Financial Accounting - Test 1

Define a business transaction in the broad sense, and give an example of two different kinds of transactions.

- A business transaction is: --An exchange of resources (assets) and obligations (debts) between a business and one or more outside parties and --Certain events that directly affect the entity such as the wearing out of equipment used to operate the business. EX. - The sale of goods or services - The use of insurance paid prior to coverage

Which basis of accounting (cash or accrual) provides more useful information to investors, creditors, and other users? Why?

- Accrual basis financial statements provide more useful information to external users. - Financial statements created under cash basis accounting normally postpone (e.g., $250,000 credit sales) or accelerate (e.g., $70,000 customer deposits) recognition of revenues and expenses long before or after goods and services are produced and delivered (until cash is received or paid). - They also do not necessarily reflect all assets or liabilities of a company on a particular date.

What is the purpose of recording adjusting entries?

- Adjusting entries are made at the end of the accounting period to record all revenues and expenses that have not been recorded but belong in the current period - They update the balance sheet and income statement accounts at the end of the accounting period.

For accounting purposes, what is an account? Explain why accounts are used in an accounting system.

- An account is a standardized format used by organizations to accumulate the dollar effects of transactions on each financial statement item. - Accounts are necessary to keep track of all increases and decreases in the fundamental accounting model.

Explain the equation for the balance sheet (also known as basic accounting equation). Define the three major components reported on the balance sheet.

- Assets = Liabilities + Stockholders' Equity 1. Assets - The probable (expected) future economic benefits owned by the entity as a result of past transactions - They are the resources owned by the business at a given point in time such as: --Cash, receivables, inventory, machinery, buildings, land, and patents 2. Liabilities - Probable (expected) debts or obligations of the entity as a result of past transactions which will be paid with assets or services in the future - They are the obligations of the entity such as: --Accounts payable, notes payable, and bonds payable 3. Stockholders' equity - Financing provided by owners of the business and operations - They claim the assets of the business after the creditor claims have been satisfied

What two accounting equalities must be maintained in transaction analysis?

- Assets = Liabilities + Stockholders' Equity - Debits = Credits

Explain the equation for retained earnings. Explain the four major items reported on the statement of stockholders' equity related to retained earnings.

- Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings. 1. Beginning-of-the-year Retained Earnings is the prior year's ending retained earnings reported on the balance sheet 2. The current year's Net Income reported on the income statement is added and the 3. current year's Dividends are subtracted from this amount 4. The ending Retained Earnings amount is reported on the end-of-period balance sheet

Explain the difference between expenses and losses

- Both expenses and losses are outflows of net assets. - Expenses occur in the normal course of operations - Losses occur from transactions peripheral to the central activities of the company. EX. A loss suffered from fire damage.

Explain the difference between revenues and gains.

- Both revenues and gains are inflows of net assets. - Revenues occur in the normal course of operations - Whereas gains occur from transactions peripheral to the central activities of the company. EX. Selling land at a price above cost (at a gain) for companies not in the business of selling land.

Under the indirect method, depreciation expense is added to net income to report cash flows from operating activities. Does depreciation cause an inflow of cash?

- Depreciation expense is added to net income to adjust for the effects of a noncash expense that was deducted in determining net income. - It does not involve an inflow of cash.

Financial Accounting Standards Boards (FASB)

- Formulates the GAAP

What is the equation for each of the following statements: - Income statement - Balance sheet - Statement of stockholders' equity

- Incomes statement: --Revenues (and gains) - Expenses (and losses) = Net Income - Balance sheet: --Assets = Liabilities + Stockholders' Equity - Statement of stockholders' equity: --Ending Stockholders' Equity = (Beginning Contributed Capital + Stock Issuances - Stock Repurchases) + (Beginning Retained Earnings + Net Income - Dividends Declared)

Describe a typical business operating cycle.

- Inventory is purchased - Cash is paid to suppliers - The product is manufactured and sold on credit - The cash is collected from the customer

Briefly distinguish investors from creditors.

