the bottom of their website's home page. On the Investors Relations
page you will find a link to the corporation's SEC filings.

133.

What is IFRS?
IFRS is the acronym for International Financial Reporting Standards.
IFRS is used throughout the world except in the United States where
U.S. GAAP (generally accepted accounting principles) is followed.
There is an urgency for the U.S. to adopt the IFRS because of the
growth in global financial markets, global commerce, acquisition of U.S.
companies by corporations outside of the U.S., multinational
corporations having subsidiaries both inside and outside of the U.S.,
and so on. Since financial statements report two or three years of
amounts, the amounts from earlier years will need to follow IFRS in
order to be comparative.
Efforts are also under way for a simplified version of IFRS that would
apply for small and medium sized privately held corporations.

134.

What is net of accumulated amortization?
Net of accumulated amortization usually refers to the amount of an
intangible asset or a deferred charge that has not yet been expensed.
Amortization is a concept similar to depreciation.
To illustrate net of accumulated amortization let's assume that five
years ago a corporation incurred bond issue costs of £600,000 when it
issued £50,000,000 in bonds that would mature 20 years later. The
£600,000 is a deferred charge because it will be amortized to expense

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over the 20-year life of the bonds. Annually £30,000 (£600,000 divided
by 20 years) will be debited to expense such as Bond Issue Expense or
Amortization Expense and will be credited to Deferred Bond Issue
Costs or Accumulated Amortization of Bond Issue Costs. After five
years, the bond issue cost net of accumulated amortization will be
£450,000. This is the original £600,000 of cost minus £150,000 of
accumulated amortization (5 years X £30,000 per year).
135.

What is depletion?
Depletion is the movement of the cost of natural resources from a
company's balance sheet to its income statements. The objective is to
match on the income statement the cost of the natural resources that
were sold with the revenues of the natural resources that were sold.
The cost of the natural resources sold is referred to as depletion
expense.
Conceptually, depletion is similar to the depreciation of property, plant
and equipment.

136.

How are period costs reported in the financial statements?
Under the accrual method of accounting, period costs such as selling,
general and administrative expenses are reported on the income
statement in the accounting period in which they are used up or expire.
They are referred to as period costs because they are not assigned to
products, and therefore cannot be included in the cost of items held in
inventory.
If a selling, general and administrative (SG&A) expense is prepaid, the
prepaid portion will be reported as a current asset. When the prepaid
expense expires, it will move to the income statement and become part
of that period's SG&A expenses.
Interest expense is also a period cost unless it is determined to be a
necessary cost of a self-constructed, long-lived asset.

137.

Why are some expenses deferred?
Generally, expenses are deferred in order to comply with the
accounting guideline known as the matching principle.
To illustrate the concept, let's assume that a company pays £3,000 on
December 30 to rent a warehouse for the upcoming three-month period
of January 1 through March 31. Since none of the £3,000 expires or is
used up in December, none of the amount should be reported as rent
expense on the income statement for the month of December. Hence

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the £3,000 is deferred to a balance sheet account such as Prepaid
Rent (or Prepaid Expenses), which is a current asset account.
During the three months of January 1 through March 31 (when the
prepaid rent is expiring) the £3,000 prepayment must be moved from
the balance sheet asset account to an income statement expense
account. The usual allocation will involve an adjusting entry to debit
Rent Expense for £1,000 and credit Prepaid Rent for £1,000 on
January 31, February 28 and March 31.
138.

Where can I find the amount of income taxes paid by a
corporation?
You can find the amount of income taxes paid by a corporation by
reading its statement of cash flows and its notes to the financial
statements.
US GAAP requires corporations to report the amount of income taxes
paid. The AICPA's Accounting Trend and Techniques indicates that
approximately half of the 500 large corporations that it surveyed had
reported the amount of income taxes paid at the bottom of the
statement of cash flows. Almost the same number had reported the
amount of income taxes paid in its notes to the financial statements.
Only 5 or 6 corporations had reported the amount within its statement
of cash flows. For U.S. corporations whose stock is publicly-traded, you
will find the statement of cash flows included in its Form 10-K, which is
the annual report to the Securities and Exchange Commission (SEC).
It is important to understand that the income tax provision reported on
the income statement is not the amount of income taxes paid in that
period.

139.

Should capital budgeting decisions be based on cash flows or
revenues and expenses?
Capital budgeting decisions should be based on cash flows that are
adjusted for the time value of money. The time value of money
recognizes that a dollar received or spent in the future is less valuable
than a dollar received or spent in the present. Calculations such as the
internal rate of return, net present value, and excess present value
include adjustments for the time value of money. In these calculations
present value factors, financial calculators, or computer software are
used to discount the cash flows to their present values.
Under accrual accounting, revenues and expenses are reported based
on accounting principles. This means that revenues are reported when
they are earned, and expenses are matched to the periods of the

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revenue. In other words, revenues and expenses are not reported on
the income statement when the money is received or spent. Further,
the revenue and expense amounts are not adjusted for the time value
of money because of the monetary unit assumption.
140.

Why isn't a key employee reported as an asset on the balance
sheet?
While an employee could be an organization's most valuable asset,
accountants record past transactions that can be measured.
Since an employee is not purchased, there is no past transaction and
cost that the accountant can record in order to report this person as an
asset owned by the entity. The salary and bonuses paid to a key
employee are reported as expenses in the period in which the
employee performed services.
Not being able to record a valuable employee as an asset is similar to a
valuable brand name developed internally by a company over time.
Since the brand name was not purchased from another entity, there is
no past transaction and purchase cost to be recorded.
I assume that an entity's payment made to another professional sports
team for a professional athlete's services for the next three years will
result in recording the payment as an asset, a prepaid expense or
deferred charge, that will then be amortized to expense over the three
year contract.

141.

