Financial Accounting and Reporting
Financial Accounting and Reporting tests whether a candidate can apply accrual accounting, recognition and measurement rules, and present coherent financial statements. Questions usually ask for the adjusting entry, the amount recognized, or the effect on the statement of financial position and profit or loss, not a definition.
Core recognition rules
- Accrual accounting records revenue when a performance obligation is satisfied and expenses when incurred, regardless of cash timing.
- Revenue recognition follows five steps: identify the contract, identify performance obligations, determine transaction price, allocate price, recognize when each obligation is satisfied.
- Inventory is measured at the lower of cost and net realizable value; cost flow assumptions change cost of sales and ending inventory.
- Depreciation allocates depreciable cost over useful life; a change in useful life or residual value is applied prospectively.
- Adjusting entries cover accruals, deferrals, and estimates; closing entries zero temporary accounts.
Worked example
On 1 December a company receives 24,000 cash for a 12-month service beginning that day. At 31 December it also owes 5,000 of December wages, unpaid. Initial entry: debit cash 24,000 and credit unearned revenue 24,000. Year-end adjustment: one month earned is 2,000, so debit unearned revenue 2,000 and credit service revenue 2,000; the remaining liability is 22,000. Wages: debit wage expense 5,000 and credit wages payable 5,000. Profit or loss shows revenue 2,000 and expense 5,000, a net decrease of 3,000. Assets include cash 24,000; liabilities are unearned revenue 22,000 plus wages payable 5,000, total 27,000; equity falls by 3,000, so the accounting equation still balances.
Traps
Recording the full cash receipt as revenue ignores the unearned liability. Omitting accrued wages understates expenses and liabilities. Depreciating land, or revising a depreciation estimate retrospectively, is wrong. Confusing net realizable value with replacement cost also loses marks. Do not net a liability against an asset unless a right of setoff exists.