Accounting Test 1

Front 1

An Asset is ...

Back 1

a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

Front 2

A Liability is ...

Back 2

a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

Front 3

Equity is ...

Back 3

the residual interest in the assets of the entity after deducting all its liabilities.

Front 4

Income is ...

Back 4

increases in economic benefits during the accounting period in the form of inflows or enhancements of assets, or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants.

Front 5

Expenses are ...

Back 5

decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants.

Front 6

Profit is ...

Back 6

the change in the equity in an entity during a period from all events other than direct contributions of captial, or withdrawals of captial by owners.

Front 7

How do you distinguish which inventory method a company is using?

Back 7

It is using a perpetual system if only a single COS account exists; and it is using periodic system if it use Purchase account.

Front 8

Explain how COS is calculated under each of the two inventory methods

Back 8

Under the perpetual systems there is no need to calculate COS as such. This is because the cost of goods sold is recorded with each transaction and entered into a specialized account which can then be balanced when a report is required.
With the periodic system COS is calculated by adding the beginning inventory amount to the purchases made during the period and then subtracting the closing inventory. This is necessary as no record is made of the cost price of goods when they are sold. Instead a physical stock take is done at the beginning and end of the reporting period with purchases recorded as an expense during the period.

Front 9

What rule relating to Net Realisable Value (NRV) is considered when valuing inventory? What impact can this rule have on Gross Profit calculations?

Back 9

The rule in question is the lower of cost or net realisable value rule. This requires inventory to be recorded at either the historic cost or the net relisable value of goods in question depending on which is the lower amount.
The impact of this rule on the financial statements will generally see a decline in Gross Profit, this is because it is unusual for the net realisable value of inventory to "recover" once it has fallen below cost. Under a perpetual system the fall in Gross Profit will result from an expense such as "write down of stock to net realisable value". A more significant impact occurs when using the periodic system. This is because the adjustment will occur at the end of the reporting period and see a reduction in the value of ending inventory. Given that COS is calculated using this figure it will appears that more goods have been sold, due to a higher COS figure, for the same revenue when in fact this is not the case.

Front 10

Explain what materiality means in accounting

Back 10

An item is considered material if it is likely to affect the decisions of those using the General Purpose Financial Reports. It may be considered material due to size or the nature of the item. Sometimes the size of these adjusting entries may be small, and have an immaterial effect on the entity's profits and financial position; but on many occasions, particularly with adjusting entries for items such as depreciation, the size and effect of the adjusting entries may be significant.

Front 11

Explain why adjusting entries are necessary under the conceptual framework.

Back 11

Under an accrual accounting system, adjusting entries are necessary in order to ensure that an entity's assets, liabilities, revenues and expenses are recorded in the appropriate accounting period.
If adjusting entries are not made then the entity is likely to be overstating its profits and overstating its financial position.

Front 12

Discuss whether all assets in the Balance sheet

Back 12

In conventional general purpose accounting reports, asset values are listed in the Balance Sheet. On the face of it, one would assume that a firm's "asset richness" would be established by comparing its total assets figure to that of another firm. The problem with attempting to do this is that the total assets figure is not a summary of a single valuation concept. For example:
Cash is reported at its current actual recoverable dollar value
With the adjustment for doubtful debs, accounts receivable is reported at its estimated recoverable dollar value.
Inventory is reported at the lower of its cost or net realisable value. Thus, depending on circumstances, what is reported may be its historic cost, or its estimated recoverable dollar value
Non-current assets are reported at their historic cost less an estimation of expired service potential (depreciation) which must therefore also be valued as a proportion of that historic cost.

Front 13

How different accountants apply accounting principles "assets richness"

Back 13

Accountants apply the aforementioned principles slightly differently (e.g. differences between opinions as to the appropriate rate of depreciation or doubtful debts to be charged).
A measurement of "asset richness" requires an agreement about the base criterion of measurement (e.g. asset richness in terms of pure historic cost?, in terms of disposal values?, in terms of replacement values?). Assets reported in a conventional Balance Sheet do not share a single base valuation criterion but rather are a conglomeration of different valuations emanating from a loose base of historic cost. "Asset richness" as a concept is therefore difficult to ascertain from a conventional balance sheet alone.