Would you please help me understand opportunity cost?
You might think of opportunity cost as the profit you had to forego.
Let's illustrate this with a little story. Suppose that you are the sole
owner of a company which uses a special machine to produce a very
unique product. Your company has a huge backlog of orders for the
product. Every hour that the machine is running, your company is able
to generate sales of £500 while incurring incremental costs and
expenses of £200. As a result, your company's profit is increasing by
£300 for each hour that the machine is running.
Now suppose an employee failed to perform a routine maintenance
task which causes the machine to be shut down for 10 hours. The
repair bill to get the machine running was £400. What was the cost of
the machine being down for 10 hours? The accounting records will
report £400 in the account Repairs and Maintenance Expense. But as
the owner, you are likely to be more upset that the employee cost you
£3,000 (10 hours X £300) in lost profits and upset customers.

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In the above story the opportunity cost was £3,000 of lost profit + the
cost of the upset customers. (From the owner's perspective, the total
cost was the £400 repair bill + £3,000 of opportunity cost described
above + the opportunity cost consisting of future lost profits from lost
customers.)
Now let's modify the story. Suppose the machine that was idled by
employee negligence was not a special machine and there was no
backlog of orders for the product. The repair bill was the same £400. In
this situation you will not be foregoing any sales or losing any
customers. Therefore the profit foregone is £0. In other words, there is
no opportunity cost of the machine being down for 10 hours. All you
have is the £400 repair bill.
This concept of opportunity cost is relevant in making decisions. For
example, in deciding whether to make or to buy a component, the
opportunity cost is an important consideration: If your plant has idle
capacity, you might opt to make a component because there is no
opportunity cost—no profit being foregone as you spend time making
the component. On the other hand, if your plant is operating at full
capacity, you would have to forego the profit on some items presently
being produced (an opportunity cost) in order to make the components.
The concept of opportunity cost is also relevant when setting transfer
prices between divisions or subsidiaries of a large company.
142.

Is the depreciation of delivery trucks a period cost or is it
manufacturing overhead?
The depreciation on the trucks used to deliver products to customers is
a period cost. The depreciation on delivery trucks will be reported as an
expense on the income statement in the period in which it occurs. It
might be reported as part of Selling Expenses or as part of Selling,
General and Administrative (SG&A) Expenses.
The depreciation on the trucks used to transport materials or work-inprocess between the facilities of a manufacturer is a component of
manufacturing overhead. In other words, the depreciation on trucks
used in the manufacturing process is assigned to the goods produced
rather than being expensed directly.

143.

What is LIFO?
LIFO is the acronym for last-in, first-out. It is a cost flow assumption
that can be used by U.S. companies in moving the costs of products
from inventory to the cost of goods sold.

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Under LIFO the latest or more recent costs of products purchased (or
produced) are the first costs expensed as the cost of goods sold. This
means that the costs of the oldest products will be reported as
inventory.
It is important to understand that while LIFO is matching the latest or
most recent costs with sales on the income statement, the company
can be shipping the oldest physical units of product. In other words, the
flow of costs does not have to match the flow of the physical units. This
is why LIFO is a cost flow assumption or an assumed flow of costs. (If
the costs flowing matched the physical units flowing, it would be the
specific identification method and there would be no need to assume a
cost flow.)
Let's illustrate LIFO with a company that has three units of the same
product in inventory. The units were purchased at different costs and in
the following sequence: £40, £44, and £46. The company ships the
oldest item (the one purchased for £40). However, under LIFO the
company will report its cost of goods sold as £46 (the latest cost). Note
that the last cost of £46 is the first cost out of inventory---the LIFO
assumption. This means that the company's inventory will report the
two first or oldest costs of £40 and £44.
LIFO has become popular because of inflation and the fact that the
U.S. income tax rules permit companies to use LIFO. With LIFO a
company is able to match its recent, more-inflated costs with its sales
thereby reporting less taxable income than would occur under another
cost flow assumption. Also, the matching of the latest costs with recent
sales is a better indicator of the company's current profitability.
144.

Why is the distinction between product costs and period costs
important?
The distinction between product costs and period costs is important for
1) properly measuring net income during a period of time and 2)
reporting the proper cost of inventory on the balance sheet.
Product costs cling to the units of products purchased or manufactured.
If a unit is unsold, the product costs will be reported as inventory, a
current asset on the balance sheet. The product costs for a retailer will
be the amount paid to the supplier plus any freight-in. Product costs for
a manufacturer will be the direct materials, direct labour, and
manufacturing overhead. Product costs will be reported on the income
statement as the cost of goods sold expense in the period that the units
of product are sold.

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Period costs do not cling or attach to the units of product and will not be
included in the cost of inventory. For example, the interest incurred by a
retailer to finance its operations will be expensed in the period in which
the interest occurs. Interest is not deferred by adding it to the cost of
the units in inventory. Similarly, selling expenses and general
administrative salaries are expensed in the period that the employees
earn those salaries, the same period in which the company incurs the
salaries expense. The insurance premiums that a company pays for
nonmanufacturing protection will be expensed in the period in which the
insurance premiums expire. (Insurance premiums for the factory
building will be included in the manufacturing overhead which will be
part of the products' cost.)
145.

Why does our company's balance sheet report its land at cost
when it is so much more valuable?
Accountants are guided by the cost principle. This requires accountants
to report assets at their cost when acquired—not their replacement cost
or market value. The historical cost is an objective amount that can
easily be audited. In contrast, the market value is subjective: one
person thinks the land is worth £1 million while another thinks it's worth
£1.5 million.
Further support for the cost principle is the accountants' going concern
assumption. A company is assumed to be continuing in business and
will not be liquidating. If your company bought the land for possible
expansion, its cost is more relevant than the amount the company
could get if it were liquidating. After all your company is not liquidating.
The revenue recognition principle would be another reason why market
values are not reported.
(P.S. I should add that some businesses are required to report assets
at market value. I believe those businesses are in industries with
significant markets and verifiable quoted market prices.)

146.

