Accounting Basics Practice Exam

Question 1 Accounting Basics

What are the four types of adjusting entries?

The four types are: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues. They ensure revenues and expenses appear in the correct period. A cash flow statement summarizes cash inflows and outflows from operating, investing, and financing activities. It explains changes in cash balance over a period. Liabilities are obligations of a business arising from past transactions, representing claims by creditors. They include current liabilities like accounts payable and long-term ones like bonds payable. Retained earnings are cumulative net income retained in the business rather than distributed as dividends. They appear in equity and fund growth, debt repayment, or share buybacks.

Question 2 Accounting Basics

What is goodwill?

Conversion costs are Direct Labor plus Manufacturing Overhead. They represent the cost of converting raw materials into finished goods. A related-party transaction is a deal between the reporting entity and a party with the ability to influence the entity, such as owners, executives, or affiliates. Disclosure is required because arm's-length terms may not apply. A credit is an entry on the right side of an account. It increases liabilities, equity, and revenue, and decreases assets and expenses. It always offsets a debit in the same transaction. Goodwill is an intangible asset representing the premium paid over fair value for an acquired business. It arises from reputation, customer relationships, and synergies, and is tested annually for impairment.

Question 3 Accounting Basics

What are closing entries?

Net book value (carrying amount) is an asset's original cost minus its accumulated depreciation. It represents the un-depreciated portion remaining on the balance sheet at a given date. Closing entries transfer temporary accounts (revenues, expenses, dividends) to retained earnings at period-end. They reset accounts for the next period. The allowance for doubtful accounts is a contra-asset that estimates uncollectible receivables. It is subtracted from Accounts Receivable on the balance sheet to show net realizable value. A journal is the book of original entry where transactions are recorded chronologically with debits and credits. It provides a complete audit trail before posting to ledgers.

Question 4 Accounting Basics

What are intangible assets?

Consolidation combines the financial statements of a parent and its majority-owned subsidiaries as if they were one entity. Intercompany balances and transactions are eliminated in consolidation. Intangible assets are long-term non-physical resources with future economic value. They include patents, trademarks, copyrights, goodwill, and software. Some have finite lives (amortized); goodwill and many trademarks are indefinite-lived. The direct write-off method records bad debt expense only when a specific account is determined to be uncollectible. It is simple but violates the matching principle, so GAAP prefers the allowance method. A debit is an entry on the left side of an account. It increases assets, expenses, and dividends, and decreases liabilities, equity, and revenue. Every debit has a matching credit.

Question 5 Accounting Basics

What is a flexible budget?

A cash flow statement summarizes cash inflows and outflows from operating, investing, and financing activities. It explains changes in cash balance over a period. Liabilities are obligations of a business arising from past transactions, representing claims by creditors. They include current liabilities like accounts payable and long-term ones like bonds payable. Bad debt expense is the cost of customer receivables deemed uncollectible. Under the allowance method, it is estimated and recorded in advance; under the direct write-off method, it is recognized only when a specific account is written off. A flexible budget adjusts the original budget to the actual level of activity. It separates fixed and variable costs, allowing fair performance evaluation at different sales volumes.

Question 6 Accounting Basics

What is the double-declining-balance depreciation method?

Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It matches asset cost to periods benefited, reducing taxable income. Double-declining-balance is an accelerated method that multiplies straight-line rate by 2 and applies it to the asset's beginning book value. Salvage value is ignored until book value reaches it. Straight-line depreciation allocates equal expense each year: (Cost - Salvage Value) / Useful Life. It is simple and widely used for assets with steady utility. Debt-to-equity ratio assesses solvency: Total Liabilities / Owner's Equity. Higher ratios indicate more leverage and risk.

Question 7 Accounting Basics

What is the difference between common stock and preferred stock?

