280 Quiz 1 (ch 1-3)

Two Ways to capture revenues

(1) Cash-basis: Record revenue when you receive cash. Record expenses when you pay out cash. (2) Accrual-basis: Record revenue in the period in which you earn it (whether or not you receive any cash). Record expenses in the period in which you incur expenses (whether or not you pay out any cash).

Pros/Cons of Cash Basis vs. Accrual

- cash is more liquid - you can't fudge cash - you can fudge accts receivable - accrual is subject to fraud (not tangible, can loose money) - discourages sale of big ticket items (nothing on account) - cash isn't a good capture of a company's revenue --> only telling you how much you're collecting in cash not fully in revenue In practice among accountants, the debate has ended in a draw. What does this mean? Companies include an accrual-based net income but they also include a cash flow statement showing the differences between cash flows from operations and the net income. This way, investors who care about cash (cash is king!) have something to make them happy.

Quantitative characteristics of accounting info

- relevance - faith of representation - comparability - consistency - verifiability - timeliness - understandability

Cash Flow Statement

1) Cash flow from operating activities 2) Cash flow from investing activities 3) Cash flow from financing activities Answers critical questions such as: (1) Where did the cash come from? (2) What was the cash used for? (3) What was the change in the cash?

Trial Balance

1. Cash (debit) 2. Accounts Receivable (debit) 3. Prepaid Insurance (debit) 4. Supplies (debit) 5. Equipment (debit) 6. Notes Payable (credit) 7. Accounts Payable (credit) 8. Salaries and Wages Payable (credit) 9. Unearned Service Revenue (credit) 10. Dividends (debit) 11. Common Stock (credit) 12. Retained Earnings (credit) 13. Service Revenue (credit) 14. Salaries Expense (debit) 15. Rent Expense (debit)

B/S Long Term Liabilities

1. Mortgage Payable Examples: Bonds Payable Long-term Notes Payable Mortgages payable Pension liabilities Lease liabilities

B/S Current Liabilities --> order? **

1. Notes Payable (owe to bank) 2. Accounts Payable (owe to supplier) --> after this go in descending money order 3. Wages Payable 4. Unearned Rent Revenue (3/4 could be switched if U/R is greater than W/P) Company reasonably expects to pay the debt from existing current assets (like cash) or by creating other current liabilities Company will pay the debt within one year or the operating cycle, whichever is longer If debt does not meet both criteria, it is classified as a long-term liability.

B/S Long-term Assets

1. Stock Investments

SE

= CS + RE(end) --> (SE) residual equity (what's left over after you pay out the creditors) - what owners of the firm own (the investors) What you own (SE) = what you invested (CS) + portion of profits you reinvest (RE) Common Stock: how much money infused in company by shareholders (invested) - total amount paid by stockholders for shares they purchase

Assets

= L + SE Assets are either claimed by creditors (Liabilities) or owners (Stockholder's Equity) Liabilities are listed before stockholder's equity. This is because in bankruptcy, they are paid out before stockholders get a dime Also sometimes called residual equity (it's the residual once you pay out creditors) - NI

RE(end)

= RE(beg) + NI - D - how much earnings have we kept within the company - RE accumulates over time - you move NI to RE every year as I/S is wiped clean and re-sets

SE(end)** - when do we use this?

= SE(beg) + ΔCS (if you get more investments) + NI - D

Limitations in a Trial Balance

A trial balance may balance even when the following errors occur: - transaction is not journalized - correct journal entry isn't posted on t-account - journal entry posted 2x - incorrect amounts used on journal entry - offsetting errors are made in recording the amount of a transaction --> as long as equal debits/credits are posted (even to the wrong account or wrong amount), the total debits will equal total credits, and trial balance will incorrectly balance Even if the trial balance column totals agree, there could be errors.

A/R N/P U/R

Accounts Receivable: debit increases ("perform service on account") Notes Payable: credit increases Unearned Revenue: credit increases Revenue: credit increases

A/R

Accounts receivable: - cash customers owe you for something - I owe you --> instead of paying cash today - "on account" or "on credit" - even if company doesn't get cash immediately, you still have revenue - an asset you'll get back in cash

Accruals vs. Deferrals

Accruals are the opposite of deferrals. Deferrals are expenses that you have prepaid but not incurred, or cash that you have received before revenue is earned. Accruals are revenues that you have earned but not been paid for, or expenses that you have incurred but not paid out.

Adjusted Trial Balance

After a company has finished with its adjusting entries, it prepares another trial balance. This is called the adjusted trial balance. The sum of debit balances should equal the sum of credit balances for the adjusted trial balance (just like for the pre-adjusted trial balance). To do this, the company transfers all the account balances after adjusting entries have been made to the trial balance. The sum of the debit balances should equal the sum of the credit balances.