What is accounting for price level changes?
In 1979 the Financial Accounting Standards Board (FASB) issued its
Statement of Financial Accounting Standards No. 33 entitled Financial
Reporting and Changing Prices. (You will find the original Statement
No. 33 on www.FASB.org.) In short, Statement No. 33 required large
companies to report supplementary information on the effects of
changing prices on its inventory and its property, plant and equipment.
(In the late 1970's the U.S. was experiencing double-digit inflation rates
and the SEC was advocating the reporting of replacement cost.)

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One disclosure required by Statement 33 was the reporting of the
effects of general inflation as indicated by the change in the consumer
price index. In other words, a large company had to disclose in the
notes to its financial statements some key amounts after adjusting
inventory and property, plant and equipment amounts for the changes
in the purchasing power of the U.S. dollar. The second disclosure
reported the effects of the changes in the specific prices of inventory
and property, plant and equipment.
In 1986 the FASB issued its Statement No. 89 which no longer required
the reporting of the information. As a result, most companies stopped
the calculations and reporting. Two of the factors in deciding to stop the
calculations was the lack of use by financial analysts and a decline in
the rates of inflation in the U.S. In other words, the accounting for price
level changes failed to pass the cost/benefit test.
147.

Is the sales tax on merchandise purchased for resale included in
inventory?
In our state, sales tax is paid only by the end customer. In other words,
a retailer does not pay sales tax on merchandise that is purchased for
resale. To avoid the sales tax, the retailer furnishes the supplier with a
reseller's certificate, which allows the supplier to not charge the sales
tax.
If a sales tax is paid by the reseller and the sales tax could have been
avoided, the sales tax would have to be expensed immediately. Costs
that are not necessary cannot be recorded as assets.
If the sales tax could not have been avoided, then the sales tax would
be part of the cost of the merchandise purchased. If the merchandise
has not been sold, the entire cost will be reported as inventory, a
current asset on the balance sheet. If the merchandise has been sold,
then the entire cost will be reported on the income statement as the
cost of goods sold.

148.

What are sales taxes?
In the United States, most of its 50 States assess a sales tax, which is
a tax on sales to the end user. For example, in the state of Wisconsin a
retailer must collect a 5% sales tax and perhaps another 0.5% for a
county sales tax on specified goods and services. The retailer must
remit the sales taxes collected within a prescribed time period.
The items subject to sales tax will vary from state to state. In some
states basic food items might not be taxed, but meals at restaurants will
be subject to sales tax. Some services might be subject to a sales tax.

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Sales of raw materials to a manufacturer will be exempt if the materials
will be used in products that will be manufactured and sold. When the
products are sold by the manufacturer to a retailer for resale, the
manufacturer will be also be exempt from collecting a sales tax. Sales
by retailer to an end consumer will require the collection of sales taxes.
Sales tax can be viewed as a tax on consumption.
In accounting, the sales taxes collected by the seller of the goods or
services are not revenues for the seller. For example, if a merchant
sells an item for £100 and the item is subject to a 5% sales tax, the
merchant will debit Cash for £105 and will credit Sales for £100 and will
credit Sales Tax Payable for £5. Sales Tax Payable is a liability
account. When the sales taxes are remitted to the state, the merchant
will debit Sales Tax Payable.
149.

What is an intangible asset?
An intangible asset is an asset that you cannot touch. Examples of
intangible assets include copyrights, patents, mailing lists, trademarks,
brand names, domain names, and so on.
Often the market value of an intangible asset is far greater than the
market value of a company's tangible assets such as its buildings and
equipment.
Accounting principles require that intangible assets be reported on a
company's balance sheet at cost or less. Since many intangible assets
are not purchased, they may not have a reportable cost. As a result,
many valuable intangible assets are not even reported as assets on the
company's balance sheet.

150.

Where is a contract with a customer reported on the balance
sheet?
A contract to perform future services for a customer is not reported on
the balance sheet of the company that will be providing the services.
For example, if Company Jay and one of its customers sign a contract
in December agreeing that Company Jay will deliver £20,000 of
services beginning in January, the contract is not reported on Company
Jay's December 31 balance sheet. (If the customer makes a deposit of
£3,000 at the time of signing the contract, the £3,000 will be recorded
by Company Jay in December with a £3,000 debit to Cash and a
£3,000 credit to the liability account Customer Deposits or Unearned
Revenues. With no down payment or advance payment in December,
there is no entry recorded.)

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The £20,000 contract is not reported as an asset on Company Jay's
December 31 balance sheet. The reason is that Company Jay has not
earned any of the contract amount and therefore does not have a right
or a receivable to the £20,000 as of December 31. Similarly, Company
Jay's income statement for December and its December 31 owner's
equity cannot include any earnings associated with the contract.
151.

FIFO and LIFO is best with which type of products?
Since FIFO and LIFO pertain to the flow of products' costs, I believe the
answer involves the rate of change in the costs of products. In other
words, if the costs of a company's products are steady, it won't matter
whether a company uses FIFO or LIFO. The reason is that the first or
older costs will be similar to the latest or recent costs. On the other
hand, if the costs of its products are increasing significantly, there will
be significant difference in profits and inventory values between FIFO
and LIFO.
In the U.S., accountants often cite LIFO as the preferred method when
products' costs are changing. The reason is the matching of the latest
costs of products with the sales revenues of the current period. U.S. tax
rules also allow for either FIFO or LIFO, but require that the same cost
flow assumption be used on both the company's tax return and on the
company's financial statements.
By using LIFO when the costs of products are increasing, the company
will be matching the recent higher costs with the current period sales.
This will provide not only the improved matching of costs with
revenues, it will also result in lower taxable income.

152.

