300+ TOP Accounting Principles Interview Questions and Answers

Q1. What Is A Capital Account?

In accounting and bookkeeping, a capital account is one of the general ledger accounts used to record 1) the amounts that were paid in to the company by an investor, and 2) the cumulative amount of the company’s earnings minus the cumulative distributions to the owners. The balances of the capital accounts are reported in the owner’s equity, partners’ equity, or stockholders’ equity section of the balance sheet. In a corporation the capital accounts include: Paid-in capital accounts such as Common Stock, Preferred Stock, Paid-in Capital in Excess of Par. These accounts report the amounts received by the corporation when the shares of its capital stock were originally issued to investors. Retained earnings accounts which typically contain the amount of the corporation’s cumulative earnings since the corporation was formed minus the cumulative dividends distributed to the stockholders.Treasury stock account (a contra account because it has a debit balance) usually reporting the amount paid by the corporation to repurchase its own shares of stock that have not been retired. In a sole proprietorship (such as one owned by Amy Fox) the capital accounts include:Amy Fox, Capital. This account begins with Amy’s original investment and is increased for each year’s earnings minus each year’s withdrawals by Amy. Amy Fox, Drawing. This account is a contra account because it will have a debit balance equal to the amount of business assets that Amy has withdrawn during the current accounting year for her personal use. At the end of each accounting year, Amy’s drawing account is closed by trferring its debit balance to the account Amy Fox, Capital. The total of the balances in the capital accounts must be equal to the reported total of the company’s assets minus its liabilities. Because of the historical cost principle and other accounting principles the total amount reported in the capital accounts will not indicate the company’s market value or net worth.

Q2. 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. 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.

Q3. 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 $120,0@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 $1,0@On the balance sheet dated as of the last day of the 36th month, accumulated depreciation will be reported as $36,0@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.

Q4. What Is Absorption Costing?

Absorption costing me 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 labor, 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 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.

Q5. 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 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.

Q6. 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.

Q7. 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.

Q8. 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.

Q9. What Is Principles Of Accounting?

Three meanings come to mind when you ask about principles of accounting: 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. Principles of accounting can also refer to the basic or fundamental accounting principles: cost principles, matching principles, full disclosure principles, materiality principles, going concern principles, economic entity principles, and so on. In this context, principles of accounting refers to the broad underlying concepts which guide accountants when preparing financial statements. 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.

Q10. 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 @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 @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.

Q11. 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 me 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 me 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 me 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 me 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 $20,0@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 $80,0@This is the asset’s cost of $100,000 minus its accumulated depreciation of $20,0@The $80,000 of beginning book value multiplied by 20% results in $16,0@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 $64,0@This is the 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 $51,2@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 $59,04@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.

Q12. 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. Other disclosures in the notes to the financial statements include the effects of foreign currencies, contingent liabilities, leases, related-party tractions, 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.

Q13. 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. A product warranty is often cited as a contingent liability that is both probable and can be estimated. Additional examples and a further explanation are presented in FASB’s Statement of Financial Accounting Standards No. 5, Accounting for Contingencies.

Q14. What Is Bad Debts Expense?

Bad debts expense often refers to the loss that a company experiences because it sold goods or provided services and did not require immediate payment. The loss occurs when the customer does not pay the amount owed. In other words, bad debts expense is related to a company’s current asset accounts receivable. It is common to see two methods for computing the amount of bad debts expense: direct write-off method allowance method The direct write-off method requires that a customer’s uncollectible account be first identified and then removed from the account Accounts Receivable. This method is required for U.S. income taxes and results in a debit to Bad Debts Expense and a credit to Accounts Receivable for the amount that is written off. The allowance method anticipates that some of the accounts receivable will not be collected. In other words, prior to knowing exactly which customers or clients will not be paying, the company will debit Bad Debts Expense and will credit Allowance for Doubtful Accounts for an estimated, anticipated amount. (The Allowance for Doubtful Accounts is a contra asset account that when combined with Accounts Receivable indicates a more realistic amount that will be turning to cash.) Many believe that the allowance method is the better method since 1) the balance sheet will be reporting a more realistic amount that will be collected from the company’s accounts receivable, and 2) the bad debts expense will be reported on the income statement closer to the time of the related credit sales.

Q15. What Is The Difference Between Product Costs And Period Costs?

A manufacturer’s product costs are the direct materials, direct labor, 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 labor, and manufacturing overhead are also “inventoriable” costs, since these are the necessary costs of manufacturing the products. Period costs are not a necessary part of the manufacturing process. As a 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.

Q16. 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.

Q17. 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. 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 me 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.

Q18. What Are Adjusting Entries?

Adjusting entries are usually made on the last day of an accounting period (year, quarter, 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 me 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. 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.)

Q19. 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.

Q20. 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 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.

Q21. 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.

Q22. What Is Gaap?

GAAP is the acronym for generally accepted accounting principles. In the U.S. that me the basic accounting principles and guidelines such as the cost principle, matching principle, full disclosure, etc., the detailed standards and other rules issued by the Financial Accounting Standards Board (FASB) and its predecessor the Accounting Principles Board, and 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.

Q23. 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.

Q24. What Is Goodwill?