Monetary unit assumption

Assumes that the dollar is the "measuring stick" used to report on financial performance. The monetary unit assumption is that in the long run, the dollar is stable—it does not lose its purchasing power. This assumption allows the accountant to add the cost of a parcel of land purchased in 2013 to the cost of land purchased in 1956

4 Basic Financial Statements

B/S I/S Cash Flow Statement (tells you your story of cash) RE Statement

Chart of Accounts

Companies generally have a list of their accounts and the account numbers that identify these accounts. These account numbers are also used in the general ledger, which we will discuss next.

B/S Current Assets

Current Assets: 1. Cash 2. Debt Investments 3. Stock Investments (short term) 4. Notes Receivable 5. Accounts Receivable 6. Inventory 7. Supplies 8. Prepaid Insurance - assets you plan to turn into cash or use up within the year (short-term) - ordered in liquidity

D

Dividend: if you take profit (NI) and distribute it back to investors (don't want to do in new company) - if dividends go up, company can afford this (a good sign!)

Why do you need an adjusting entry?

Does not send bill until quarter is over (end of June) Suppose Cornerstone prepares their financials every month. Since I worked in April, this revenue was earned. Cornerstone needs to make an adjusting entry at the end of the April. A/R (debit) Revenue (credit) Without this adjusting entry, Cornerstone's Accounts Receivable (asset) and Revenues would both be understated.

B/S PPE --> order (diminishing price)

Equipment Land Buildings Accumulated Depreciation - equipment Depreciation: these assets are tangible and used for a long time --> practice of spreading asset over years you plan to use that asset Depreciation expense: total cost/lifetime of using a good - a yearly expense (put on I/S) ** Accumulated Depreciation: total amount of depreciation (increases each year)

Annual Report

Every U.S. company that is publicly traded must issue annual reports (Sometimes called 10Ks) Can you guess how often? Every year! Companies also issue quarterly reports (10Qs) that contain the financials for the quarter - less info than an annual report In addition to the four financial statements, this annual report also contains: Management Discussion and Analysis (MD&A) Notes to the Financials Statements Auditor's Report

GAAP

Generally Accepted Accounting Principles - Standards that accountants developed to ensure that companies report their financial position and performance consistently -tells companies in US what they can do/not do -company uses two measurement principles to record its assets, liabilities, SE, RE (compliance and presentation of financial information for a company) as it prepares its financial statements -Assets: resource company owns -Liability: what you owe

Historical Cost Fair Value

Historical Cost: what you paid Pros: Reliable - the price is true (you have a receipt for it) *** Cons: Could be outdated/not relevant *** - measurement basis used when a reliable estimate of fair value is not available - indicates that fair value changes subsequent to purchase aren't recorded in the accounts Fair Value: if you mark it up to market value Pros: Relevant - it's "up-to-date" *** Cons: Not always reliable, especially if there is no real "price" for the asset/liability in the marketplace. *** If no real price, would require subjective valuation - potential for accounting manipulation

Cash Basis

In cash-basis accounting, revenues are only recorded when cash is received. On the other hand, expenses are only recorded when cash is paid out. It's highly likely that the timing of when cash is received (revenue) does not correspond with the timing of when cash is paid out (expense). This does not accurately capture a company's net income (earnings).

Book Value

Includes accumulated depreciation The difference between the cost of any depreciable asset and its related accumulated depreciation is called its book value.

Inventory Supplies COGS

Inventory: assets you intend to sell, different than supplies Supplies: what you use to help you sell it (cups/plates) COGS: expense

Why do you need an adjusting entry? pt 2

Molly pays her employees every 3 months (in March, June, September and December). So she would pay them their first paycheck of the year on March to cover work for January, February and March. She needs to make an adjusting entry for accrued salaries to account for the fact that her employees have worked so expenses have been incurred. She doesn't pay out anything until March. In March, she would pay out $6,000 ($2,000 * 3) in salaries with cash. However, at the end of January, she has incurred $2,000 salary expenses for the month of January. Therefore, she needs to make the an adjusting entry. For the month of March, The salaries payable is simply 4,000 because she is paying in March (not incurring more payables)

Normal Balance

Normal balances just refer to the type of balance expected of a particular account. - Asset accounts have left-side balances, whereas liabilities and stockholder's equity have right-side balances.

If the note bears interest at 12%, how many months has it been outstanding?

Note Payable = 5000 5000 x .12 = 600/12 = 50/month Since Interest payable on B/S is 50, note has been outstanding for 1 month

RE

RE + NI - D Retained earnings statement reports the changes in retained earnings over a specific period of time. It shows why the retained earnings increased or decreased during the period. Do they pay dividends? How much in dividends? Do they pay dividends every year? Are they increasing their dividend payments?