Front 14

Why is it that some items that may fit the definitions given are not included in the Balance Sheet of an entity?

Back 14

An asset should be recognised in the Balance Sheet when and only when:
(a) it is probable that the future economic benefits embodied in the asset will eventuate; and
(b) the asset possesses a cost or other value that can be measured reliably.
A liability should be recognised in the Balance Sheet when and only when:
(a) it is probable that the future sacrifice of economic benefits will be required; and
(b) the amount of the liability can be measured reliably.

Front 15

Explain the relationship between profit and capital.

Back 15

The profit of an entity is the surplus that emerges from transactions and other events after maintaining opening owners capital intact, allowance having being made for capital contributions and distributions to the owners. An entity is regarded as entering a reporting period with a particular capital or net assets; this is the owners investment. The net assets (capital) are changed by transactions and other events and the surplus, after allowing for capital contributions and distributions to owners, is profit.

Front 16

Explain how the way in which income and expenses are defined reflects the relationship between profit and capital.

Back 16

The way in which income and expenses are defined reflects the relationship between profit and capital in that profit is the increase in capital during a period other than capital contributions and distributions to owners while income is defined as increases in capital other than capital contributions and expenses as decreases in capital other than distributions to owners. Thus by subtracting the decreases in capital (expenses) from the increases in capital (income) we are left with the net increase in capital, which is profit.

Front 17

Explain, with reference to concepts from the conceptual framework for financial reporting, why balance day adjustments are necessary to correctly measure profit.

Back 17

Balance day adjustments apply the accrual concept and the accounting period boundary. Accrual accounting recognises income and expenses in the periods when goods and services are supplied rather than in the periods when cash is received or paid. Certain accounting entries made at the end of the accounting period to achieve a proper allocation of revenues and expenses to accounting periods are known as balance day adjustments.

Front 18

Using concepts from the conceptual frame work for financial reporting, explain the initial accounting treatment of the fee received (20,000 legal fee, work to be completed over next 3 months)
and its treatment over the next 3 months.

Back 18

The 20,000 received would initially be recognised as a liability. On receipt of the money, the lawyer would have an obligation to either provide services or refund the money (a future sacrifice). Moreover, the amount of the liability can be reliably measured (transaction = 20,000) and it is probable that a sacrifice of benefits (the services) will occur.

Front 19

"The amount of total assets in a conventional Balance Sheet represents the amount that could be realised on the sale of those assets". Explain, with reasons, whether you agree with this statement

Back 19

Disagree. Very few assets will be measured by reference to the net realisable value attribute. In most cases the historic cost attribute will be used due to the reliability of the measurement (it is usually evidenced by a transaction). A number of examples could be used (revalued amount, lower of cost and net realisable value, present value, recoverable amount).
The statement will only be correct where the entity is no longer a going concern and then the assets will be measured at liquidation values (realisable amount)

Front 20

Explain what is meant by reliability and how it is being applied in the case of goodwill generated by a business.

Back 20

Reliability means that information can be relied upon to represent faithfully, without undue bias or error, transactions and events which have occurred, been measured and reported. Internally generated goodwill is not recognised because as there is no transaction, it is difficult to reliably measure the amount of goodwill. Moreover, if management was so disposed, there could be a biased estimate to boost the amount of assets via goodwill. On the other hand purchased goodwill can be recognised because there is a transaction will provides of the amount paid for goodwill.

Front 21

Explain the term relevance and why it is a necessary qualitative attribute of a financial report.

Back 21

Relevance is characterised by the information's influence on economic dicisions by helping users form predictions about outcomes and confirming or correcting user's past decisions and for accountability purposes. It is a necessary characteristic to ensure the objectives of producing general purpose financial reports are satisfied.

Front 22

Outline, with reasons, whether accounting reports favour reliability more than relevance.

Back 22

Many would argue that accounting reports favour reliability over relevance. For example, some would argue for the presentation of information concerning market prices or replacement cost as the information is more relevant than historic cost. However, a preference is exhibited for the relevance because it can be reliably measured.