- Investors purchase part of a business - Hope to gain by: --receiving part of what the company earns and/or --selling the company in the future at a higher price than they paid - Creditors lend money to a company for a specific length of time - Hope to gain by charging interest on the loan

What is the purpose of the income statement?

- It presents information about the revenues, expenses, and the net income of the entity - For a specified period of time

What is the purpose of the statement of stockholders' equity?

- It reports changes in each of the company's stockholders' equity accounts during the accounting period --Includes issue and repurchase of stock - It also reports how net income and dividends affect the company's retained earnings - During that period

What is the purpose of the balance sheet?

- It reports the financial position of an entity --So it reports information about the assets, liabilities, and stockholders' equity - At a given date

Explain why stockholders' equity is increased by revenues and decreased by expenses.

- Net income equals revenues minus expenses. Thus revenues increase net income and expenses decrease net income. - Because net income increases stockholders' equity, revenues increase stockholders' equity and expenses decrease it.

What are noncash investing and financing activities? Give two examples. How are they reported on the statement of cash flows?

- Noncash investing and financing activities are activities that would normally be classified as investing or financing activities, except no cash was received or paid. - EX. --Purchase of assets by issuing stock or bonds --Repayment of loans using noncash assets --Conversion of bonds into stock - Noncash investing and financing activities are not reported in the statement of cash flows, because there was no cash received or cash paid; however, the activities are disclosed in a separate schedule.

Deferred Expenses

- Other Current Assets - Selling, General and Administrative Expense Any additional use of PPE during the period will need to be recorded - Accumulated Depreciation - Cost of Products and/or Cost of Services

Which accounts should close at the end of the year? Why?

- Product revenue - Service revenue - Interest revenue - Cost of products - Cost of services - Interest expense - Research and development expense - Selling, general, and administrative expenses - Other expenses - Income tax expense Temporary accounts that accumulate during the period are closed at the end of the year to the permanent account Retained Earnings

Explain the equation of the income statement. What are the three major items reported on the income statement?

- Revenues - Expenses = Net Income (or Net Loss if negative) - The 3 major items reported on the income statement are: 1. Revenues 2. Expenses 3. Net income

What is the purpose of the statement of cash flows?

- Shows: --the flow of cash into the entity (sources) --the flow of cash out of the entity (uses) --the net increase or decrease in cash - During the period

Briefly differentiate between a sole proprietorship, a partnership, and a corporation.

- Sole proprietorship is an unincorporated business owned by one individual - Partnership is an unincorporated association of two or more individuals to carry on a business - Corporation is a business that is organized under the laws of a particular state --A charter is granted and the entity is authorized to issue shares of stock as evidence of ownership by the owners (stockholders)

Briefly describe the way the accounting measurement rules (GAAP) are determined in the US.

- The Securities and Exchange Commission (SEC) --U.S. government agency which determines the financial statements that public companies must provide to stockholders and the measurement rules used in producing those statements. - The Financial Accounting Standards Board (FASB) --Private sector body given the primary responsibility to work out the detailed rules which become generally accepted accounting principles (GAAP)

Explain why the income statement accounts are closed but the balance sheet accounts are not.

- The income statement accounts are closed at the end of the accounting period because, in effect, they are temporary subaccounts to retained earnings (i.e., a part of stockholders' equity). - They are used only for accumulation during the accounting period. --When the period ends, these accumulated accounts must be transferred (closed) to retained earnings. - The closing process serves: 1. To correctly state retained earnings 2. To clear out the balances of the temporary accounts for the year just ended so that these subaccounts can be used again during the next period for accumulation and classification purposes. Balance sheet accounts are not closed at the end of the period because they reflect permanent accumulated balances of assets, liabilities, and stockholders' equity. Permanent accounts show the entity's financial position at the end of the period and are the beginning amounts for the next period.

