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Chapter 3
Adjusting the Accounts
Learning Objectives
After studying this chapter, you should be able to:
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1.
Explain the time period assumption.
2.
Explain the accrual basis of accounting.
3.
Explain the reasons for adjusting entries.
4.
Identify the major types of adjusting entries.
5.
Prepare adjusting entries for deferrals.
6.
Prepare adjusting entries for accruals.
7.
Describe the nature and purpose of an adjusted trial balance.
Preview of Chapter 3
Financial and Managerial Accounting
Weygandt Kimmel Kieso
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Timing Issues
Accountants divide the economic life of a business into
artificial time periods (Time Period Assumption).
.....
Jan.
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Feb.
Mar.
Apr.

Generally a month, a quarter, or a year.

Also known as the “Periodicity Assumption”
Dec.
LO 1 Explain the time period assumption.
Timing Issues
Fiscal and Calendar Years
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
Monthly and quarterly time periods are called interim
periods.

Public companies must prepare both quarterly and
annual financial statements.

Fiscal Year = Accounting time period that is one year in
length.

Calendar Year = January 1 to December 31.
LO 1 Explain the time period assumption.
Timing Issues
Question
The time period assumption states that:
a. revenue should be recognized in the accounting
period in which it is earned.
b. expenses should be matched with revenues.
c. the economic life of a business can be divided into
artificial time periods.
d. the fiscal year should correspond with the calendar
year.
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LO 1 Explain the time period assumption.
Timing Issues
Accrual- vs. Cash-Basis Accounting
Accrual-Basis Accounting
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
Transactions recorded in the periods in which the
events occur.

Revenues are recognized when earned, rather than
when cash is received.

Expenses are recognized when incurred, rather than
when paid.
LO 2 Explain the accrual basis of accounting.
Timing Issues
Accrual- vs. Cash-Basis Accounting
Cash-Basis Accounting
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
Revenues recognized when cash is received.

Expenses recognized when cash is paid.

Cash-basis accounting is not in accordance with
generally accepted accounting principles (GAAP).
LO 2 Explain the accrual basis of accounting.
Timing Issues
Recognizing Revenues and Expenses
Revenue Recognition Principle
Recognize revenue in the
accounting period in which it
is earned.
In a service enterprise,
revenue is considered to be
earned at the time the service
is performed.
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LO 2 Explain the accrual basis of accounting.
Timing Issues
Recognizing Revenues and Expenses
Expense Recognition Principle
Match expenses with
revenues in the period when
the company makes efforts to
generate those revenues.
“Let the expenses follow
the revenues.”
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LO 2 Explain the accrual basis of accounting.
Timing Issues
Illustration 3-1
GAAP relationships in revenue
and expense recognition
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LO 2 Explain the accrual basis of accounting.
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LO 2 Explain the accrual basis of accounting.
Timing Issues
Question
One of the following statements about the accrual basis of
accounting is false. That statement is:
a. Events that change a company’s financial statements
are recorded in the periods in which the events occur.
b. Revenue is recognized in the period in which it is
earned.
c. The accrual basis of accounting is in accord with
generally accepted accounting principles.
d. Revenue is recorded only when cash is received, and
expenses are recorded only when cash is paid.
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LO 2 Explain the accrual basis of accounting.
A list of concepts is provided in the left column below, with a
description of the concept in the right column below. There are more
descriptions provided than concepts. Match the description of the
concept to the concept.
f
e
c
b
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LO 2
The Basics of Adjusting Entries
Adjusting Entries
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
Ensure that the revenue recognition and expense
recognition principles are followed.

Necessary because the trial balance may not contain
up-to-date and complete data.

Required every time a company prepares financial
statements.

Will include one income statement account and one
balance sheet account.
LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries
Question
Adjusting entries are made to ensure that:
a. expenses are recognized in the period in which they
are incurred.
b. revenues are recorded in the period in which they are
earned.
c. balance sheet and income statement accounts have
correct balances at the end of an accounting period.
d. all of the above.
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LO 3 Explain the reasons for adjusting entries.
The Basics of Adjusting Entries
Types of Adjusting Entries
Illustration 3-2
Categories of adjusting entries
Deferrals
Accruals
1. Prepaid Expenses.
3. Accrued Revenues.
Expenses paid in cash and
recorded as assets before
they are used or consumed.
Revenues earned but not yet
received in cash or recorded.
2. Unearned Revenues.
4. Accrued Expenses.
Cash received and recorded
as liabilities before revenue is
earned.
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Expenses incurred but not yet
paid in cash or recorded.
LO 4 Identify the major types of adjusting entries.
The Basics of Adjusting Entries
Types of Adjusting Entries
Trial Balance –
Each account is
analyzed to
determine whether
it is complete and
up-to-date.
Illustration 3-3
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LO 4 Identify the major types of adjusting entries.
The Basics of Adjusting Entries
Adjusting Entries for Deferrals
Deferrals are either:

