Chapter 4, ACCOUNTING 1
Classified Balance Sheet
A classified balance sheet places each asset and each liability into a specific category. Assets are shown in order of liquidity (liquidity measures how quickly and easily an account can be converted to cash) Liabilities are classified as current (due within one year) or long term (due after one year)
What is a chart of accounts?
A chart of account is a list of accounts used by a company
Adjusting Entries
Adjusting entries are made at the end of the accounting period to record revenues to the period in which they are earned and expenses to the period in which they occur. Adjusting entries also update asset and liability accounts. The two basic categories are deferrals and accruals.
Which accounts have a normal balance on the debit side (i.e. any increases are recorded as debits)?
Assets, Expenses, Dividends
Fiscal Year
Fiscal year is an accounting year of any 12 consecutive months that may or may not coincide with the calendar year: Example of the fiscal year: Jan-Dec (coincides with the calendar year); Feb-Jan of next year (12 consecutive months starting from Feb, often used by retailer companies such Macy's)
Which accounts have a normal balance on the credit side (i.e. any increases are recorded as credits)?
Liabilities, Common Stock, Revenues
Definition of equity
Owners' claims to the assets of the business increases in equity result from: contributed capital (also called owner contribution/paid in capital), revenues decreases in equity result from: dividends (also called owner distribution), expenses
Monetary unit assumption
The assumption that requires the items on the financial statements to be measured in terms of a monetary unit (dollar amount)
Matching Principle
The matching principle guides accounting for expenses and ensures: All expenses are recorded when they are incurred during the period. Expenses are matched against the revenues of the period. The goal is to compute an accurate net income or net loss for the time period. Examples of applications of matching principle: depreciation/amortization/depletion expense: matching depreciation expense when using the asset; accrued liabilities: interest payable/expense, salaries payable/expense allowance for bad debt is based on matching principle, the direct write-off violates the matching principle The matching principle requires businesses to record Warranty Expense in the same period that the company records the revenue related to the warranty.
Examples of Deferred Expenses
advance payments of future expenses, also called prepaid expenses treated as assets until used recognizes as an expense by an adjusting journal entry when the prepayment is used 1. Prepaid Rent Prepaid Rent (debit) Cash(credit) when the rent expense incurred at the end of each month Rent Expense (debit) Prepaid Rent (credit) 2. Office Supplies Office Supplies beginning balance + Purchase of Supplies during the period if any - Office Supplies Used=Office Supplies on Hand When purchased office supplies: Office Supplies (debit) Cash(credit) Adjusting journal entry at the end of accounting period (some of all the of supplies purchased are used): Supplies Expense (debit) Office Supplies (credit) 3. Depreciation when purchased property, plant, and equipment: Computer (or other long-lived asset) (debit) Cash(credit) Adjusting journal entry to record the depreciation at end of accounting period: Depreciation Expense-Computer (debit) Accumulated Depreciation-Computer (credit)
What is a contra-account? What are the characteristics of a contra-asset account?
A contra-account has two main traits: 1. it is paired with and is listed immediately after its related account in the chart of accounts and associated financial statement 2. its normal balance is the opposite to the normal balance of the related account Example: Accumulated Depreciation: is a contra-asset account it has a normal balance of credit (opposite to asset's normal balance of debit) Examples of contra-accounts from later chapters: contra-asset account: allowance for bad debt (its main account is accounts receivable) contra-liability account: discount on bonds payable adjunct-liability account: premium on bonds payable
What is a T-account?
A shortened form of the ledger left side: debit right side: credit
What are source documents?
Accountants record the transactions after reviewing source documents. Example of source documents: sales invoices, loan certificates, etc.
Why is accounting important?
Accounting is the information system that: measures business activities processes the information into reports communicate the results to decision makers
What is an income statement? How is it structured?
All revenues- All expenses=Net Income (if positive)/ Net Loss (if negative) Income statement covers a period of time.
What is the purpose of the adjusted trial balance, and how do we prepare it?