Does the accrual method apply to the purchase of equipment?
The accrual method does apply to the purchase of equipment (as well
as applying to revenues and expenses).
To illustrate, let's assume that on December 29 a company ordered
and received some equipment to be used in its operations. The
payment for the equipment is to be made on February 10. Under the
accrual method, on December 29 the company should debit the asset
account Equipment and credit the liability account Accounts Payable.
(When the supplier or vendor is paid on February 10, the company's
asset Cash will be credited and its liability account Accounts Payable
will be debited.)

153.

Why is manufacturing overhead allocated to products?
Manufacturing overhead, which is also known as factory overhead,
burden, and indirect manufacturing costs, needs to be allocated to
products for the following reasons:

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1. Some of the goods manufactured are not sold in the same period in
which they were produced.
2. The goods not sold must be reported at their cost in the company's
asset entitled Inventory.
3. Accounting principles require that each product's inventory cost
include both direct and indirect manufacturing costs.
4. Indirect costs by definition mean they are not directly traceable to a
product and will require an allocation.
5. Some companies set their products' selling prices based on their
costs. In the long run, the products' selling prices must be large enough
to cover all of a company's manufacturing costs (including the indirect
manufacturing costs) plus the company's selling, general and
administrative expenses and a profit for the company's owners.
If a company never has inventory (because each period it sells all of its
production) the allocation of manufacturing overhead could be avoided.
The reason is that all of the manufacturing costs will be reported as the
cost of goods sold. However, the company may still choose to allocate
the manufacturing overhead for internal pricing decisions or to comply
with a government contract.
154.

Why is there a large difference between share value and
stockholders' equity?
There can be many reasons why the market value of a corporation's
stock is much greater than the amount of stockholders' equity reported
on the balance sheet. Let's start by defining stockholders' equity as the
difference between the assets amounts reported on the balance sheet
minus the liability amounts. Next, the accountant's cost principle
requires that only the cost of items purchased can be reported as an
asset. This means that valuable trade names that were never
purchased (but were developed over time) are not reported on the
balance sheet. The same holds for a great management team and an
amazing reputation. The cost principle also means that many long-term
assets are reported at cost (and not at their current higher market
value). Many plant assets are reported at minimal amounts because
their costs have been reduced by the cumulative amount of
depreciation taken over the years.
Other factors contributing to a high market value might be a
corporation's earnings and dividends that are consistently growing
and/or a special niche for its products or services that is recognized by
the market.
Lastly, a corporation's stockholders' equity may have been reduced
from the purchase of treasury stock at a high cost.

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155.

Are repairs to office equipment and factory equipment period
costs?
Repairs to office equipment are period costs. That is, the cost of the
repairs to office equipment will be reported as a selling, general and
administrative (SG&A) expense in the period in which the repairs take
place.
Repairs to factory equipment are not period costs. Rather, the costs of
repairs to factory equipment are product costs. The repair costs within
the factory are part of the factory overhead (also known as
manufacturing overhead) which is assigned to the products when they
are manufactured. When those products are sold, the costs of the
products (raw materials, direct labour, and factory overhead) will be
expensed as the cost of goods sold. Until the products are sold, the
products' costs will be reported as the current asset Inventory.

156.

What is illusory profit?
Illusory profit, also called phantom profit, is the difference between 1)
the profit reported using historical costs required by US GAAP, and 2)
the profit computed using replacement costs. Illusory profit is greatest
during periods of rising costs at companies with significant amounts of
inventory and plant assets.
For example, when inventory is measured by using the first-in, first-out
cost flow assumption under US GAAP, the actual historical cost of
inventory that is charged to the cost of goods sold during periods of
rising costs is smaller than the amount computed using replacement
costs. This smaller amount of costs charged to the income statement
means reporting greater profit. The difference in the profit is said to be
illusory.
In the case of plant assets used during periods of rising costs, the
depreciation expense reported on the income statement based on
historical costs (required by US GAAP) will be less than the
depreciation computed by using the higher replacement cost of the
plant assets. The additional profit from this difference in depreciation is
considered to be illusory profit.

157.

Should inventories be reported at their cost or at their selling
prices?
The general answer is that inventories should be reported at cost. A
merchant's inventory would be reported at the merchant's cost to
purchase the items. A manufacturer's inventory would be at its cost to
produce the items (the cost of direct materials, direct labour, and
manufacturing overhead).

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The conservatism principle requires that an amount less than cost be
used when the replacement cost is less than the original cost. When
this is the case, the selling price minus the cost to complete and
dispose might be the amount to be reported. (The selling price minus
the cost to complete and dispose is the net realizable value.) In a few
industries, such as gold mining and meatpacking, it is accepted
practice to report the inventory at its net realizable value.
Since the unit cost of items in inventory is likely to be changing (think
inflation), the costs used for inventory reporting will be based on a cost
flow assumption. For example, the FIFO cost flow assumption will
result in the inventory being reported at the more recent costs, since
the first costs are assumed to have been the first costs out of inventory.
Under the LIFO cost flow assumption, the inventory will be valued at
the older costs, since the more recent costs are assumed to be the first
costs to flow out of inventory.
158.

What is the rationale for not reporting plant assets at their
liquidation value?
I will assume that the plant assets' liquidation values are higher than
the present carrying values when answering your question.
Plant assets (buildings and equipment used in manufacturing; also
called fixed assets) are not reported at their higher liquidation value
because of several accounting principles. Below are four accounting
principles that come to mind.
The cost principle requires that plant assets be reported at amounts
that are not greater than cost. Cost is an objective and verifiable
amount. Liquidation value is subjective and the amount can vary
significantly depending on the assumptions made.
The matching principle requires that the cost of plant assets be
allocated to depreciation expense. This means that over a plant asset's
useful life some of the plant asset cost is matched with revenues on the
income statement. Therefore the plant asset's carrying amount will be
decreasing each period.
The going concern assumption implies that the company will be
continuing in business. Since it is assumed that the company is not
liquidating, the liquidation value of the plant assets is not relevant.
The revenue recognition principle prohibits a company from showing a
gain from merely holding a plant asset. What would you credit if you
increased the plant asset amount?