Prepaid expenses
OR

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Unearned revenues.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Prepaid Expenses
Payment of cash, that is recorded as an asset because
service or benefit will be received in the future.
Cash Payment
BEFORE
Expense Recorded
Prepayments often occur in regard to:
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
insurance

rent

supplies

equipment

advertising

buildings
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Prepaid Expenses

Expire either with the passage of time or through use.

Adjusting entry:
►
Increase (debit) to an expense account and
►
Decrease (credit) to an asset account.
Illustration 3-4
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LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration: Pioneer Advertising Agency
purchased supplies costing $2,500 on
October 5. Pioneer recorded the payment
by increasing (debiting) the asset
Supplies. This account shows a balance
of $2,500 in the October 31 trial balance.
An inventory count at the close of
business on October 31 reveals that
$1,000 of supplies are still on hand.
Oct. 31
Supplies expense
Supplies
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1,500
1,500
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-5
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LO 5
The Basics of Adjusting Entries
Illustration: On October 4, Pioneer
Advertising paid $600 for a one-year fire
insurance policy. Coverage began on
October 1. Pioneer recorded the payment
by increasing (debiting) Prepaid
Insurance. This account shows a balance
of $600 in the October 31 trial balance.
Insurance of $50 ($600 ÷ 12) expires
each month.
Oct. 31
Insurance expense
50
Prepaid insurance
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50
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-6
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LO 5
The Basics of Adjusting Entries
Depreciation
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
Buildings, equipment, and vehicles (assets with long
lives) are recorded as assets, rather than an expense,
in the year acquired.

Depreciation allocates a portion of the asset’s cost as
an expense during each period of the asset’s useful life.

Depreciation does not attempt to report the actual
change in the value of the asset.
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration: For Pioneer Advertising,
assume that depreciation on the
equipment is $480 a year, or $40 per
month.
Oct. 31
Depreciation expense
Accumulated depreciation
40
40
Accumulated Depreciation is called a contra asset account.
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LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-7
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LO 5
The Basics of Adjusting Entries
Statement Presentation

Accumulated Depreciation is a contra asset account
(credit).

Appears just after the account it offsets (Equipment) on
the balance sheet.

Book value is the difference between the cost of any
depreciable asset and its accumulated depreciation.
Illustration 3-8
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LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-9
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LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Unearned Revenues
Receipt of cash that is recorded as a liability because the
revenue has not been earned.
Cash Receipt
BEFORE
Revenue Recorded
Unearned revenues often occur in regard to:
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
Rent

Magazine subscriptions

Airline tickets

Customer deposits
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Unearned Revenues

Adjusting entry is made to record the revenue that has
been earned and to show the liability that remains.

Results in a decrease (debit) to a liability account
and an increase (credit) to a revenue account.
Illustration 3-10
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LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration: Pioneer Advertising received $1,200 on October 2
from R. Knox for advertising services expected to be completed by
December 31. Unearned Service Revenue shows a balance of
$1,200 in the October 31 trial balance. Analysis reveals that the
company earned $400 of those fees in October.
Oct. 31
Unearned service revenue
Service revenue
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400
400
LO 5 Prepare adjusting entries for deferrals.
The Basics of Adjusting Entries
Illustration 3-11
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LO 5
The Basics of Adjusting Entries
Illustration 3-12
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LO 5 Prepare adjusting entries for deferrals.
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The Basics of Adjusting Entries
Adjusting Entries for Accruals
Accruals are made to record

Revenues earned
OR

Expenses incurred
in the current accounting period that have not been
recognized through daily entries.
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LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Accrued Revenues
Revenues earned but not yet received in cash or recorded.
Revenue Recorded
BEFORE
Cash Receipt
Accrued revenues often occur in regard to:
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
Rent

Interest

Services performed
LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Accrued Revenues

Adjusting entry shows the receivable that exists and
records the revenues earned.