In accounting, goodwill is an intangible asset associated with a business combination. Goodwill is recorded when a company acquires (purchases) another company and the purchase price is greater than the combination or net of 1) the fair value of the identifiable tangible and intangible assets acquired, and 2) the liabilities that were assumed. Goodwill is reported on the balance sheet as a noncurrent asset. Since 2001, U.S. companies are no longer required to amortize the recorded amount of goodwill. However, the amount of goodwill is subject to a goodwill impairment test at least once per year. (Beginning in 2015, private companies may opt to amortize goodwill generally over a 10-year period and thereby minimize the cost and complexity involved with testing for impairment.) Outside of accounting, goodwill could refer to some value that has been developed within a company as a result of delivering amazing customer service, unique management, teamwork, etc. This goodwill, which is unrelated to a business combination, is not recorded or reported on the company’s balance sheet.

Q25. 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 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.)

Q26. What Is A Long-term Liability?

A long-term liability is a noncurrent liability. That is, a long-term liability is an obligation that is not due within one year of the date of the balance sheet (or not due within the company’s operating cycle if it is longer than one year).  Some examples of long-term liabilities are the noncurrent portions of the following: bonds payable long-term lo capital leases pension liabilities postretirement healthcare liabilities deferred compensation deferred revenues deferred income taxes derivative liabilities Some long-term debt that is due within one year of the balance sheet date could continue to be reported as a long-term liability if there is: a long-term investment that is sufficient and restricted for the payment of the debt, or intent and a financing arrangement that replaces the debt with new long-term debt or with capital stock.

Q27. 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.

Q28. 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 or a contra inventory account is credited. The debit in the entry to write down inventory is reported in an 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 equity 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.

Q29. 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 $50,0@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 $5,0@The company’s balance sheets will report the equipment’s historical cost minus the accumulated depreciation. The cost principle also me 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 traction 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.

Q30. What Is Accrued Income?

Accrued income is an amount that has been earned, there is a right to receive the amount, and 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 @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 semiannual $3,000). No interest will be received in December since it will be part of the $3,000 to be received on June @The $500 of interest earned during December, but not yet received or recorded as of December 31 is known as accrued income. 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.

Q31. 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.)

Q32. 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 traction. 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 its 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 traction and should include all costs necessary to get the asset in place and ready for use.

Q33. 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.

Q34. 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 $20,0@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.

Q35. 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 tractions. 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 @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 3@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).

Q36. 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 pays an insurance premium of $2,400 for the six-month period of December 1 through May 3@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 $4@This me 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).

Q37. What Are Operating Expenses?

Operating expenses are the costs associated with a company’s main operating activities and which are reported on its income statement. For example, a retailer’s main operating activities are the buying and selling of merchandise or goods. Therefore, its operating expenses will include: Cost of goods sold. These costs are reported as operating expenses on the income statement because of the matching principle. The revenues from the sale of merchandise must be matched with the cost of the merchandise that is sold. Selling, general and administrative expenses (SG&A). These costs are reported as operating expenses on the income statement because they pertain to operating the main business during that accounting period. These costs may have expired, may have been used up, or may not have a future value that can be measured. Some authors define operating expenses as only SG&A. In other words, they do not include the cost of goods sold as an operating expense. Such a definition will be deficient for calculating a company’s operating income. Clearly, the calculation of operating income cannot omit the cost of goods sold.

Q38. 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 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 @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.

Q39. 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.

Q40. 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 $8@This is consistent with the cost principle which me 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 $79@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 $79@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. 

Q41. What Is The Difference Between The Cash Basis And The Accrual Basis Of Accounting?

Under the cash basis of accounting… Revenues are reported on the income statement in the period in which the cash is received from customers. Expenses are reported on the income statement when the cash is paid out. Under the accrual basis of accounting… Revenues are reported on the income statement when they are earned—which often occurs before the cash is received from the customers. 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.

Q42. 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 $8,0@January’s insurance expense will be $2,000—the amount that has expired during January.

Q43. 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 tractions 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 behavior, break-even point, profit planning, operational budgeting, capital budgeting, relevant costs for decision making, activity based costing, and standard costing.

Q44. 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.

Q45. 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 interest 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 interest expense of $32,000 for 60 months beginning on March 1.

Q46. 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, under the straight line method of depreciation 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).

Q47. What Is 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.

Q48. 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 $20,0@Since the adjusting entries do not involve cash, depreciation expense is referred to as a noncash expense.

Q49. What Is Working Capital?

Working capital is the amount of a company’s current assets minus the amount of its current liabilities. For example, if a company’s balance sheet dated June 30 reports total current assets of $323,000 and total current liabilities of $310,000 the company’s working capital on June 30 was $13,0@If another company has total current assets of $210,000 and total current liabilities of $60,000 its working capital is $150,000. The adequacy of a company’s working capital depends on the industry in which it competes, its relationship with its customers and suppliers, and more. Here are some additional factors to consider: The types of current assets and how quickly they can be converted to cash. If the majority of the company’s current assets are cash and cash equivalents and marketable investments, a smaller amount of working capital may be sufficient. However, if the current assets include slow-moving inventory items, a greater amount of working capital will be needed. The nature of the company’s sales and how customers pay. If a company has very consistent sales via the Internet and its customers pay with credit cards at the time they place the order, a small amount of working capital may be sufficient. On the other hand, a company in an industry where the credit terms are net 60 days and its suppliers must be paid in 30 days, the company will need a greater amount of working capital. The existence of an approved credit line and no borrowing. An approved credit line and no borrowing allows a company to operate comfortably with a small amount of working capital. How accounting principles are applied. Some companies are conservative in their accounting policies. For instance, they might have a significant credit balance in their allowance for doubtful accounts and will dispose of slow-moving inventory items. Other companies might not provide for doubtful accounts and will keep slow-moving items in inventory at their full cost. In short, analyzing working capital should involve more than simply subtracting current liabilities from current assets.

Q50. 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.