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Those four accounting principles provide some of the rationale for not
reporting the liquidation value when it is higher than cost.
If a company is not a going concern or if the plant asset's value has
been impaired, the above rationale does not hold. For those situations
you will need to follow the appropriate accounting rules.
159.

What is apportionment?
An apportionment is an allocation based on some proportions.
I associate the term apportionment with a corporation's taxable income
that was earned in many states within the U.S. In that situation, the
corporation's taxable income must be allocated or apportioned to each
of the states based upon certain accepted factors. In the past, the
apportionment or allocation was often based on a corporation's tangible
property, employees, and sales in each of the states. More recently,
apportionments seem to be based more on sales or receipts within
each state.
Since AccountingCoach.com does not cover income taxes, you should
contact a tax professional for a more accurate and complete
explanation.

160.

What is Form 10-K?
Form 10-K is a corporation's annual report filed with the U.S. Securities
and Exchange Commission (SEC). Form 10-K is required for U.S.
corporations whose stock is publicly traded.
Form 10-K contains a wealth of information on the corporation in
general such as its products, sales, markets, risks, officers, directors,
and more. A significant portion of the Form 10-K is entitled
Management's Discussion and Analysis of Financial Condition and
Results of Operation. Another major section is Financial Statements
and Supplementary Data. You will learn much about the corporation
and about accounting by reading a corporation's entire Form 10-K. (In
other words, don't skip the notes to the financial statements.)
A corporation's Form 10-K is usually available from each corporation's
website (usually under Investor Relations). You can also access and
download the SEC reports at no cost from
http://www.sec.gov/edgar/searchedgar/webusers.htm.

161.

What is the accounting entry when an order is received?
There is no accounting entry into the general ledger accounts when an
order is received. The reason is there is no sale or sales revenues and

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no accounts receivable until the goods are shipped or delivered--depending on the sales terms.
A record will likely be created in the company's system to track the
order, plan for materials, shipping, etc., but there will not be an entry
into the company's general ledger until the order is at the shipping
stage.
162.

Why is the Cash Flow Statement identified as one of the financial
statements?
The Cash Flow Statement or Statement of Cash Flows is required as
part of a full set of financial statements because of the Financial
Accounting Standards Board's Statement of Financial Accounting
Standards No. 95, Statement of Cash Flows.
You can read Statement No. 95 at no cost at www.FASB.org/st

163.

What is a lien?
A lien is a legal document filed by a creditor (lender) in order to record
its claim on the debtor's (borrower's) property. The lien is recorded at a
government's office. The lien provides a creditor with some protection
or collateral until the debtor pays the creditor the amount owed.
Here are three examples of liens:
1. A bank may lend a retailer £50,000 but one of the conditions is that
the bank will file a lien on the retailer's inventory. In this situation the
bank's lien results in its loan becoming secured.
2. A mortgage is a lien filed by a lender in order to secure the lender's
long-term real estate loan. The lien will require that the lender be paid
the amount owed on the loan before the real estate can be transferred
to another party.
3. The U.S. government may file a lien on a company's assets until a
tax obligation has been paid.
A lien on a company's assets is to be disclosed in the company's

164.

Where is the discount on the purchase of office furniture
recorded?
The discount received on the purchase of office furniture that will be
used by a company is recorded in the same asset account in which the
office furniture is recorded. That account might be Furniture and

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Fixtures or Office Furniture. (The discount is not recorded in Purchase
Discounts as this account is only for the discounts on the purchase of
merchandise that will be sold.)
To illustrate, let's assume that a company purchases furniture for the
office of a newly appointed executive. The cost of the furniture is
£10,000 and the invoice allows a discount of 1% if it is paid within 10
days. If the company pays the invoice within 10 days, the Furniture and
Fixtures account will increase by £9,900 (£10,000 minus the discount of
£100). The depreciation calculations will be based on the cost of
£9,900.
165.

Is a manufacturer's product warranty part of its manufacturing
overhead or is it part of its SG&A expense?
The costs associated with a manufacturer's product warranty are part
of its selling expenses and therefore part of its SG&A expenses.
If the future costs of the warranty coverage are probable and can be
estimated, they are recorded at the time of the sale. The accounting
entry will debit Warranty Expense and will credit Warranty Liability. If
the estimated warranty costs are recorded at the time of the sale, the
actual costs of the repair work or the replacement of the product during
the warranty period will be debited to the Warranty Liability account--thereby reducing the liability balance.

166.

How do you account for the rebate on an automobile?
The rebate on the purchase of an automobile should be recorded as a
reduction of the automobile's cost.
The lower automobile cost will result in lower depreciation expense.

167.

Are repairs to office equipment an expense?
Repairing and maintaining office equipment is an immediate expense.
This is true even if the repair cost is a very large amount.
If a large expenditure is made to improve office equipment, that cost
would be recorded as an asset and then depreciated over the
remaining life of the equipment.
Small expenditures to improve office equipment are usually expensed
immediately because of the materiality concept. This means the
amount is so small that no one will be misled by having the entire
amount appear immediately as an expense rather than appearing as
depreciation expense over several years. Often improvements of less

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than £500 or £1,000 are considered immaterial and are expensed
immediately.
168.

How should the cost of a yearly subscription for a newspaper be
recorded?
In theory, the payment in advance for a one-year subscription should
initially be recorded as a debit to Prepaid Expenses and a credit to
Cash. During the subscription period, you would debit Subscription
Expense and would credit Prepaid Expenses.
For example, if the annual subscription cost is £240 and it is paid in
advance, you would initially debit Prepaid Expenses for £240 and credit
Cash for £240. If your company issues monthly financial statements,
then each month during the subscription period you would debit
Subscription Expense for £20 and credit Prepaid Expenses for £20.
This results in 1) the matching of £20 to expense on each of the
monthly income statements, and 2) the balance sheet reporting the
amount that is prepaid or not yet expired.
At a large company, the annual cost of £240 will usually be an
immaterial amount. The materiality concept will allow you to violate the
matching principle, and to avoid the monthly adjusting entry, by simply
debiting Subscription Expense for the entire £240 at the beginning of
the one-year subscription period.