Explain why the income statement and the statement of cash flows are dated "For the Year Ended December 31," whereas the balance sheet is dated "At December 31".

- The income statement and the statement of cash flows report the inflows and outflows of resources *during a period of time* - The balance sheet represents financial position *at a specific date*

Financial Statements:

1. Balance Sheet 2. Income Statement 3. Statement of Cash Flows 4. Statement of Stockholders' equity

List the four types of adjusting entries

1. Deferred revenues 2. Accrued revenues 3. Deferred expenses 4. Accrued expenses

Companies should take 3 important steps to assure investors that the company's records are accurate:

1. Maintain a system of controls over both the records and the assets of the company 2. Hire outside independent auditors to audit the fairness of the financial statements 3. Form a committee of the board of directors to oversee the integrity of these other safeguards

3 main types of business:

1. Sole proprietorship 2. Partnership 3. Corporation

What are the purposes for closing the books?

1. Transfer the balances in the temporary income statement accounts to retained earnings 2. Reduce the revenue, gain, expense, and loss accounts to a zero balance so that they can be used for the accumulation process during the next period. - A closing entry must be entered into the system through the journal and posted to the ledger accounts to state properly the temporary and permanent account balances (i.e., zero balances in the temporary accounts).

What criteria must normally be met for revenue to be recognized under accrual basis accounting?

1. When the company transfers promised goods or services to customers 2. In the amount it expects to receive

Current liability

A liability that will be settled by providing cash, goods, or other services within the coming year

Historical cost

A measurement model that requires assets to be recorded at the cash-equivalent cost on the date of the transaction. - Cash-equivalent cost is the cash paid plus the dollar value of all noncash considerations

What is a journal entry?

A method for expressing the effects of a transaction on accounts in a debits-equal-credits format. - The title of the account to be debited is listed first and the title of the account to be credited is listed underneath the debited accounts. - The debited amounts are placed in a left-hand column and the credited amounts are placed in a right-hand column.

Asset

A probable future economic benefit owned or controlled by the entity as a result of past transactions

Liability

A probable future sacrifice of economic benefits of the entity arising from preset obligations as a result of a past transaction

What is a T-account? What is its purpose?

A tool for: - Summarizing transaction effects for each account - Determining balances - Drawing inferences about a company's activities - It is a simplified representation of a ledger account with a debit column on the left and a credit column on the right.

A standardized format used to accumulate data about each item reported on financial statements.

Account

A system that collects and processes financial information about an organization and reports that information to decision makers

Accounting

The organization for which financial data are to be collected (separate and distinct from its owners)

Accounting entity

Amounts owed from customers.

Accounts receivable

Explain the effect of adjusting entries on cash.

Adjusting entries have no effect on cash. - For deferred revenues and deferred expenses, cash was received or paid at some point in the past. - For accruals, cash will be received or paid in a future accounting period. - At the time of the adjusting entry, there is no cash being received or paid.

What is a contra-asset? Give an example of one.

An account related to an asset that is an offset or reduction to the asset's balance. EX. Accumulated Depreciation is a contra-account to the equipment and buildings accounts.

Current asset

An asset that will be used or turned into cash within one year - Inventory is always considered a current asset regardless of how long it takes to produce and sell the inventory

Sole proprietorship

An unincorporated business owned by 1 person (often owner is manager)

Partnership

An unincorporated business owned by 2 or more persons (or partners) - Agreement in partnership contract - Each partner is responsible for the debts of business (unlimited liability)

Accounting equation:

Assets = Liabilities + Equity

The fundamental accounting model.