At the end of the fiscal period, an adjusted trial balance is prepared. An adjusted trial balance is a list of all the accounts with their adjusted balances. The purpose is to ensure total debits equal total credits
Examples of Asset Accounts
Cash, Accounts Receivable, Short-term Notes Receivable, Prepaid Expenses, Inventory (above are current assets) Land, Building, Equipment, Furniture, Fixtures, Computer, long-term investments, long-term Notes Receivables (above are long-term assets) Prepaid Expenses is an ASSET account!
What does CPA and CMA stand for?
Certified Public Accounts (CPAs) serve the general public. Certified Management Accounts (CMAs) often works for a single company.
Current Assets VS. Long-term Assets
Current Assets will be converted to cash, sold, or used up during the next 12 months or within the business operating cycle if the cycle is longer than a year. Examples of current assets listed in order of liquidity: cash, accounts receivable, inventory, supplies, prepaid expenses Long-term assets are all the assets that will not converted to cash or used up within the business's operating cycle or one year, whichever is greater.
Current Liabilities VS. Long-term Liabilities
Current liabilities must be paid either with cash or with goods and services within one year or within the entity's operating cycle. Examples of current liabilities: Accounts Payable, Salaries Payable, Unearned Revenues. Long-term liabilities are liabilities that do not need to be paid within one year or within the operating cycle.
Definition of Liability
Debts owned to the creditors
Relationship Among the Financial Statements
Net income or net loss from the income statement flows to the Statement of Retained Earnings. Ending balance of Retained Earnings (=Beginning Balance + Revenue - Expenses - Dividends) from the Statement of Retained Earnings flows to the Balance Sheet. Ending balance of all other accounts except for Retained Earnings are acquired from adjusted trial balance. Ending balance of cash is used to prepare statement of cash flows (total change of cash account=ending balance of cash in the current period - ending balance of cash in the prior period=change of cash from operating+change of cash from investing+change of cash from financing activities)
What are the characteristics of a corporation?
Owners of a corporation: shareholders/stockholders: they are not personally liable for the company debt Corporations are managed by managers/executives The managers and executives are appointed by board of directors. A corporation is a separate legal entity that pays tax (double tax: corporation pays corporate taxes if there is a profit; if corporation pays out dividends to shareholders, shareholders pay individual tax on the dividends)
Which organization oversees the US financial markets?
Securities and Exchange Commission (SEC)
What is a journal?
The record of the transactions in date order
Cost principle
Transactions are recorded at the ACTUAL amount paid
Time Period Concept
assumes that business activities are sliced into small time segments and that financial statements can be prepared for specific periods, such as a month, quarter, or year
cash basis vs accrual basis accounting
cash basis: revenues/expenses recorded when cash is received/paid; not allowed under GAAP; easier to follow accrual basis: revenue recorded when earned; expenses recorded when incurred; provide a better picture of a business's net income or loss; used by most business
Balance Sheet
reports assets, liabilities, and stockholders' equity as of the last day of the accounting period (balance sheet recorded at the point of time)
What is a balance sheet? How is it structured?
reports on assets, liabilities, and stockholders' equity of the business as of a specific date (point of time).
Income Statement
reports revenues and expenses and calculates net income or net loss for the period
Statement of Retained Earnings
shows how retained earnings changed during the period due to net income (or net loss) and dividends
Examples of Liabilities Accounts
Accounts Payable, Notes Payable, Accrued Liabilities (such as Salaries Payables, Utilities Payable, Interest Payable), Unearned Revenue Unearned revenue is a liability account! Differences between Accounts Payable and Notes Payable? Notes Payable is WRITTEN promise to pay in the future.