IFRS allows capitalization of development costs once technical and commercial feasibility is established. GAAP requires most research and development costs to be expensed as incurred, with limited exceptions for software. A deferred tax liability arises when book income is higher than taxable income, creating a future tax payment obligation. Accelerated tax depreciation is a common cause. LIFO liquidation occurs when a company sells more inventory than it buys, dipping into older, cheaper LIFO layers. This shifts older costs into COGS, often raising reported income in inflationary periods. Common stock carries voting rights and residual dividend claims. Preferred stock typically has priority in dividends and liquidation but usually no voting rights; it often has a fixed dividend.

Question 8 Accounting Basics

What is LIFO inventory method?

LIFO (Last-In, First-Out) assumes newest costs are sold first. It is allowed under GAAP but not IFRS, often used for tax benefits in inflation. Owner's equity represents the residual interest in assets after deducting liabilities. It includes owner investments, retained earnings, and accumulated profits. Conversion costs are Direct Labor plus Manufacturing Overhead. They represent the cost of converting raw materials into finished goods. Break-even units = Total Fixed Costs / (Sales Price per Unit - Variable Cost per Unit). Each unit above break-even contributes profit equal to its contribution margin.

Question 9 Accounting Basics

What is a constructive obligation?

SOX is a 2002 U.S. law that strengthened corporate governance and internal controls over financial reporting. It requires CEOs and CFOs to certify financial statements and auditors to attest to internal controls. An aging of receivables groups outstanding invoices by age (0-30, 31-60, 61-90, over 90 days) to estimate uncollectible amounts. Older balances are assigned higher bad-debt probabilities. A constructive obligation is an obligation created by established patterns of past practice or published policies that lead others to expect the entity will discharge it. Even without a legal contract, it is recognized as a liability. Vertical analysis expresses each financial statement item as a percentage of a base figure (revenue for the income statement, total assets for the balance sheet). It reveals the structure of the business.

Question 10 Accounting Basics

What is a fiscal year?

A fiscal year is a 12-month accounting period that may end on any date, not necessarily December 31. Many retailers use a 52/53-week fiscal year ending on a Saturday closest to month-end. Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It matches asset cost to periods benefited, reducing taxable income. ASC 606 is the revenue recognition standard that uses a five-step model: identify the contract, identify performance obligations, determine the transaction price, allocate the price, and recognize revenue when obligations are satisfied. A chart of accounts is a list of all accounts used by a business to classify transactions. It organizes accounts into categories like assets, liabilities, equity, revenues, and expenses.

Question 11 Accounting Basics

What is the accounting equation?

Non-controlling interest is the portion of a subsidiary's equity not attributable to the parent. It appears separately in consolidated equity and as a separate line of net income disclosure. Liabilities are obligations of a business arising from past transactions, representing claims by creditors. They include current liabilities like accounts payable and long-term ones like bonds payable. The effective interest method calculates interest expense by multiplying the bond's carrying value by the market (effective) rate at issuance. The difference between this and the cash interest payment is the discount or premium amortization. The accounting equation is Assets = Liabilities + Owner's Equity. It represents the fundamental relationship showing that a company's resources equal claims on those resources.

Question 12 Accounting Basics

What is a tax shield?

A tax shield is a reduction in taxable income that lowers tax owed. Common shields include depreciation, interest expense, and certain operating expenses. Value equals the tax rate times the deductible amount. A deferred tax asset arises when taxable income is higher than book income due to temporary differences, or when carryforwards exist. It represents future tax savings and is recorded if more likely than not realizable. A fixed asset (PP&E) is a long-term tangible asset used in operations, not held for resale. Examples include buildings, machinery, vehicles, and land improvements. Land is not depreciated. The primary branches are financial accounting, which focuses on external reporting; managerial accounting, for internal decision-making; tax accounting, for compliance with tax laws; and auditing, for verifying financial statements.

Question 13 Accounting Basics

What is EBIT vs. EBITDA?