Assets = Liabilities + Stockholders' Equity

An examination of the financial reports to ensure that they represent what they claim and conform with generally accepted accounting principles

Audit

A report that describes the auditor's opinion of the fairness of the financial statement presentations and the evidence gathered to support that opinion

Audit report

Accounts Receivable

Balance Sheet Categorization: CA Debit or Credit: Debit

Prepaid Expenses

Balance Sheet Categorization: CA Debit or Credit: Debit

Short-Term Investments

Balance Sheet Categorization: CA Debit or Credit: Debit

Accounts Payable

Balance Sheet Categorization: CL Debit or Credit: Credit

Accrued Expenses Payable

Balance Sheet Categorization: CL Debit or Credit: Credit

Long-Term Investments

Balance Sheet Categorization: NCA Debit or Credit: Debit

Plant, Property, and Equipment

Balance Sheet Categorization: NCA Debit or Credit: Debit

Long-Term Debt

Balance Sheet Categorization: NCL Debit or Credit: Credit

Common Stock

Balance Sheet Categorization: SE Debit or Credit: Credit

Retained Earnings

Balance Sheet Categorization: SE Debit or Credit: Credit

Reports assets, liabilities, and stockholders' equity.

Balance sheet

Corporation

Business incorporated under the laws of a particular state - Owners are called stockholders or shareholders - Ownership is represented by shares of capital stock - Organizers file an approved application for incorporation - State issues a charter - Charter gives the corporation the right to operate as a separate legal entity: separate and apart from its owners (limited liability)

Going concern assumption

Businesses are assumed to operate into the foreseeable future. That is, they are not expected to liquidate.

What are cash equivalents? How are purchases and sales of cash equivalents reported on the statement of cash flows?

Cash equivalents are short-term, highly liquid investments that are purchased within three months of the maturity date. The statement of cash flows does not separately report the details of purchases and sales of cash equivalents because these transactions affect only the composition of total cash and cash equivalents. The statement of cash flows reports the change in total cash and cash equivalents from one period to the next.

CPA

Certified Public Accountant

Represents the shares issued at par value.

Common stock

An incorporated entity that issues shares of stock as evidence of ownership

Corporation

Financial accounting

Creditors and stockholders (external decision makers) need same info. but to see if company can pay back interest and pay dividends

Decrease assets; increase liabilities and stockholders' equity.

Credits

Economic resources to be used or turned into cash within one year.

Current assets

Probable economic resources expected to be used or turned into cash beyond the next 12 months.

Current assets

Paid cash on accounts payable for expenses incurred last period Debit and Credit?

Debit: Accounts Payable Credit: Cash

Performed services this period on credit Debit and Credit?

Debit: Accounts Receivable Credit: Service Revenue

Collected cash on accounts receivable for services performed last period Debit and Credit?

Debit: Cash Credit: Accounts Receivable

Issues stock to new investors Debit and Credit?

Debit: Cash Credit: Common Stock Additional Paid-in Capital

Collected cash for services performed this period Debit and Credit?

Debit: Cash Credit: Service Revenue

Debit and Credit: Increase/Decrease?: Gains

Debit: Decrease Credit: Increase

Debit and Credit: Increase/Decrease?: Revenues

Debit: Decrease Credit: Increase

Purchased equipment for use in the business; paid one-third cash and signed a note payable for the balance Debit and Credit?

Debit: Equipment Credit: Cash, Note Payable

Paid three-fourths of the income tax expense incurred for the year; the balance will be paid next year Debit and Credit?

Debit: Income Tax Expense Credit: Cash, Income Taxes Payable

Debit and Credit: Increase/Decrease?: Expenses

Debit: Increase Credit: Decrease

Debit and Credit: Increase/Decrease?: Losses

Debit: Increase Credit: Decrease

Made payment on the equipment note in (a); the payment was part principal and part interest expense Debit and Credit?

Debit: Note Payable, Interest Expense Credit: Cash

Paid cash for salaries and wages earned by employees this period Debit and Credit?

Debit: Operating Expenses Credit: Cash

Incurred operating expenses this period to be paid next period Debit and Credit?

Debit: Operating expenses Credit: Accounts payable

Paid operating expenses incurred this period Debit and Credit?

Debit: Operating expenses Credit: Cash

Used some of the supplies on hand for operations Debit and Credit?