Relevance of the Trial Balance with Adjusting Entries

Remember: A trial balance has all the account balances that eventually flow into the financial statements. A company may have ending balances for accounts like Cash, Accounts Receivable, Revenues, etc. However, the trial balance may not contain up-to-date or complete data. Why is this? (1) Some events are not journalized daily because it isn't practical. It isn't practical for Molly to do a journal entry every time she uses a piece of paper to make a flier advertising her business, or even every time she gives candy to her clients' children. (2) Some events expire as a result of the passage of time They don't generate any source documents or any other evidence that a transaction occurred. With events that occur because time passes, there may not be any source documents. Classic example of this is the wearing down ("depreciation") of buildings or equipment. More on this in Chapter 9! (3) Finally, some items may be unrecorded. Molly only pays her employees every three months (March, June, September and December) So a trial balance taken at the end of February won't have any wages reflected until she pays in March. If we don't adjust the trial balance to account for these issues, it will not be accurate. It won't abide by the revenue recognition and expense recognition principles. Since the trial balance flows into the financial statements, the statements will not be accurate. This is why we use what are called adjusting entries.

Expense recognition principle

Requires recognition of expenses in the same period as related revenues. The expense recognition principle states that expenses should be recognized in the same period as the revenues to which they relate. If this were not the case, expenses would likely be recognized as incurred, which might predate or follow the period in which the related amount of revenue is recognized.

I/S

Revenues Expenses (in order) --> cover a period of time - Income Statement reports the profitability of the company over a specific period of time (such as over a year). - A company's past net income can provide useful information for predicting future net income It contains useful information for investors: How much the company is spending on expenses? Are they effectively controlling expenses? How sales or expenses are changing over time? How much interest expense are they paying? Is their net income stable over time or does it fluctuate? wipe clean, NOT CUMULATIVE - how a company did --> "report card' - how much R/E they incurred - includes COGS

3 Rules

Rule 1: Debits are on the left side of the T-account, Credits are on the right side Rule 2: Debits must always equal credits this is just another way to say that the balance sheet must balance. - For each transaction, debits = credits Rule 3: - D.E.A.D. --> Debits increase Expenses, Assets, and Dividends - Transactions that increase expenses, assets or dividends are debits to that account. - Transactions that decrease expenses, assets or dividends are credits to that account. - C.R.C.L. --> Credits increase Revenues, Common Stock, and Liabilities. - Transactions that increase revenues, common stock, and liabilities are credits to that account. - Transactions that decrease revenues, common stock and liabilities, are debits to that account.

Accounting Cycle

Step 1: Transaction (affect B/S) The recording process begins with a business transaction. -Business documents (or source documents), such as a sales slip, a check, an invoice or bill, or receipt of payment provides evidence of the transaction. -Using these documents, a company analyzes how this transaction affects specific accounts Step 2: Journalizing transaction --> journal entries -The general journal is a formal chronological listing of each transaction and how it affects the balances in particular accounts. Step 3: Posting to Ledger --> t-account - A ledger contains the records for a group of related accounts. - A general ledger is the collection of accounts that flow into a company's financial statements. - The general ledger consists of five types of accounts: assets, liabilities, stockholder's equity, revenues and expenses Step 4: Prepare trial balance - A trial balance is a list of accounts and their balances at a given time. -Companies generally prepare the trial balance at the end of an accounting period, such as at the end of a quarter or year. -Companies prepare a trial balance as a check (hence the name "trial") that debits = credits. Step 5: Prepare financial statements - Final step is to use the trial balances to prepare a company's financial statements.

Fiscal vs Calendar Year

The accounting time period that is for one year in length is called a fiscal year. A fiscal year begins with the first day of a month and ends twelve months later. A fiscal year could coincide with the calendar year. This means the fiscal year begins on January 1 and ends December 31. However, for many companies, their fiscal year differs from the calendar year. --> but for many companies fiscal year differs from the calendar year --> ex. retail companies want the fiscal year to end in March to account for the influx in returns from the holiday season (more accurate depiction of the revenue)

Cash vs. Accrual

The accrual basis of accounting provides more useful information for decision makers because it recognizes revenues when the performance obligation is satisfied and expenses when incurred.

Revenue recognition principle.

The revenue recognition principle states that one should only record revenue when it has been earned, not when the related cash is collected.

