- CFA Exams
- June 2018 Level I > Study Session 6. Financial Reporting and Analysis: > Reading 23. Financial Reporting Mechanics
- 5. Accruals and Valuation Adjustments
Subject 5. Accruals and Valuation Adjustments
Most companies use accrual basis accounting, recognizing revenue when it is earned (the goods are sold or the services performed) and recognizing expenses in the period incurred without regard to the time of receipt or payment of cash. Net income is revenue earned minus expenses incurred.
Although operating a business is a continuous process, there must be a cut-off point for periodic reports. Reports are prepared at the end of an accounting period.
- A balance sheet must list all assets and liabilities at the end of the accounting period.
- An income statement must list all revenues and expenses applicable to the accounting period.
Some transactions span more than one accounting period and they require adjustments. Adjustments are necessary for determining key profitability performance measures because they affect net income, assets, and liabilities. Adjustments, however, never affect the cash account in the current period. They provide information about future cash flow. For example, accounts receivable indicates expected future cash inflows.
The four basic types of adjusting entries are:
- Unearned revenues are revenues that are received in cash before delivery of goods/services. These "revenues" are not earned yet and thus should be recorded as liabilities. An adjusting entry should be: a debit to a liability account (e.g., unearned revenue) and a credit to a revenue account (e.g., revenue). Examples are magazine subscription fees and customer deposits for services.
- Accrued revenues are revenues that are earned but not yet received or recorded. They are also called unrecorded revenues. An adjusting entry should be: a debit to an asset account (e.g., accounts receivable) and a credit to a revenue account (e.g., interest revenue). Examples include interest revenues, rent revenues, etc. Such revenues accumulate with the passing of time, but the company may have not received payment or billed the client.
- Deferred expenses are expenses that benefit more than one period. When these assets are consumed, expenses should be recognized: a debit to an expense account and a credit to an asset account. For example, prepaid expenses (e.g., prepaid insurance, rent, etc.) are expenses paid in advance and recorded as assets before they are used or consumed. Another example is depreciation. The cost of a long-term asset is allocated as an expense over its useful life. At the end of each period, a depreciation expense is recorded through an adjusting entry: a debit to a depreciation expense account and a credit to an accumulated depreciation account (a contra account used to total past depreciation expenses on specific long-term assets).
- Accrued expenses are expenses that are incurred but not yet paid or recorded. At the end of the accounting period, the accrued expense is recorded through an adjusting entry: a debit to an expense account (e.g., salaries expense) and a credit to a liability account (e.g., salaries payable). Examples are employee salaries and interest on borrowed money.
In some cases valuation adjustments entries are required for assets. For example, trading securities are always recorded at their current market value, which can change from time to time.
- If the value of an asset has increased, then there should be a gain on the income statement or an increase to other comprehensive income.
- If the value of an asset has decreased, then there should be a loss on the income statement or a decrease to other comprehensive income.
Practice Question 1When adjusting a prepaid expense account, which of the following should occur?
A. A portion of an asset is recognized as an expense.
B. A portion of an asset is recognized as revenue.
C. A portion of an asset is recognized as a liability.Correct Answer: A
When adjusting a prepaid expense, such as prepaid insurance, the required adjusting entry recognizes and transfers a portion of the prepaid expense to an appropriate expense account, reducing the balance of the prepaid expense account.
Practice Question 2An end-of-period adjustment for depreciation of fixed assets is necessary ______.
I. for proper statement of net income
II. to recognize the expense of using fixed assets
III. to be consistent with the matching principleCorrect Answer: I, II and III
An adjustment for depreciation expenses matches expenses with revenues for the period, thus contributing to the correct statement of net income for the period.
Practice Question 3Which of the following accounts is a liability?
A. Unexpired insurance
B. Insurance expense
C. Prepaid insurance
D. Unearned insurance feesCorrect Answer: D
Unexpired insurance is an asset account. It may also be called prepaid insurance and represents amounts paid for insurance that has not yet expired. The party that purchased insurance coverage uses this account. Unearned insurance fees is a liability account. It represents fees collected for insurance coverage provided to others that has not yet expired. The party that sells insurance uses this account.
Practice Question 4A company that rents an office from others (i.e., a lessee or tenant) would never have an entry in which of the following accounts for that particular lease?
A. Prepaid rent
B. Rent payable
C. Unearned rent
D. Rent expenseCorrect Answer: C
Prepaid rent could appear in an entry in the lessee's books if rent is paid in advance. Rent payable could appear if rent is due but has not yet been paid and rent expense appears when rent payments are made. Unearned rent would not appear in the lessee's books regarding this particular lease because it represents rent received in advance from a lessee and is a liability to the lessor.
Practice Question 5Bryson Company accepts an advance fee of $1,000 for services to be provided next year. This transaction would include a ______.
I. credit to cash
II. debit to accounts receivable
III. credit to unearned service fees
IV. credit to service feesCorrect Answer: III
The receipt of cash is recorded as a debit to the cash account. Because services have not yet been performed, this transaction would also include a credit to unearned service fees.
Practice Question 6When adjusting an unearned revenue account, which of the following should occur?