Examples of Accrued Expenses
Accrued Expenses are expenses a business has incurred but has not yet paid. 1. Salaries Expense AJE to record the salaries expense incurred but has not paid: Salaries Expense (debit) Salaries Payable (credit) JE to record the payment for salaries payable Salaries Payable (debit) Cash (credit) 2. Interest Expense AJE to record the interest expense incurred but has not paid: Interest Expense (debit) Interest Payable (credit) JE to record the payment for Interest payable Interest Payable (debit) Cash (credit) 3. Utilities Expense AJE to record the utilities expense incurred but has not paid: Utilities Expense (debit) Utilities Payable (credit) JE to record the payment for Utilities payable Utilities Payable (debit) Cash (credit)
Example of Accrued Revenue
Accrued revenue arise when: a company performs a service but has not yet collected/received cash or a company delivers a product but has not yet collected/received cash AJE to record the revenue earned but has not received payment: Accounts Receivable (debit) Revenue (credit) JE to record the receipt of payment for Accounts Receivable Cash (debit) Accounts Receivable(credit)
How to determine the balance of a T-account?
All debits -All credits if positive, ending balance is a debit if negative, ending balance is a credit remember, if the account has an ending balance from last account period, need to carry over to the current period's T-account beginning balance
How to determine the balance of a T-account?
All debits -All credits if positive, ending balance is a debit if negative, ending balance is a credit remember, if the account has an ending balance from last accounting period, need to carry over to the current period's T-account beginning balance In later chapters, we learn that only permanent account (assets, liabilities, equity accounts) are carried over from last period to the next period, the temporary accounts (revenues, expenses, dividends, income summary accounts) are closed to zero at the end of each period.
What's a transaction?
Any event that affects the financial position of the business Affect any least two accounts (you can make a JE out of a transaction)
Closing entries
Closing entries transfer revenues, expenses, and Dividends to Retained Earnings. Revenues and expenses may be transferred first to an account titled Income Summary. Income Summary is a temporary account that summarizes the net income (or net loss) for the period. Closing entries are prepared after the financial statements are prepared. To close revenues accounts: Debit Revenue Credit Income Summary To close expense accounts: Debit Income Summary Credit Expense To close Income Summary account, the debit or credit depends on whether there is a net income or net loss Net Income: Debit Retained Earnings Credit Income Summary Net Loss: Debit Income Summary Credit Retained Earnings To close dividends: Debit Retained Earnings Credit Dividend
Examples of Equity Accounts
Common Stock, Preferred Stock, Additional Paid in Capital of Common Stock, Additional Paid in Capital of Preferred Stock, Dividends, Revenues, Expenses Remember: Dividends, and Expenses are subtractions (they decrease stockholders' equity)
Deferrals and Accruals
Deferrals: defer the recognition of revenues or expenses to a date after the cash is received or paid. Two types of deferrals: deferred expenses (prepaid expenses, office supplies, depreciation expense); deferred revenues: unearned revenue Accruals: record an expense before the cash is paid, or records revenue before the cash is received Two types of accruals: accrued expenses (salaries expense, interest expense, utilities expense); accrual revenues: debit to accounts receivable, credit to cash
What are the 4 rules that govern accounting studied in Chapter 1?
Economic entity assumption Going concern assumption Cost principle Monetary unit assumption
Accounting information should be faithful represented. What does faithful representation mean?
Faithful representation means being completed, neutrual, and free from error.
Which organization oversees creation and governance of accounting standards?
Financial Accounting Standards Board (FASB)
Who are users of accounting information?
Financial accounting provides information to EXTERNAL users such as creditors, and investors Managerial accounting provides information to INTERNAL users such as managers, employees
What does GAAP stand for?
Generally Accepted Accounting Principles (GAAP)
What are the four financial statements? In what order are they prepared?
Income statement, statement of retained earnings, balance sheet, statement of cash flows. We first prepare the income statement. After we get the net income/loss from income statement, we prepare the statement of retained earnings. Then, with the ending balance of retained earnings, we prepare the balance sheet (we also use the adjusted trial balance to prepare balance sheet). In the end, we use the balance of cash in the balance sheet to prepare the statement of cash flows.
Accounting information should be relevant. What does relevant mean?