Adjusting entry:
►
Increases (debits) an asset account and
►
Increases (credits) a revenue account.
Illustration 3-13
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LO 6
The Basics of Adjusting Entries
Illustration: In October Pioneer Advertising
Agency earned $200 for advertising services
that had not been recorded.
Oct. 31
Accounts receivable
200
Service revenue
200
On November 10, Pioneer receives cash of
$200 for the services performed.
Nov. 10
Cash
200
Accounts receivable
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200
LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Illustration 3-14
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LO 6
The Basics of Adjusting Entries
Illustration 3-15
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LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Accrued Expenses
Expenses incurred but not yet paid in cash or recorded.
Expense Recorded
BEFORE
Cash Payment
Accrued expenses often occur in regard to:
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
Rent

Taxes

Interest

Salaries
LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Accrued Expenses

Adjusting entry records the obligation and recognizes the
expense.

Adjusting entry:
►
Increase (debit) an expense account and
►
Increase (credit) a liability account.
Illustration 3-16
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LO 6
The Basics of Adjusting Entries
Illustration: Pioneer Advertising signed a three-month note
payable in the amount of $5,000 on October 1. The note requires
Pioneer to pay interest at an annual rate of 12%.
Illustration 3-17
Oct. 31
Interest expense
Interest payable
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50
50
LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Illustration 3-18
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LO 6
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The Basics of Adjusting Entries
Illustration: Pioneer Advertising last paid salaries on October 26;
the next payment of salaries will not occur until November 9. The
employees receive total salaries of $2,000 for a five-day work
week, or $400 per day. Thus, accrued salaries at October 31 are
$1,200 ($400 x 3 days).
Illustration 3-19
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LO 6 Prepare adjusting entries for accruals.
The Basics of Adjusting Entries
Illustration 3-20
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LO 6
The Basics of Adjusting Entries
Illustration 3-21
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LO 6 Prepare adjusting entries for accruals.
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Micro Computer Services Inc. began operations on August 1,
2014. At the end of August 2014, management attempted to
prepare monthly financial statements. The following information
relates to August. 1. Prepare the adjusting journal entries needed
at August 31, 2014.
1. At August 31, the company owed its employees $800 in
salaries and wages that will be paid on September 1.
Salaries and wages expense
Salaries and wages payable
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800
800
LO 6
Micro Computer Services Inc. began operations on August 1,
2014. At the end of August 2014, management attempted to
prepare monthly financial statements. The following information
relates to August. 1. Prepare the adjusting journal entries needed
at August 31, 2014.
2. On August 1, the company borrowed $30,000 from a local
bank on a 15-year mortgage. The annual interest rate is 10%.
Interest expense
Interest payable
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250
250
LO 6
Micro Computer Services Inc. began operations on August 1,
2014. At the end of August 2014, management attempted to
prepare monthly financial statements. The following information
relates to August. 1. Prepare the adjusting journal entries needed
at August 31, 2014.
3. Revenue for services performed but unrecorded for August
totaled $1,100.
Accounts receivable
Service revenue
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1,100
1,100
LO 6
The Basics of Adjusting Entries
Summary of Basic Relationships
Illustration 3-22
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LO 6 Prepare adjusting entries for accruals.
The Adjusted Trial Balance
Adjusted Trial Balance
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
Prepared after all adjusting entries are journalized and
posted.

Purpose is to prove the equality of debit balances and
credit balances in the ledger.

Is the primary basis for the preparation of financial
statements.
LO 7 Describe the nature and purpose of the adjusted trial balance.
Illustration 3-25
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The Adjusted Trial Balance
Question
Which of the following statements is incorrect concerning the
adjusted trial balance?
a. An adjusted trial balance proves the equality of the total debit
balances and the total credit balances in the ledger after all
adjustments are made.
b. The adjusted trial balance provides the primary basis for the
preparation of financial statements.
c. The adjusted trial balance lists the account balances
segregated by assets and liabilities.
d. The adjusted trial balance is prepared after the adjusting
entries have been journalized and posted.
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LO 7
Preparing Financial Statements
Financial Statements are prepared directly from the
Adjusted Trial Balance.
Balance
Sheet
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Income
Statement
Retained
Earnings
Statement
LO 7 Describe the nature and purpose of the adjusted trial balance.
Illustration 3-26
3-60
LO 7
Illustration 3-27
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LO 7
APPENDIX 3A
Alternative Treatment of Prepaid Expenses and
Unearned Revenues
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
When a company prepays an expense, it debits that
amount to an expense account.