169.

Are estimates allowed in bookkeeping?
While bookkeeping involves mostly precise amounts from sales and
purchase invoices, cash receipts and checks written, etc. there are
situations when estimates need to be entered. This is especially true
when monthly financial statements are prepared under the accrual
method of accounting. For instance, the monthly bookkeeping entries
for depreciation, property taxes, utilities, fringe benefits and more will
need to be estimates.
Even the end-of-year financial statements will require some estimated
amounts. For example, a company's liability for warranties on its
products and its allowance for uncollectible accounts receivable will
need to be estimates. Providing an estimated amount is better than
ignoring reality and reporting a zero amount.
I recommend that the company's accountant review the estimated
amounts that will be entered in the bookkeeping or accounting system.

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170.

Can I capitalize this year's R&D?
Generally, R&D costs cannot be capitalized for U.S. financial
statements according to the Statement of Financial Accounting
Standards No. 2, Accounting for Research and Development Costs.
The original pronouncement can be viewed at www.FASB.org/st.
We are not able to address the second part of your question, which
involved the R&D costs on the income tax returns. You will need to ask
an income tax adviser or do a search on www.IRS.gov regarding the
capitalization of R&D costs for income tax purposes.

171.

If a mortgage payment is due on January 1, should the payment
be accrued at December 31?
If the interest portion of the January 1 loan payment is for the month of
December, then the interest portion should be accrued as of December
31.
To illustrate, let's assume that the amount of the mortgage loan
payment due on January 1 is £1,000 and it consists of £300 of interest
from December 1 through 31, and a principal payment of £700. Since
the £300 of interest has occurred during December and since the
company has an obligation as of December 31 to the lender for that
interest, the company must accrue the interest. This is accomplished
with an adjusting entry dated December 31 in which Interest Expense is
debited for £300 and Interest Payable is credited for £300.
There is no accrual for the principal portion of the loan payment. The
principal balance of the loan is not reduced until the actual principal
payment occurs.

172.

Which date is used to record a credit card transaction?
When a business uses its credit card, the transaction date is the date
the credit card is used, not the date that the credit card statement is
paid.
For example, if a business uses its credit card to purchase an asset on
December 30, both the asset and the liability to the credit card
company should be recorded as of December 30.
When the business pays the credit card company (perhaps 30 days
later), the business will be reducing its cash and its liability to the credit
card company.

173.

How do you record the sales tax on the purchase of an asset?
Accountants define the cost of an asset as all of the costs that are
necessary to obtain the asset and to get it ready for use.

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If your state does not allow an exemption from sales tax for the asset
you purchased, the sales tax should be recorded as part of the cost of
the asset.
174.

What does it mean to rotate stock?
To rotate stock means to arrange the oldest units in inventory so they
are sold before the newer units. For example, a grocery store will
restock its shelves by putting the oldest units in the front part of the
shelves. The newest units will be placed in the back of the shelves. The
hope is that the customer will select the most convenient (older) units
from the front of the shelf.
It is important to rotate stock in all areas: retail display area,
warehouse, factory, etc. The reason to rotate stock is to reduce the
losses from deterioration and obsolescence.
Ideally, when a company rotates its stock the units are physically
flowing first-in, first-out (FIFO). However, in the accounting for the cost
of inventory and the cost of the goods sold, the company may use a
cost flow assumption which is different from the flow of the physical
units. For example, a U.S. company may use the last-in, first-out (LIFO)
cost flow assumption even though it diligently rotates its stock of goods.

175.

Should an owner's compensation be recorded as an expense or in
the Drawing account?
If the enterprise is a sole proprietorship, the owner's compensation
should be debited to the Drawing account.
If the enterprise is a corporation, the owner's gross compensation
should be debited to a salary expense account.

176.

What does NOI stand for?
NOI is the acronym for net operating income. Net operating income is
also referred to as income from operations.
NOI excludes discontinued operations, extraordinary items, and no
operating (or other) items such as interest expense, interest revenues,
gains, and losses.

177.

I don't understand the conservatism principle. Why do losses get
recorded but not gains?
Conservatism has to do with uncertainty. When uncertainty exists
between two alternatives that appear to be reasonable, the accountant
"breaks the tie" by picking the alternative that reports less profit and
less asset amount (or more liability amount).

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If there is uncertainty as to whether there was a gain, the rule says
don't record it. Because of the uncertainty and because you did not
record the potential gain, there will be less profit and less asset
amounts being reported.
(If there is certainty about a gain, then you do report the gain. For
example, if a company sells its old delivery truck for cash and the
amount received is greater than the truck's book value, there is no
uncertainty and a gain is reported.)
If there is uncertainty about whether or not there is a loss, the rule
directs you to record the loss. By recording the potential loss, you will
be reporting less profit and less asset amounts.
If there is a potential loss, but it is impossible to measure the amount
for a journal entry, there needs to be a disclosure in the notes to the
178.

Are deposited checks reported as cash?
Deposited checks that are not post-dated (not dated with a future date)
are reported as cash. Accountants define cash as more than just
currency and coins. For example, unrestricted checking accounts are
also reported as cash.

179.