A fiscal year is a 12-month accounting period that may end on any date, not necessarily December 31. Many retailers use a 52/53-week fiscal year ending on a Saturday closest to month-end. EBIT is Earnings Before Interest and Taxes. EBITDA is EBIT plus Depreciation and Amortization. EBITDA is often used as a proxy for cash flow and to compare capital-intensive firms. Owner's equity represents the residual interest in assets after deducting liabilities. It includes owner investments, retained earnings, and accumulated profits. Impairment is a write-down of an asset's carrying value when its fair value has fallen below book value and the decline is other-than-temporary. The loss appears on the income statement.

Question 14 Accounting Basics

What is double-entry bookkeeping?

Expenses are costs incurred to generate revenue, such as salaries, rent, and utilities. They reduce owner's equity when matched against revenues. Double-entry bookkeeping records each transaction with equal debits and credits to maintain the accounting equation. Every debit must have a corresponding credit, ensuring accuracy and balance. A bond is a long-term debt security issued by corporations or governments to raise capital. Bondholders receive periodic interest payments and the face value at maturity. Cost principle requires assets to be recorded at historical cost, not market value. It provides objective, verifiable amounts.

Question 15 Accounting Basics

What is gross profit?

The four types are: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues. They ensure revenues and expenses appear in the correct period. Prime costs are Direct Materials plus Direct Labor. They are the most directly traceable costs of producing a product and exclude manufacturing overhead. Gross profit is Revenue minus COGS. It measures profit from core operations before operating expenses, interest, and taxes. It is a key indicator of pricing and production efficiency. Going concern assumption assumes the business will continue operating indefinitely without liquidation. It justifies capitalizing assets over their useful lives.

Question 16 Accounting Basics

What is capitalizing vs. expensing a cost?

Capitalizing records a cost as an asset on the balance sheet and depreciates it over time. Expensing records the cost immediately on the income statement. Material long-term benefits generally require capitalization. Accrual basis accounting records revenues when earned and expenses when incurred, regardless of cash flow. It provides a more accurate picture of financial performance than cash basis. Asset accounts normally carry a debit balance. Cash, Accounts Receivable, Inventory, and Equipment all increase with debits and decrease with credits. A tax shield is a reduction in taxable income that lowers tax owed. Common shields include depreciation, interest expense, and certain operating expenses. Value equals the tax rate times the deductible amount.

Question 17 Accounting Basics

What is the indirect method of cash flow?

Primary users include investors, creditors, regulators, management, and employees. They use the information to assess profitability, liquidity, solvency, and operational efficiency. ROE measures profitability for owners: Net Income / Average Equity x 100. Higher ROE indicates efficient use of equity. A trial balance is a list of all ledger accounts with debit and credit balances to verify equality of totals. It detects arithmetic errors but not all mistakes. The indirect method starts with net income and adjusts for non-cash items (depreciation) and changes in working capital to derive operating cash flow. It is the most commonly used format.

Question 18 Accounting Basics

What is a bond?

Asset accounts normally carry a debit balance. Cash, Accounts Receivable, Inventory, and Equipment all increase with debits and decrease with credits. Current assets are resources expected to be converted to cash or used within one year, such as cash, receivables, and inventory. A bond is a long-term debt security issued by corporations or governments to raise capital. Bondholders receive periodic interest payments and the face value at maturity. A qualified opinion contains a specific exception or departure from GAAP that is material but not pervasive. Users should treat the financial statements with caution in the affected area.

Question 19 Accounting Basics

What is the difference between IFRS and GAAP in fixed asset revaluation?

An asset provides future economic benefit and appears on the balance sheet. An expense is a cost consumed in the current period and appears on the income statement. Capitalizing creates an asset; expensing recognizes it immediately. Interest coverage is Operating Income (EBIT) divided by Interest Expense. It measures ability to pay interest on outstanding debt. A ratio below 1.5 signals potential solvency problems. SOX is a 2002 U.S. law that strengthened corporate governance and internal controls over financial reporting. It requires CEOs and CFOs to certify financial statements and auditors to attest to internal controls. IFRS allows fixed assets to be revalued to fair value, with changes flowing through OCI or income. GAAP generally requires fixed assets to remain at historical cost.