When a company receives payment for future
services, it credits the amount to a revenue account.
LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A
Prepaid Expenses
Company may choose to debit (increase) an expense account
rather than an asset account. This alternative treatment is simply
more convenient.
Illustration 3A-2
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LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A
Unearned Revenues
Company may credit (increase) a revenue account when they
receive cash for future services.
Illustration 3A-5
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LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3A
Summary of Additional Adjustment Relationships
Illustration 3A-7
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LO 8 Prepare adjusting entries for the alternative treatment of deferrals.
APPENDIX 3B
CONCEPTS IN ACTION
Qualities of Useful Information
Illustration 3B-1
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LO 9 Discuss financial reporting concepts.
APPENDIX 3B
CONCEPTS IN ACTION
Enhancing Qualities
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
Comparability

Consistency

Verifiability

Timeliness

Understandability
LO 9 Discuss financial reporting concepts.
APPENDIX 3B
CONCEPTS IN ACTION
Illustration 3B-2
Assumptions
in Financial
Reporting
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LO 9
APPENDIX 3B
CONCEPTS IN ACTION
Illustration 3B-2
Assumptions
in Financial
Reporting
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LO 9
APPENDIX 3B
CONCEPTS IN ACTION
Principles of Financial Reporting

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Measurement Principles
►
Cost Principle
►
Fair Value Principle

Revenue Recognition Principle

Expense Recognition Principle

Full Disclosure Principle
LO 9 Discuss financial reporting concepts.
APPENDIX 3B
CONCEPTS IN ACTION
Principles of Financial Reporting

Constraints in Financial Reporting
Illustration 3B-3
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LO 9
Key Points
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
Companies applying IFRS also use accrual-basis accounting to
ensure that they record transactions that change a company’s
financial statements in the period in which events occur.

Similar to GAAP, cash-basis accounting is not in accordance with
IFRS.

IFRS also divides the economic life of companies into artificial time
periods. Under both GAAP and IFRS, this is referred to as the time
period assumption.

IFRS requires that companies present a complete set of financial
statements, including comparative information annually.
Key Points
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
The general revenue recognition principles required by GAAP that
are used in this textbook are similar to those under IFRS.

As the Feature Story illustrates, revenue recognition fraud is a
major issue in U.S. financial reporting. The same situation occurs in
other countries, as evidenced by revenue recognition breakdowns
at Dutch software company Baan NV, Japanese electronics giant
NEC, and Dutch grocer AHold NV.

Under IFRS, revaluation of items such as land and buildings is
permitted. IFRS allows depreciation based on revaluation of assets,
which is not permitted under GAAP.
Key Points

The terminology used for revenues and gains, and expenses and
losses, differs somewhat between IFRS and GAAP. For example,
income is defined as:
Increases in economic benefits during the accounting period in
the form of inflows or enhancements of assets or decreases of
liabilities that result in increases in equity, other than those
relating to contributions from shareholders.

Expenses are defined as:
Decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of
liabilities that result in decreases in equity other than those
relating to distributions to shareholders.
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Looking into the Future
The IASB and FASB are now involved in a joint project on revenue
recognition. The purpose of this project is to develop comprehensive
guidance on when to recognize revenue. This approach focuses on
changes in assets and liabilities as the basis for revenue recognition. It
is hoped that this approach will lead to more consistent accounting in
this area.
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GAAP:
a. provides very detailed, industry-specific guidance on
revenue recognition, compared to the general guidance
provided by IFRS.
b. provides only general guidance on revenue recognition,
compared to the detailed guidance provided by IFRS.
c. allows revenue to be recognized when a customer makes
an order.
d. requires that revenue not be recognized until cash is
received.
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Which of the following statements is false?
a. IFRS employs the periodicity assumption.
b. IFRS employs accrual accounting.
c. IFRS requires that revenues and costs must be capable of
being measured reliably.
d. IFRS uses the cash basis of accounting.
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As a result of the revenue recognition project being undertaken
by the FASB and IASB:
a. revenue recognition will place more emphasis on when
revenue is earned.
b. revenue recognition will place more emphasis on when
revenue is realized.
c. revenue recognition will place more emphasis on when
changes occur in assets and liabilities.
d. revenue will no longer be recorded unless cash has been
received
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