Adjusting Entries

There are two types of adjusting entries: (A) Deferrals (or prepayments) - Pre-paid expenses (supplies, inventory, insurance, depreciation) --> recorded every time they're used up - Unearned Revenues The recognition of these expenses or revenues is deferred to the future - hence, they are called deferrals. (B) Accruals - Accrued Revenue - Accrued Expenses (utility expense, interest expense, salaries expense)

Notes to Financials

These are notes that help explain or supplement information that is in the four financial statements. The notes are important - they provide more detail and clarify the financial statements Examples: Significant accounting policies (or changes in policies) and/or methods used in preparing the financials (e.g., revenue recognition, refunds, customer loyalty rewards, etc.) Important news, such as recent acquisitions or litigation Intangible assets such as goodwill (more in Chapter 9) Stock compensation Fair Value measurements Income taxes Business segment information

Accrual

This illustrates why accrual-basis accounting better captures Company X's performance, especially over time. On a cash basis, it looks like the company is making net income in both April and May. It also looks like the company is drastically improving its performance in net income in May versus April. However, what really happened? All of the consulting services happened in April and the company had no consulting work in May. Key is Revenue Recognition: Under accrual-basis accounting, revenue is recognized* in the period in which the performance obligation is satisfied. But what does it mean to the performance obligation is satisfied? *Recognize: Recorded in the financial statements of a given period

Auditor's Report

This is the letter from the independent outside auditor stating that it is the auditor's opinion regarding: (1) The fairness of the presentation of financial position and results of operations (2) Their conformance with GAAP If the auditor is satisfied with points 1 and 2, then the auditor will express an unqualified opinion. If the auditor expresses anything other than an unqualified opinion, take caution!

MD&A

This is where the management of the company talks about various financial aspects of the company Think of this as a fireside chat Some things that might be mentioned: Ability to pay near-term debt/obligations Ability to fund current operations and/or grown How they did this year, compared with last year Why they might have not done so well Trends - positive or negative - in the industry Is by nature highly subjective

Contra Assets

Under GAAP, companies show the accumulated depreciation in what's called a contra-asset account. For depreciation, this contra-asset account is called Accumulated Depreciation. A contra-asset account is an account that offsets an asset account on the balance sheet. This account appears right after the account is offsets. Contra-accounts have increases, decreases and normal balances opposite to the account it offsets. Less: Accumulated Depreciation for example Why might showing the contra account be more preferable than decreasing the asset directly on the balance sheet? Discloses both the original cost of the asset and the total cost that has expired to date.

Expense Recognition

What about expenses? Rule of thumb: "Let the expenses follow the revenues." (matching principle) What does this mean? This means that expenses are recognized in the same time period that the company makes efforts to generate those revenues. How does this work? Remember your taco stand? You sold one taco today for $3. Suppose this cost $2 to make. What happens? Revenues of $3 are recognized today. To match revenues, we also recognize $2 in expenses today. *** Expenses related to the revenues (in this case, the taco cost $2 to make) are recognized at the same time as the revenues (matching principle).

Another way to view it:

What is the cost of the taco called in accounting jargon? Cost of goods sold (COGS): Total cost of merchandise sold during the period. This is an expense (so it reduces net income) that is directly related to the revenue recognized from the sale of goods. What is the offsetting entry (to make debits = credits)? Inventory! Official Definition of inventory: Goods held by a company for the purpose of sale to customers.

Prepaid Insurance

You pay for insurance in advance (e.g., 1 yr) Prepaid insurance is an asset When you purchase the insurance: Prepaid insurance increases Cash decreases

U/R

You receive money from a customer in advance for services or goods (think Groupon, gift certificates, college tuition, etc.) Unearned Revenue is a liability (you owe a service or good) When you receive cash for services/goods to be provided in the future: Unearned Revenue (liability) increases Cash increases *** NOTE: Revenue is not recognized until services or goods have been performed/delivered (More on this in Chapter 4)

B/S

cumulative numbers - LONG TERM - snapshot of company's wealth at a point in time**** - as of 12/31/18 Useful to judge how much debt and/or other obligations a company has - important for bankruptcy risk or potential creditors How much cash the company has to pay off debt and immediate needs Accounts receivable - what your customers owe you - if this is high, might be a concern that your customers aren't paying you in a timely manner (More in Chapter 8) You can see the components of their assets - do they have a lot of property, plant, and equipment? Supplies? Cash?

Account

just an accounting record of increases or decreases in a specific asset, liability or owner's equity item. A company has an account for each asset, liability, or owner's equity item. Examples: Cash, Accounts Receivable, Accounts Payable, Revenue, Utility Expense, Advertising Expense, Common Stock

Accounting Information

provides information on form of financial statements and additional disclosures useful for decision making

T-Account

refers to how the account is depicted. There is a title (such as "Cash"), a left side and a right side. Any idea what this might look like?