Question 20 Accounting Basics

What is the role of the Financial Accounting Standards Board (FASB)?

Accruals are adjusting entries for revenues earned but not yet received (accrued revenue) or expenses incurred but not yet paid (accrued expense). They ensure proper period matching under accrual accounting. Under LIFO, the newest (higher) costs flow to COGS, matching current costs against current revenue. This lowers net income and reduces taxes in inflationary periods. Straight-line depreciation allocates equal expense each year: (Cost - Salvage Value) / Useful Life. It is simple and widely used for assets with steady utility. The FASB is the U.S. private-sector body that sets GAAP for public and private companies. It issues Accounting Standards Codification (ASC) updates through due process.

Question 21 Accounting Basics

What are adjusting entries?

Net income is the bottom-line profit: total revenues minus total expenses, including taxes and interest. It increases retained earnings and is the basis for earnings per share. Temporary accounts are revenues, expenses, and dividends. They accumulate activity for one period and are closed to retained earnings at period end, starting each new period with zero balance. Adjusting entries update accounts at period-end for accruals, deferrals, depreciation. They ensure accrual accounting and proper matching. Depreciation expense is the amount charged in a single period and reported on the income statement. Accumulated depreciation is the running total of all depreciation recorded to date and is a contra-asset on the balance sheet.

Question 22 Accounting Basics

What is the full disclosure principle?

Full disclosure principle requires all relevant information affecting decisions to be disclosed in financial statements or notes. Accrual basis accounting records revenues when earned and expenses when incurred, regardless of cash flow. It provides a more accurate picture of financial performance than cash basis. Working capital is Current Assets minus Current Liabilities. It measures short-term liquidity and the cushion available to fund operations. Positive working capital signals operational health. A deferral is an adjusting entry for cash received or paid before revenue is earned or expense is incurred. Examples include prepaid insurance and unearned rent. They shift recognition to the correct period.

Question 23 Accounting Basics

What is a temporary difference?

SOX is a 2002 U.S. law that strengthened corporate governance and internal controls over financial reporting. It requires CEOs and CFOs to certify financial statements and auditors to attest to internal controls. Time period assumption divides business life into artificial periods like quarters or years for reporting. It enables periodic financial statements. The FASB is the U.S. private-sector body that sets GAAP for public and private companies. It issues Accounting Standards Codification (ASC) updates through due process. A temporary difference is a difference between the book carrying amount of an asset or liability and its tax basis that will reverse in future periods. It produces deferred tax assets or liabilities.

Question 24 Accounting Basics

What are liabilities?

Liabilities are obligations of a business arising from past transactions, representing claims by creditors. They include current liabilities like accounts payable and long-term ones like bonds payable. GAAP stands for Generally Accepted Accounting Principles, a set of standardized guidelines used primarily in the U.S. for preparing financial statements to ensure consistency and comparability. Permanent accounts are assets, liabilities, and equity. Their balances carry forward from one period to the next and are not closed at period end. Primary users include investors, creditors, regulators, management, and employees. They use the information to assess profitability, liquidity, solvency, and operational efficiency.

Question 25 Accounting Basics

What is the net profit margin?

A related-party transaction is a deal between the reporting entity and a party with the ability to influence the entity, such as owners, executives, or affiliates. Disclosure is required because arm's-length terms may not apply. The matching principle requires expenses to be recorded in the same period as related revenues. It ensures accurate profitability measurement. Primary users include investors, creditors, regulators, management, and employees. They use the information to assess profitability, liquidity, solvency, and operational efficiency. Net profit margin is Net Income divided by Revenue. It indicates the percentage of revenue kept as profit after all expenses, including taxes and interest.

Question 26 Accounting Basics

What is the cash ratio?