What if an employee's actual vacation payment is greater than the
amount that has been accrued?
It is common for companies to accrue its vacation pay expense and
liability by using the pay rates at the time of the adjusting entries. If an
employee is entitled to a greater amount because of a pay rate
increase, the difference is expensed in the accounting period when the
actual vacation payment is recorded.
Let's illustrate this with a company that has an accounting year ending
on December 31, 2012 and only one employee. The company's
handbook specifies that the employee's vacation accrues monthly and
that the vacation check will be paid on each July 1. Let's assume that
on July 1, 2013 the employee will be entitled to 80 hours of vacation
pay at the employee's pay rate on that date. On December 31, 2012
the employee's pay rate is £15 per hour and the company's liabilities
include £600 for accrued vacations (80 hours X 6/12 year X £15). On
June 30, 2013 the company will report an accrued liability of £1,200 (80
hours X £15). However, on June 10, 2013 the employee received a 3%
pay rate increase. This means the employee's vacation check on July
1, 2013 will be £1,236 (£15.45 X 80 hours). The difference of £36
(£1,236 v. £1,200) is simply charged to Vacation Expense in the period
of the vacation pay entry. In other words, the vacation pay entry will
include a debit to Vacations Payable or Accrued Vacations Liability for

£1,200 (the amount that has been accrued in earlier periods) and a
debit to Vacation Expense for £36. The credits will include the payroll
withholdings and the liability for the net payroll amount or Cash.
As shown above, the additional £36 was simply debited to Vacation
Expense in the period of the vacation pay entry. The past monthly
accruals were not changed or restated as the estimates and the
amount of difference is immaterial.
180.

Do variance accounts have an impact on financial statements? Or
are they for performance evaluation only?
Since the financial statements must reflect the cost principle, both the
standard costs and the variances must be included in the financial
statements.
For example, if a direct material has a standard cost of £400 but the
company paid £422, the financial statement must report £422 (the
standard cost of £400 plus the price variance of £22).

181.

Is a utility bill an expense?
The utility bill for a retailer or for a service company is an expense.
Under the accrual basis of accounting, the utility bill is an expense for
the period indicated by the meter reading dates.
A manufacturer's utility bill is more complicated. The utility bill for its
selling and general administration will be an expense for the period
indicated by the meter reading dates. However, the utility bill for the
direct and indirect manufacturing operations is part of its manufacturing
overhead. As such, the utility bill will be assigned or allocated to the
units produced. In other words, the utility bill will be clinging to the units
produced. Some of the utility cost will be clinging to the units in
inventory and therefore will be part of the cost of the asset inventory.
Some of the utility cost will be clinging to the units that have been sold
and will be part of the expense known as the cost of goods sold.

182.

What is NIFO?
NIFO is the acronym for next-in, first-out.
NIFO is a cost flow assumption, just as FIFO and LIFO are cost flow
assumptions. However, NIFO is not acceptable for financial reporting
since it calls for a future cost. NIFO is sometimes used as an
expression of replacement cost.
Even though NIFO cannot be used for valuing inventory and the cost of
goods sold on the financial statements, it is useful for making decisions.

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For example, some companies will use NIFO when determining selling
prices.
183.

What is self-insurance?
Self-insurance means no insurance. For example, if a retailer decides
to self-insure its buildings, the retailer will not have an insurance policy
to pay for losses that may occur to its buildings. If a person causes a
loss to one of the retailer's buildings, the retailer will have to bring a
claim against that person. In other words, the retailer will be on its own
and will not be able to turn to an insurance company to take care of the
problem.
Self-insurance may be feasible if a company owns a large number of
buildings and each building is in a different city. For example, a retailer
with 100 small stores finds that the annual cost for property insurance
to cover all 100 stores is £100,000. If the total actual property damages
for the stores never exceeded £40,000 in a year, the company may
decide that self-insurance is a good business risk.
Generally, self-insurance is too risky for an individual and for a small
business with one store. The reason is that a huge loss to its one
building may be too much to recover from. Every company should
review its specific situation with a professional risk management
adviser before opting to self-insure.
When a company does self-insure, it will report its actual losses in the
accounting period in which the losses occur. This may result in huge
losses in some years and no losses in other years. (On the other hand,
if a company has an insurance policy, the premiums it pays will result in
a more consistent amount of insurance expense each and every year.)

184.

Where can I learn about the accounting terms used in not-forprofit organizations?
Terms such as permanently restricted funds, temporarily restricted
funds and other terms used by not-for-profit organizations are
discussed in the Financial Accounting Standards Board's Statements of
Financial Accounting Standards Nos. 116 and 117. You can read these
two statements at no cost on their website www.FASB.org/st.

185.

If cash and a note are exchanged for a plant asset, is the amount
of the note used in the depreciation calculation?
A plant asset's cost is depreciated, unless the asset is land.
Cost is defined as the cash or cash equivalent amount at the time of
the transaction. This means that the asset's cost is the cash amount
plus the note's present value at time that the asset is purchased.

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To illustrate this, let's assume that equipment is purchased by giving
£50,000 of cash plus a promissory note of £100,000. If the note has an
interest rate that is a fair rate considering the market rates and the
riskiness of the party signing the note, then the present value of the
note is £100,000. The equipment will then be recorded at its cost of
£150,000. This cost of £150,000 will be depreciated over the
equipment's useful life.

186.

187.

If the note specifies zero interest, then the present value of the note is
less than £100,000. Let's assume that the note's present value is
computed to be £90,000. This means that the asset's cost will be
£140,000—the cash of £50,000 plus the note's £90,000 of present
value. Assuming no salvage value, the total depreciation expense over
the life of the equipment will equal £140,000. The £10,000 difference
will be reported as interest expense over the life of the note.
What is a debenture?
A debenture is an unsecured bond. In other words, a debenture is a
bond without a lien on specific assets owned by the issuing corporation.
Why is a product that sells for £50 reported in inventory at its cost
of £40?
Generally, items in inventory are valued at their cost--not their selling
prices–because of the cost principle.
Another reason for not valuing items in inventory at their selling prices
is that inventory items cannot be sold without a sales effort. Until that
effort is made and an item is actually sold, the company cannot report
the £10 increase from £40 to £50. This is referred to as the revenue
recognition principle. In other words, only after an item is actually sold
can the company report the revenue of £50 minus the cost of £40 for a
gross profit of £10.
There are some exceptions to cost. One exception is industries where
no sales effort is required and the extensive effort of production has
been completed. In these industries the inventory can be reported at its
net realizable value, which is the sales value minus the costs to
dispose of the items. The gold mining industry and certain other
commodities are examples of this exception to cost.
Another exception can occur in any industry when a product will have
to be sold for less than its cost. In that situation the item might be
reported in inventory close to its net realizable value, provided it is less
than the item's cost. (U.S. income tax rules require conformity between
tax and financial reporting. As a result, there are complexities involved.)