A. A portion of a liability is recognized as an expense.
B. A portion of a liability is recognized as revenue.
C. A portion of a revenue account is recognized as a liability.Correct Answer: B
When adjusting an unearned revenue account, such as unearned service fees, the required adjusting entry transfers the earned portion of the unearned revenue account to an appropriate revenue account, reducing the balance of the unearned revenue account (liability).
Practice Question 7The initial recording of unearned revenue would generate a ______ and this account is a(n) ______.
A. credit to revenue; liability
B. credit to unearned revenue; liability
C. debit to revenue; assetCorrect Answer: B
The revenue is not earned when the cash is received, so we have to debit cash and credit unearned revenue. It is a liability account.
Practice Question 8The accrual basis is generally considered to be superior to the cash basis in predicting a firm's future ______.
A. cash receipts/payments
B. timing of cash flows
C. profitabilityCorrect Answer: C
Accrual net earnings reflect a realistic picture of performance because the recording of revenue and expense items is tied to the earnings process experienced by the firm. Thus, it follows that predictions of future profitability also tend to be more realistic when a firm uses the accrual basis.
Practice Question 9What does a company record when it receives a cash payment for services before it performs the services?
A. Accrued liabilities
B. Unearned revenue
C. Accounts payableCorrect Answer: B
Payments received before the company performs services are recorded as a liability called unearned revenue.
Practice Question 10Which of the following statement(s) is (are) true?
I. If no errors are made in the daily recording of transactions, adjusting entries are unnecessary at the end of the period.
II. An adjusting entry to recognize wages payable at year-end causes a decrease in total assets.
III. An adjusting entry to recognize that an advance payment from a customer has now been earned will cause an increase in assets.
IV. Adjusting entries to accrue unrecorded expenses such as salaries and interest expenses causes an increase in expenses and a corresponding decrease in assets.
A. III and IV
B. II and III
C. None of themCorrect Answer: C
Practice Question 11Which of the following statement(s) is (are) true?
I. The accumulated depreciation account has a credit balance and is increased by the year-end adjusting entry for depreciation.
II. For most companies, adjusting entries are made on a yearly basis.
III. An end-of-period journal entry in which the office supplies expense account is debited and the office supplies account is credited is an example of an adjusting entry.
IV. Adjusting entries may involve recording expenses before they are due to be paid.
A. I, II, III and IV
B. I, III, IV
C. I, II and IIICorrect Answer: B
II. For most companies, adjusting entries are made on a monthly basis. Monthly adjustments provide a more accurate presentation of interim (monthly) statements.
III. Adjusting entries are made at the end of the accounting period for the purpose of recognizing revenue and expenses that are not properly measured as a result of journalizing transactions as they occur.
IV. For example, accruing unpaid wages at the end of the accounting period assigns the wages to the current time period even though they will be paid in the subsequent time period.
Practice Question 12Which of the following statement(s) is (are) false?
I. Adjusting entries may involve recording revenues before cash is received.
II. For every accrued expense there will be a corresponding change in accrued revenue.
III. Most adjusting entries involve the cash account.
IV. The systematic allocation of the cost of an asset to expense during the periods of its useful life is called adjusting.
A. II, and IV
B. II, III and IV
C. All of them are falseCorrect Answer: B
I. For example, accruing interest revenue on a note receivable will assign the interest to the current time period even though it will be collected in a subsequent time period.
II. Recording an accrued expense requires a corresponding change in an accrued liability. Recording accrued revenue requires a corresponding change in an asset account.
III. Rarely, if ever, do adjusting entries involve cash.
IV. Depreciation is the systematic allocation of the cost of an asset to expense during the periods of its useful life.
Practice Question 13Which of the following accounts is an asset?
A. Unearned insurance fees
B. Insurance payable
C. Prepaid insuranceCorrect Answer: C
Unearned insurance fees is a liability account. Liability accounts represent an obligation to make payments, transfer assets, or provide services to other entities in the future. Asset accounts represent economic resources owned by a business. Prepaid insurance is an asset account because it represents insurance that has been paid for in advance.
Practice Question 14Ben Ripper pays insurance on his office building for coverage for the following year. He would record this transaction by debiting ______
A. cash and crediting prepaid insurance.
B. prepaid insurance and crediting cash.
C. insurance expense and crediting cash.Correct Answer: B
Assets are increased with debits and decreased with credits. The cash account must be decreased and the prepaid insurance account increased by the amount of the payment (both are asset accounts). This transaction would be recorded as a debit to prepaid insurance and a credit to cash.
Practice Question 15Cash is received for services not yet performed. This transaction affects an asset account and a(n) ______.
A. asset account
B. liability account
C. revenue accountCorrect Answer: B
This transaction affects an asset account and a liability account. The receipt of cash affects an asset account (cash) and a liability account (unearned revenue) because payment has been received for services not yet performed.
Practice Question 16When adjusting for an unpaid expense that has been incurred but not recorded, which of the following occur?
A. An expense is increased and a liability is increased.
B. An expense is increased and an asset is decreased.
C. An expense is increased and a liability is decreased.Correct Answer: A
When adjusting for an unpaid expense, such as accrued wages, an appropriate expense account (wages expense) is debited and an appropriate liability account (wages payable) is credited.
Study notes from a previous year's CFA exam:
e. describe the need for accruals and valuation adjustments in preparing financial statements;