LIFO liquidation occurs when a company sells more inventory than it buys, dipping into older, cheaper LIFO layers. This shifts older costs into COGS, often raising reported income in inflationary periods. Weighted-average assigns the same unit cost to all items, recalculated each period as (Total cost of goods available) / (Total units available). It smooths price fluctuations between FIFO and LIFO results. Cash ratio is (Cash + Cash Equivalents) / Current Liabilities. It is the most conservative liquidity measure, showing ability to pay current debts with cash on hand. The price-to-earnings ratio is Market Price per Share divided by EPS. It shows how much investors pay for $1 of current earnings. High P/E signals growth expectations or overvaluation.

Question 27 Accounting Basics

What is internal control?

Internal control is a system of policies, procedures, and safeguards designed to ensure reliable financial reporting, effective operations, and compliance with laws. The COSO framework defines five components. Additional paid-in capital is the amount paid by investors above the par value of stock. It is a component of paid-in capital and reflects premiums received from share issuances. Free cash flow is Operating Cash Flow minus Capital Expenditures. It represents cash available to expand the business, pay dividends, reduce debt, or buy back shares. A chart of accounts is a list of all accounts used by a business to classify transactions. It organizes accounts into categories like assets, liabilities, equity, revenues, and expenses.

Question 28 Accounting Basics

What is a trial balance?

Operating income is Gross Profit minus operating expenses (selling, general, and administrative). It reflects earnings from core business activities, excluding interest and taxes. Also called EBIT in some definitions. Cash dividends pay shareholders in cash and reduce assets. Stock dividends issue additional shares and transfer value from retained earnings to contributed capital; they do not change total equity. Accounting cycle is the process from recording transactions to preparing financial statements: journalize, post, trial balance, adjustments, adjusted trial balance, statements, closing, post-closing trial balance. A trial balance is a list of all ledger accounts with debit and credit balances to verify equality of totals. It detects arithmetic errors but not all mistakes.

Question 29 Accounting Basics

What is mark-to-market accounting?

Mark-to-market revalues certain assets and liabilities to current market prices, with changes flowing through income or equity. It is required for trading securities and used for derivatives. Book value per share is Total Stockholders' Equity divided by Shares Outstanding. It represents the per-share claim on net assets if the company were liquidated at book value. Adjusting entries update account balances to reflect accruals and deferrals before statements. Closing entries zero out temporary accounts and transfer their net balances to retained earnings. A debit is an entry on the left side of an account. It increases assets, expenses, and dividends, and decreases liabilities, equity, and revenue. Every debit has a matching credit.

Question 30 Accounting Basics

What is the cash conversion cycle (CCC)?

OCI includes revenues, expenses, gains, and losses that bypass the income statement and are recorded directly in equity. Examples: unrealized gains/losses on AFS securities, foreign currency translation, pension adjustments. Net book value (carrying amount) is an asset's original cost minus its accumulated depreciation. It represents the un-depreciated portion remaining on the balance sheet at a given date. LIFO liquidation occurs when a company sells more inventory than it buys, dipping into older, cheaper LIFO layers. This shifts older costs into COGS, often raising reported income in inflationary periods. CCC measures the time between paying for inputs and collecting cash from customers: DIO + DSO - DPO. A shorter cycle frees up working capital and improves liquidity.

Question 31 Accounting Basics

What is impairment?

Weighted-average assigns the same unit cost to all items, recalculated each period as (Total cost of goods available) / (Total units available). It smooths price fluctuations between FIFO and LIFO results. Time period assumption divides business life into artificial periods like quarters or years for reporting. It enables periodic financial statements. Under LIFO, the newest (higher) costs flow to COGS, matching current costs against current revenue. This lowers net income and reduces taxes in inflationary periods. Impairment is a write-down of an asset's carrying value when its fair value has fallen below book value and the decline is other-than-temporary. The loss appears on the income statement.

Question 32 Accounting Basics

What is fair value?

