Chapter 3: How are Business Activities Recorded and Measured?

Question 1

What is cash basis accounting, and how is it commonly used by small businesses?

Answer 1

Cash basis accounting is an accounting method where revenues are recorded when cash is received, and expenses are recorded when cash is paid.

This method is commonly used by small businesses, including local retailers, where transactions are relatively straightforward, and they typically do not have to report to external users.

Question 2

How is personal financial performance typically measured, and what is the key indicator of performance?

Answer 2

Personal financial performance is typically measured by the difference between the account balance at the end of a period and the balance at the beginning of the period.

The key indicator of performance is whether there is more or less cash at the end compared to the beginning of the period.

Question 3

What is a potential drawback of using cash basis accounting, and how can it impact the interpretation of a company’s performance?

Answer 3

A potential drawback of using cash basis accounting is that it can lead to an incorrect interpretation of a company’s future performance.

Looking solely at cash flows in the first year, investors and creditors might see negative cash flows and misinterpret the company’s ability to generate future cash flows.

In reality, the company may have positive cash flows in other years, and sales transactions could generate consistent revenue even if cash collections vary.

Question 4

Cash basis earning measurement

Answer 4

Question 5

ACCRUAL BASIS ACCOUNTING

Answer 5

ACCRUAL BASIS ACCOUNTING
A method of accounting that records revenues when earned and expenses when incurred, regardless of the timing of cash receipts or payments.

Question 6

What is the accrual basis of accounting, and how does it differ from cash basis accounting?

Answer 6

The accrual basis of accounting is a method where revenues and expenses are recognized when the transactions that cause them occur, regardless of when cash is received or paid.

It differs from cash basis accounting, which records revenues and expenses based on actual cash receipts and payments.

Question 7

What is the key principle of accrual accounting when recognizing revenues?

Answer 7

The key principle of accrual accounting for recognizing revenues is to do so when they are earned, meaning when goods are delivered or services are performed.

Question 8

How does accrual accounting improve the accuracy of financial reporting compared to cash basis accounting?

Answer 8

Accrual accounting improves the accuracy of financial reporting by recognizing revenues and expenses when they are actually incurred or earned, providing a more faithful representation of a company’s financial position and performance, even if cash transactions occur at different times.

Question 9

What is the core revenue recognition principle in accounting, and what does it specify?

Answer 9

The core revenue recognition principle in accounting specifies both the timing and the amount of revenue to be recognized during an accounting period.

It requires that a company recognize revenue when goods and services are transferred to customers in an amount it expects to be entitled to receive.

Question 10

What is the first step in recognizing revenue, especially in complex sales contracts, and what does it involve?

Answer 10

The first step in recognizing revenue is to identify the contract between the company and the customer.

This contract can be written, verbal, or implied and represents the agreement between the parties for the sale of goods or services.

Question 11

What is the second step in recognizing revenue, and what does it require?

Answer 11

The second step in recognizing revenue is to identify the seller’s performance obligations, which are the promised goods and services that the company commits to deliver to the customer as part of the contract.

Question 12

What is the third step in recognizing revenue, and what is its purpose?

Answer 12

The third step in recognizing revenue is to determine the transaction price, which is the amount the seller expects to be entitled to receive from the customer. This step helps calculate the total revenue expected from the contract.

Question 13

What is the fourth step in recognizing revenue, and how is it applied?

Answer 13

The fourth step in recognizing revenue is to allocate the transaction price to the performance obligations. In this step, the total transaction price is divided among the specific goods or services that the company has promised to deliver to the customer as part of the contract.

Question 14

What is the fifth and final step in recognizing revenue, and when is revenue recognized?

Answer 14

The fifth and final step in recognizing revenue is to recognize revenue when each performance obligation is satisfied. Revenue is recognized when the company fulfills its obligations, transferring control and ownership of goods or services to the customer, and receives the agreed-upon payment.

Question 15

What is the critical point for revenue recognition under the five-step model, and why is it important?

Answer 15

The critical point for revenue recognition under the five-step model is when goods or services are delivered, not when cash is received from customers.

This distinction is crucial because cash can be received before, during, or after the delivery of goods or services, and revenue recognition is tied to the fulfillment of performance obligations, not cash receipts.

Question 16

How are revenue recognition entries handled when cash is received from customers at different times in relation to the delivery of goods or services?

Answer 16

Revenue recognition entries are made based on the timing of the delivery of goods or services. Entries are made on the date the goods or services are delivered and another one on the date of cash receipt, if these events occur at different times.