Relevant means users should be able to make a decision based on the accounting information.
Stockholders' Equity
Stockholders' equity represents the stockholders' claims to the assets of the business. Reflects the stockholders' contributions through common stock Represents the amount of assets left over after the corporation has paid its liabilities
Post-closing trial balance
The accounting cycle ends with a post-closing trial balance: A list of the accounts and their balances at the end of the period, after journalizing and posting the closing entries Includes only permanent accounts Differences between Post-closing Trial Balance and Adjusted Trial Balance: All accounts before Retained Earnings (include Assets, Liabilities, and Common Stock) have the same balance; Retained Earnings is updated to ending balance in post-closing trial balance (adjusted trial balance has a beginning balance in Retained Earnings); All the temporary accounts (revenue, expenses, dividends) are removed or have zero balances in the post-closing trial balance
What is the accounting cycle?
The accounting cycle is the process by which companies produce their financial statements for a specific period. It is the steps that are followed throughout the time period. It starts with the beginning asset, liability, and stockholders' equity account balances left over from the preceding period.
What is an account
The accounting equation contains three categories of accounts: assets, liabilities, and equity. Each part contains accounts. An account is the detailed record of all increases, and decreases that have occurred in an account during a specified period.
Going concern assumption
The assumption that the company will continue in operation for the foreseeable future.
What is the closing process, and how do we close the accounts?
The closing process zeroes out all revenue and expense accounts in order to measure each period's net income separately from all other periods. Temporary accounts relate to a particular accounting period and are closed at the end of that period Revenues, Expenses, Income Summary, and Dividends accounts are temporary accounts. Permanent accounts are not closed at the end of the period Asset, Liability, Common Stock, and Retained Earnings accounts are permanent accounts.
Operating Cycle
The period of time between the purchase of inventory and the collection of any receivable from the sale of the inventory. The cycle is a 3-step cycle: 1. cash is used to acquire goods and services 2. these goods and services are sold to customers 3. the business collects cash from customers
Revenue Recognition Principle
The revenue recognition principle tells accountants when to record revenue and requires companies follow a five step process: Step 1: Identify the contract with the customer. Step 2: Identify the performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the performance obligations in the contract. Step 5: Recognize revenue when (or as) the entity satisfies each performance obligation.
What is a statement of cash flows? How is it structured?
The statememt of cash flows reports the changes in Cash account during period. Net Cash flows of operating activities (net means cash inflows minus cash outflows) +Net Cash flows of investing activities +Net Cash flows of financing activities =Net Increase/Decrease in Cash account during the period which equals ending balance of cash minus beginning balance of cash The balances of cash are acquired from balance sheet.
What is a statement of retained earnings? How is it structured?
The statement of retained earnings informs the users about how much of the earnings were kept and reinvested in the company. Retained Earning Beginning Balance +Net Income/Net Loss(from Income Statement) -Dividends =Retained Earning Ending Balance
Examples of Long-term Assets
There are three types of long-term assets: 1. long-term investments: investments in bonds or stocks that the company intends to hold for longer than one year 2. Property, Plant, and Equipment (PPE): long-lived, tangible assets, used in the operation of a business 3. Intangible Assets: are assets with no physical form that are valuable because of special rights carried
What is a transaction?
Transactions always involve at least two accounts (you should be able to make a Journal Entry out of it). A transaction is any event that affects the financial position of the business and can be measured with faithful representation.
What is posting?
Transferring data from the journal to the ledger is called posting.
Example of Deferred Revenue
deferred revenue occurs when a company receives cash before it performs the service or delivers the product; deferred revenue is a liability because the business owes the customer the product, the service Deferred revenue is also called unearned revenue. Upon performance or delivery, deferred revenue is converted to earned revenue JE to record the upfront payment from customer for services not performed yet Cash (debit) Unearned Revenue (credit) AJE (Adjusting Journal Entry) to record the partial or total completion of the service: Unearned Revenue (debit) Service Revenue(credit)