Assets are resources owned or controlled by a business that provide future economic benefits. They are classified as current (e.g., cash, inventory) or non-current (e.g., property, equipment). Break-even units = Total Fixed Costs / (Sales Price per Unit - Variable Cost per Unit). Each unit above break-even contributes profit equal to its contribution margin. EOQ is the optimal order quantity that minimizes total inventory costs (ordering plus holding). Formula: sqrt(2DS/H), where D is annual demand, S is ordering cost, and H is holding cost per unit. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. It is the basis for mark-to-market accounting.

Question 33 Accounting Basics

What is accounting?

Temporary accounts are revenues, expenses, and dividends. They accumulate activity for one period and are closed to retained earnings at period end, starting each new period with zero balance. Under FIFO, the oldest (cheapest) costs flow to COGS, leaving the most recent (higher) costs in ending inventory. The balance sheet therefore reflects more current replacement values, increasing reported inventory and net income. Accounting is the process of recording, summarizing, analyzing, and reporting financial transactions of a business to provide useful information for decision-making. It serves as the language of business, helping stakeholders understand financial health. The statement of retained earnings shows changes in retained earnings over a period, starting with beginning balance, adding net income, subtracting dividends. It links income statement to balance sheet.

Question 34 Accounting Basics

What is the equity method of accounting?

Weighted-average assigns the same unit cost to all items, recalculated each period as (Total cost of goods available) / (Total units available). It smooths price fluctuations between FIFO and LIFO results. Accounts payable are short-term liabilities owed to suppliers for purchases on credit. They represent obligations payable within one year. IFRS prohibits LIFO and requires inventory at the lower of cost and net realizable value. GAAP allows LIFO and uses lower of cost or market (now largely LCNRV under ASU 2015-11) for inventories. The equity method records the investor's proportional share of the investee's net income as investment revenue, with a corresponding increase in the investment account. Dividends reduce the investment account, not income. Used for significant influence (typically 20-50% ownership).

Question 35 Accounting Basics

What is treasury stock?

Materiality refers to information significant enough to influence decisions. Immaterial items may be accounted for differently for efficiency. Treasury stock is shares that a company has issued and then reacquired, held in the corporation's treasury. It is recorded at cost as a contra-equity account, reducing total stockholders' equity. Bank reconciliation reconciles company cash records with bank statement, identifying timing differences, errors, or theft. It ensures accurate cash balances. Additional paid-in capital is the amount paid by investors above the par value of stock. It is a component of paid-in capital and reflects premiums received from share issuances.

Question 36 Accounting Basics

What are accruals in accounting?

Cash ratio is (Cash + Cash Equivalents) / Current Liabilities. It is the most conservative liquidity measure, showing ability to pay current debts with cash on hand. Accruals are adjusting entries for revenues earned but not yet received (accrued revenue) or expenses incurred but not yet paid (accrued expense). They ensure proper period matching under accrual accounting. Revenue recognition principle states revenue is recognized when earned and realizable, not necessarily when cash is received. Key criteria include persuasive evidence and delivery. Gross profit margin is (Gross Profit / Revenue) x 100, showing profitability from core operations before overhead.

Question 37 Accounting Basics

What is accrual basis accounting?

A cash flow statement summarizes cash inflows and outflows from operating, investing, and financing activities. It explains changes in cash balance over a period. Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It matches asset cost to periods benefited, reducing taxable income. Accrual basis accounting records revenues when earned and expenses when incurred, regardless of cash flow. It provides a more accurate picture of financial performance than cash basis. Break-even point is the sales volume at which total revenue equals total costs: Fixed Costs / Contribution Margin per Unit. Above it the business operates profitably; below it, at a loss.

Question 38 Accounting Basics

What is the percentage-of-completion method?

DSO is Average Accounts Receivable divided by (Net Credit Sales / 365). It is the average number of days to collect cash after a sale. Lower DSO means faster collection. The four types are: (1) prepaid expenses, (2) unearned revenues, (3) accrued expenses, and (4) accrued revenues. They ensure revenues and expenses appear in the correct period. Percentage-of-completion recognizes revenue on long-term contracts in proportion to costs incurred relative to total estimated costs. It is required when estimates are reliable and collections are assured. Gross profit is Revenue minus COGS. It measures profit from core operations before operating expenses, interest, and taxes. It is a key indicator of pricing and production efficiency.