Debit: Operating expenses Credit: Supplies

Purchased a patent (an intangible asset); paid cash Debit and Credit?

Debit: Patents Credit: Cash

On the last day of the current period, paid cash for an insurance policy covering the next two years Debit and Credit?

Debit: Prepaid Expenses Credit: Cash

Purchased supplies to be used later; paid cash Debit and Credit?

Debit: Supplies Credit: Cash

Increase assets; decrease liabilities and stockholders' equity.

Debits

Every transaction has at least two effects on the accounting equation.

Dual effects

How is earnings per share computed and interpreted?

Earnings per share = Net income ÷ average number of shares of stock outstanding during the period - Earnings per share measures the average amount of net income for the year attributable to one share of common stock

Briefly explain the responsibility of independent auditors in the accounting communication process.

Examine the financial reports (prepared by management) and the underlying records - To assure that the reports represent what they claim and conform with GAAP

Accrued expenses

Expenses that have been incurred by the end of the accounting period but which will be paid in a future accounting period - EX. Recording Utilities Payable for utilities expense incurred during the period that has not yet been paid

Useful information should be complete, neutral, and free from error.

Faithful representation

FASB

Financial Accounting Standards Board

2. Income Statement

Financial performance *during* a particular period of time (month, quarter, year) (whether or not customer has paid yet) - *Revenues* - *Expenses* → But net income does NOT equal cash (because someone can still owe you money)

1. Balance Sheet

Financial position *at* a point in time (end of month, quarter, year) - *Assets* ("stuff", economic resources) - *Liabilities* (non-owner) - *Equity* (owner) ("claims to stuff", sources of financing)

Cash flow from Financing activities

From creditors and investors IN - Borrow stock - Issue stock OUT - Repay principal - Repurchase stock - Pay dividend

Financial accounting involves reporting outside of the company so they must comply with

Generally Accepting Accounting Principles (GAAP) and other regulatory agencies (SEC)

GAAP

Generally accepted accounting principles

The concept that businesses will operate into the foreseeable future.

Going concern assumption

The concept that assets should be recorded at the amount paid on the exchange date.

Historical cost

Accrued Expenses

Interest incurred on Short-term Note Payable and Long-term Debt will need to be recorded - Accrued Liabilities - Interest Expense (E) There are likely many other accrued expenses to be recorded, including wages, warranties, and utilities; pension, and contingencies - Accrued Liabilities - Selling, General, and Administrative Expenses (among other expenses) - Other Liabilities (L) (pension and contingencies among other expenses) Income taxes must be computed for the period and accrued - Income Tax Payable - Income Tax Expense

Accumulated Revenues

Interest may be earned on short-term investments - Interest Receivable - Interest Revenue Any unrecorded sales or services provided will need to be recorded - Accounts Receivable - Product Revenue and/or Service Revenue

Probable debts or obligations to be settled with assets or services.

Liabilities

Managerial (management) accounting

Managers (internal decision makers) manage operating, investing, and financial activities of firm

Deferred Revenues

May need to be adjusted for any revenue earned during the period - Deferred Revenue - Product Revenue and/or Service Revenue

Explain what the time period assumption means.

Means that the financial condition and performance of a business can be reported periodically, usually every month, quarter, or year, even though the life of the business is much longer.

The concept that states that accounting information should be measured and reported in the national monetary unit without adjustment for changes in purchasing power.

Monetary unit assumption

A women's clothing retailer orders 30 new display stands for $300 each for future delivery. What accounting concept did you apply?

No exchange transaction because no exchange or receipt of cash, goods, or services and thus is not a transaction

A local company is a sole proprietorship (one owner); its owner buys a car for $10,000 for personal use. Answer from the local company's point of view. What accounting concept did you apply?

No exchange transaction because of the separate-entity assumption

The account that is credited when money is borrowed from a bank.

Notes payable

A legal amount per share.