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188.

How do I record exterior cement work? Is it an asset or an
expense?
If the cement work was done to repair or maintain existing cement
work, then the expenditure should be recorded as an expense. Even if
the cost is very large, repairs and maintenance must be expensed. The
cost of repairs or maintenance cannot be recorded as an asset.
If the cement work is an addition or an improvement (more than
repairing or maintaining existing cement work), the cost of the cement
work is viewed as a new asset. If the amount is significant, you should
record the expenditure as an asset and then depreciate the cost over
the useful life. However, if the amount of the addition or the
improvement is relatively small, the accounting concept of materiality
allows you to expense the entire amount immediately.

189.

What type of expense is the purchase of propane?
Technically, the purchase of propane is not an expense. Depending on
the business, the propane is an asset until it is used, resold, or included
in a product that is sold. At that time it will become an expense.
If the purchased propane is used relatively soon, accountants will
usually skip recording the asset. Here are three examples of how the
expense might be reported on the company's income statement.
Example 1. A service company purchases £900 of propane to heat its
office for the following month. Technically the propane is an asset until
used. However, the accountant is likely to skip recording of the asset
and will record the purchase as a £900 operating expense.
Example 2. A local dealer purchases large quantities of propane and
then delivers the propane in small quantities to its customers. The
dealer will record the purchase as the asset Propane Inventory. As the
propane is sold, the dealer will reduce Propane Inventory for the cost of
the propane sold and will increase the expense Cost of Goods Sold.
Example 3. A manufacturer uses propane in its factory operations. The
cost of the propane purchased is likely to be recorded as Manufacturing
Overhead. Manufacturing Overhead is allocated to the products
manufactured and will be part of the products' cost. If the products are
in Inventory, those products' costs are assets. If the products are sold,
those products' costs will be expensed as Cost of Goods Sold.

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190.

If a mortgage payment is due by December 31, but the payment is
not made until the following month, should the loan payment be
accrued at December 31?
The interest portion of the mortgage payment should be accrued as of
December 31 under the accrual method of accounting. In other words,
there needs to be an adjusting entry dated December 31 to debit
Interest Expense and to credit Interest payable for the amount of
interest owed as of December 31.
The principal balance on the mortgage loan already appears in the
general ledger and on the balance sheet as the liability Mortgage Loan
Payable. Therefore, there is no accrual needed for the principal portion
of the loan payment due at December 31.

191.

Is the sales tax paid on merchandise that you will resell an
expense?
I believe that most states have sales tax exemptions for merchandise
purchased for resale. Check with your state's sales tax department to
see if you can obtain a resellers permit to avoid being charged the
sales tax by your suppliers.
If you purchase an asset and the sales tax is required, the sales tax
should be recorded as part of the cost of the goods or services
received. For example, if you were required to pay sales tax on the new
company car, the cost of the car will include the sales tax. If you
purchased supplies and the cost of the supplies was subject to sales
tax, the sales tax is part of the cost of the supplies. If you received
services that were subject to the sales tax, the sales tax is a necessary
part of the cost of the services.

192.

Is the deposit for a booth at a future trade show an asset?
The deposit for a booth at a future trade show is an asset until the trade
show occurs.
Once the trade show occurs the deposit amount should be moved from
the balance sheet asset account to an income statement expense
account.

193.

How can I determine the difference in earnings from using LIFO
instead of FIFO?
The difference in a corporation's earnings from using LIFO instead of
FIFO can be determined by the amounts reported in the balance sheet
account LIFO Reserve. Generally, the LIFO Reserve information is
found in the notes to the financial statements.

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194.

Isn't objectivity violated when estimates are used in bookkeeping
and accounting?
The use of estimates does not necessarily violate objectivity. If it is not
possible to determine the exact amount of an expense and/or liability
within a reasonable time, estimates may be necessary. In that situation,
objectivity is met when the estimated amounts are similar to the
amounts that another professionally-trained person would also compute
with the same available information.
The accounting principles, guidelines and characteristics often involve
some degree of trade-offs. For example, a company's financial
statements are expected to be both timely and precise. Unfortunately,
achieving timeliness and relevance may require sacrificing some
precision and reliability.

195.

Reducing the Need for Accruing Expenses
One day I was explaining to the owner of a small business that I would
have to accrue for the shipping expenses associated with his
company's sales. Since the shipping company billed him on the 15th of
each month for his shipments from the 16th of the previous month until
the 15th of the current month, we needed to estimate the expense for
the second half of the month. For example, when I was preparing his
company's November 30th balance sheet and its November income
statement, we didn't have the shipping expense for November 16 - 30.
(He also let me know that during this 15-day period, the shipping
expense would be higher than any other 15-day period due to holiday
sales.)
He listened carefully as I explained the matching principle, accrual-type
adjusting entries, and reversing entries. As soon as I had finished, he
phoned the shipping company and asked that his billing period be
changed to cover the calendar month. They were pleased to make the
change.
Next, the owner called his bank and asked if the bank would be able to
deduct the current month's loan interest from the company's checking
account on the last day of each month. The bank was pleased to
arrange for this procedure.
In less than 15 minutes, the owner eliminated the need for me to
calculate/estimate the amounts for two adjusting entries every month.
Soon, each month's actual amounts would be arriving automatically.

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195 Accounting Principles Questions and Answers for Accounting Exams and Job Interview

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