This ensures that revenue is recognized when the performance obligations are satisfied, regardless of the timing of cash receipts.

Question 17

How does a company handle revenue recognition when cash is received before the goods or services are delivered?

Answer 17

When cash is received before goods or services are delivered, the company does not recognize revenue immediately.

Instead, it creates a liability account (e.g., Deferred Revenue) to represent the goods or services owed to customers.

Revenue is recognized when the goods or services are delivered, and the liability account is reduced as the promise to deliver is satisfied.

Question 18

How is revenue recognition handled when cash is received at the same time as the goods or services are delivered?

Answer 18

When cash is received at the same time as goods or services are delivered, revenue is recognized immediately.

The company earns revenue when it delivers the goods or services and receives cash payment from customers simultaneously.

Question 19

How does a business recognize revenue when cash is received after the goods or services are delivered?

Answer 19

When cash is received after goods or services are delivered, revenue is still recognized when the goods or services are delivered.

In this case, the company records both Sales Revenue and an asset account (Accounts Receivable) when the goods are delivered, representing the customer’s promise to pay in the future. When the customer pays the invoice, the Cash account increases, and the Accounts Receivable asset decreases.

Question 20

EXPENSE RECOGNITION PRINCIPLE

Answer 20

EXPENSE RECOGNITION PRINCIPLE
Requires that expenses be recorded in the same period when incurred in earning revenue.

Question 21

What does the expense recognition principle require, and why is it important in accounting?

Answer 21

The expense recognition principle requires that expenses be recorded in the same period when they are incurred in earning revenue.

It is important because it ensures a matching of costs with benefits, meaning that all resources consumed in generating revenue during a specific period are recognized as expenses in that same period.

Question 22

What are some examples of expenses that are incurred in earning revenue, and how are they recognized?

Answer 22

Expenses incurred in earning revenue:

include salaries to employees (wages expense),

utilities (utilities expense),

inventory items that are sold (cost of sales),

facilities rented (rent expense),

and the use of buildings and equipment for production (depreciation expense).

These expenses are recognized as incurred, regardless of when cash is paid. Entries are made on the date the expense is incurred and another on the date of cash payment if they occur at different times.

Question 23

How does the expense recognition principle handle expenses that may not be directly identifiable with specific sources of revenue?

Answer 23

The expense recognition principle acknowledges that some expenses, such as utilities, rent of facilities, insurance, and interest, may not be directly identifiable with specific sources of revenue but are necessary to generate revenue during the period.

These expenses are still recognized when incurred, as they contribute to the overall cost of generating revenue in that period.

Question 24

How does a company handle cash payments when assets are purchased in advance for future use in generating revenue?

Answer 24

When cash is paid before the expense is incurred to generate revenue, assets like office supplies, insurance, rent, or equipment are recorded as assets initially

. These expenses are recognized over future periods as they are used. For example, office supplies bought but used in the following month are initially recorded as an asset (Office Supplies) and later expensed (Supplies Expense) when used.

Question 25

What happens when cash is paid in the same period as the expense is incurred to generate revenue?

Answer 25

When cash is paid in the same period as the expense is incurred, the expense is recognized immediately.

For instance, if a company like Gildan pays $500 cash for an immediate repair to sewing machines, the expense (Repairs Expense) is recorded in the same period.

Question 26

How does a company account for expenses when cash is paid after the cost is incurred to generate revenue?

Answer 26

When cash is paid after the cost is incurred to generate revenue, expenses are recognized when incurred.

For example, when a company uses utilities, incurs interest expenses, or owes wages to employees who worked in the current period, these expenses are recorded in the period when they are incurred, even if the cash payment occurs in a later period.

Question 27

What motivates managers to meet or exceed earnings expectations, and how can this motivation lead to unethical accounting decisions?

Answer 27

Managers are motivated to meet or exceed earnings expectations because it can bolster the company’s share prices.

Some managers, driven by greed, may make unethical accounting decisions, including falsifying revenues and expenses, to achieve this goal.

Question 28

What are some potential consequences of managers making unethical accounting and reporting decisions?

Answer 28

Managers who engage in unethical accounting and reporting decisions can face criminal charges and may be sentenced to jail.

Additionally, these actions can lead to negative consequences for shareholders (loss of investment value), employees (job loss and pension fund impacts), and relationships with customers and suppliers (distrust).