Question 39 Accounting Basics

What is the effective interest method?

Debt-to-equity ratio assesses solvency: Total Liabilities / Owner's Equity. Higher ratios indicate more leverage and risk. A balance sheet is a financial statement showing assets, liabilities, and equity at a specific point in time. It reflects the accounting equation in detail. The effective interest method calculates interest expense by multiplying the bond's carrying value by the market (effective) rate at issuance. The difference between this and the cash interest payment is the discount or premium amortization. Break-even point is the sales volume at which total revenue equals total costs: Fixed Costs / Contribution Margin per Unit. Above it the business operates profitably; below it, at a loss.

Question 40 Accounting Basics

What is an income statement?

Debt-to-equity ratio assesses solvency: Total Liabilities / Owner's Equity. Higher ratios indicate more leverage and risk. LIFO (Last-In, First-Out) assumes newest costs are sold first. It is allowed under GAAP but not IFRS, often used for tax benefits in inflation. The indirect method starts with net income and adjusts for non-cash items (depreciation) and changes in working capital to derive operating cash flow. It is the most commonly used format. An income statement reports revenues, expenses, and net income over a period. It shows profitability: Net Income = Revenues - Expenses.

Question 41 Accounting Basics

What is the conservatism principle?

SOX is a 2002 U.S. law that strengthened corporate governance and internal controls over financial reporting. It requires CEOs and CFOs to certify financial statements and auditors to attest to internal controls. Conservatism principle advises understating assets or income and overstating liabilities when uncertainty exists. It promotes prudence to avoid overstating performance. OCI includes revenues, expenses, gains, and losses that bypass the income statement and are recorded directly in equity. Examples: unrealized gains/losses on AFS securities, foreign currency translation, pension adjustments. EBIT is Earnings Before Interest and Taxes. EBITDA is EBIT plus Depreciation and Amortization. EBITDA is often used as a proxy for cash flow and to compare capital-intensive firms.

Question 42 Accounting Basics

What is bank reconciliation?

A cash flow statement summarizes cash inflows and outflows from operating, investing, and financing activities. It explains changes in cash balance over a period. Unearned revenue is a liability for cash collected before goods or services are delivered. As the obligation is fulfilled, an adjusting entry converts it into earned revenue. Bank reconciliation reconciles company cash records with bank statement, identifying timing differences, errors, or theft. It ensures accurate cash balances. EPS is Net Income attributable to common shareholders divided by weighted-average common shares outstanding. Basic EPS uses only common shares; diluted EPS also includes the effect of convertibles and options.

Question 43 Accounting Basics

What is return on assets (ROA)?

Margin of safety is Actual or Budgeted Sales minus Break-even Sales. It shows how much sales can drop before the company incurs a loss. Expressed as a percentage of actual sales, it is a risk measure. Units-of-production depreciation allocates cost based on actual usage: (Cost - Salvage) x (Units this period / Total estimated units). It suits assets whose wear is tied directly to output, like machinery. ROA is Net Income divided by Average Total Assets, expressed as a percentage. It measures how efficiently assets produce profit. Lower ROA in asset-heavy industries is normal. The accounting equation is Assets = Liabilities + Owner's Equity. It represents the fundamental relationship showing that a company's resources equal claims on those resources.

Question 44 Accounting Basics

What is absorption costing?

The indirect method starts with net income and adjusts for non-cash items (depreciation) and changes in working capital to derive operating cash flow. It is the most commonly used format. Interest coverage is Operating Income (EBIT) divided by Interest Expense. It measures ability to pay interest on outstanding debt. A ratio below 1.5 signals potential solvency problems. Absorption costing expenses all production costs (variable and fixed) as inventory costs. Fixed overhead is capitalized in inventory until sold. GAAP requires absorption costing for external reports. Net income is the bottom-line profit: total revenues minus total expenses, including taxes and interest. It increases retained earnings and is the basis for earnings per share.

