Chapter 3
Accrual Accounting and the Financial Statements
Questions
1. Under accrual accounting, the accountant recognizes the impact of a business transaction on an entity when the transaction occurs, whether or not cash is received or paid. Revenues are recognized when they are earned, and expenses are recognized when they are incurred—not necessarily when the cash changes hands. The cash basis of accounting recognizes revenues only when cash is received and expenses only when cash is paid. 2. The revenue principle provides guidance on (a) when to record revenue. (b) the amount of revenue to record. 3. The matching principle directs the accounting for expenses. Accountants identify all the expenses incurred during the period, measure those expenses, and match them against the revenue earned during the period. Matching expenses against revenues means to subtract the expenses from the revenues to compute net income or net loss for the period.

Chapter 3

Accrual Accounting and the Financial Statements

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4. Five categories of adjusting entries, with examples, are: a. Prepaid expenses — prepaid rent, prepaid insurance, and supplies b. Amortization — amortization of buildings, furniture, and equipment c. Accrued expenses — accrued salary expense and accrued interest expense d. Accrued revenues — accrued service revenue and accrued interest revenue e. Unearned revenues — unearned service revenue and unearned subscription revenue 5. Yes, all adjusting entries affect net income or net loss. Adjusting entries assign revenues to the period in which they are earned and expenses to the period in which they are incurred, and revenues and expenses affect income or loss. 6. At the end of this first year, the Prepaid Insurance account has an expense element of $600 (1/3 of $1,800) and an asset element of $1,200 (2/3 of $1,800). 7. Prepaid expense is not an expense.