Question 45 Accounting Basics

What is activity-based costing (ABC)?

Liability accounts normally carry a credit balance. Accounts Payable, Loans Payable, and Accrued Expenses all increase with credits and decrease with debits. ABC assigns overhead costs to products or services based on the activities they consume. It provides more accurate cost information than volume-based allocation, especially for diverse product lines. A fixed asset (PP&E) is a long-term tangible asset used in operations, not held for resale. Examples include buildings, machinery, vehicles, and land improvements. Land is not depreciated. Full disclosure principle requires all relevant information affecting decisions to be disclosed in financial statements or notes.

Question 46 Accounting Basics

What is the units-of-production depreciation method?

A trial balance is a list of all ledger accounts with debit and credit balances to verify equality of totals. It detects arithmetic errors but not all mistakes. A compound journal entry involves more than two accounts but still maintains equal debits and credits. For example, one transaction may debit several expense accounts and credit one cash account. Treasury stock is shares that a company has issued and then reacquired, held in the corporation's treasury. It is recorded at cost as a contra-equity account, reducing total stockholders' equity. Units-of-production depreciation allocates cost based on actual usage: (Cost - Salvage) x (Units this period / Total estimated units). It suits assets whose wear is tied directly to output, like machinery.

Question 47 Accounting Basics

What is a T-account?

A fiscal year is a 12-month accounting period that may end on any date, not necessarily December 31. Many retailers use a 52/53-week fiscal year ending on a Saturday closest to month-end. A T-account is a visual representation of a ledger account shaped like the letter T, with debits on the left and credits on the right. It is used to teach and analyze the effect of journal entries. Double-entry bookkeeping records each transaction with equal debits and credits to maintain the accounting equation. Every debit must have a corresponding credit, ensuring accuracy and balance. Under FIFO, the oldest (cheapest) costs flow to COGS, leaving the most recent (higher) costs in ending inventory. The balance sheet therefore reflects more current replacement values, increasing reported inventory and net income.

Question 48 Accounting Basics

What is the LIFO reserve?

The LIFO reserve is the cumulative difference between inventory reported under FIFO and under LIFO. Companies disclose it in notes to help users convert LIFO results to FIFO for comparability. Monetary unit assumption states financial transactions are recorded in a stable currency unit, ignoring inflation effects. EBIT is Earnings Before Interest and Taxes. EBITDA is EBIT plus Depreciation and Amortization. EBITDA is often used as a proxy for cash flow and to compare capital-intensive firms. A reversing entry is an optional entry made at the start of a new period that reverses a prior period's accrual. It simplifies bookkeeping by letting routine transactions be recorded normally.

Question 49 Accounting Basics

What is the economic order quantity (EOQ)?

A chart of accounts is a list of all accounts used by a business to classify transactions. It organizes accounts into categories like assets, liabilities, equity, revenues, and expenses. EOQ is the optimal order quantity that minimizes total inventory costs (ordering plus holding). Formula: sqrt(2DS/H), where D is annual demand, S is ordering cost, and H is holding cost per unit. Going concern assumption assumes the business will continue operating indefinitely without liquidation. It justifies capitalizing assets over their useful lives. Operating activities, investing activities, and financing activities. Operating shows core cash from the business; investing covers long-term assets; financing covers debt and equity transactions.

Question 50 Accounting Basics

What is a debit in double-entry bookkeeping?

CCC measures the time between paying for inputs and collecting cash from customers: DIO + DSO - DPO. A shorter cycle frees up working capital and improves liquidity. The indirect method starts with net income and adjusts for non-cash items (depreciation) and changes in working capital to derive operating cash flow. It is the most commonly used format. The matching principle requires expenses to be recorded in the same period as related revenues. It ensures accurate profitability measurement. A debit is an entry on the left side of an account. It increases assets, expenses, and dividends, and decreases liabilities, equity, and revenue. Every debit has a matching credit.