Par value

An unincorporated business owned by two or more persons

Partnership

3. Statement of Cash Flows

Presents cash inflow and outflow into 3 categories: 1. *Operating* - directly related to earning income (EX. cash from customer, cash paid to suppliers and employees) 2. *Investing* - related to the acquisition or sale of the company's plant, equipment, and investments 3. *Financing* - directly related to the financing of the enterprise itself (EX. payment to investor and creditors)

Deferred expenses

Previously recorded assets that need to be adjusted at the end of the period to reflect incurred expenses - EX. Prepaid Insurance must be adjusted for the portion of insurance expense incurred in the current period

Deferred revenues

Previously recorded liabilities that need to be adjusted at the end of the period to reflect revenues that have been earned EX. Unearned Ticket Revenue must be adjusted for the portion of ticket revenues earned in the current period

A company with stock that can be bought and sold by investors on established stock exchanges

Pubicly traded

Cash flow from Investing activities

Purchase and disposal of productive assets (CAPEX) and investments in the securities of other companies IN - Sell PP&E - Sell investments OUT - Buy PP&E - Buy investments

A construction company signs a contract to build a new $500,000 warehouse for a corporate customer. At the signing, the corporation writes a check for $50,000 to the construction company as the initial payment for the construction (receiving construction in progress). Answer from the standpoint of the corporation (not the construction company).

Received: Building (A) Given: Cash (A)

A new company is formed and sells 100 shares of $1 par value stock for $12 per share to investors.

Received: Cash (A) Given: Common stock and Additional paid-in capital (E)

A company borrows $1,000 from a local bank and signs a six-month note for the loan.

Received: Cash (A) Given: Notes payable (L)

A publishing firm purchases for $40,000 cash the copyright (an intangible asset) to a manuscript for an introductory accounting text.

Received: Copyright (A) Given: Cash (A)

A company purchases for $18,000 cash a new delivery truck that has a list, or sticker, price of $21,000. At what amount would you record the truck? What measurement principle are you applying?

Received: Equipment (A) Given: Cash (A) - Truck would be recorded at $18,000 - Historical cost principle

A company orders and receives 10 personal computers for office use for which it signs a note promising to pay $25,000 within three months.

Received: Equipment (A) Given: Notes Payable (L)

A company purchases 100 shares of Apple Inc. common stock as an investment for $5,000 cash.

Received: Investments (A) Given: Cash (A)

A company purchases a piece of land for $50,000 cash. An appraiser for the buyer values the land at $52,500. At what amount would you record the land? What measurement principle are you applying?

Received: Land (A) Given: Cash (A) - Land would be recorded at $50,000 - Historical cost principle

A company pays $1,500 principal on its note payable (ignore interest).

Received: Notes payable (L) Given: Cash (A)

A manufacturing company acquires the patent (an intangible asset) on a new digital satellite system for television reception, paying $500,000 cash and signing a $400,000 note payable due in one year.

Received: Patent (A) Given: Cash (A) and Notes payable (L)

A manufacturing firm declares a $100,000 cash dividend to be distributed to stockholders next period.

Received: Retained earnings (E) Given: Dividends payable (L)

1. Cash flow from Operating activities

Related to revenues and expenses reported on the income statement IN - Cash from customers - Dividends on investments - Interest on investments OUT - Inventory (COGS) - Salaries - Income taxes - Interest on loans - Electricity

Useful information has predictive and feedback value.

Relevance

4. Statement of Stockholders' equity

Reports the changes in each of the company's stockholders' equity accounts, including the change in the retained earnings balance caused by net income and dividends during the reporting period - *Retained Earnings* - amount of earnings (profit) reinvested in the business (not distributed as dividends) - *Common Stock* - the investment of cash and other assets in the business by the stockholders

Monetary unit assumption

Requires information to be reported in the national monetary unit without any adjustment for changes in purchasing power

Separate entity assumption

Requires that business transactions are separate from the transactions of the owners. - EX. The purchase of a truck by the owner for personal use is not recorded as an asset of the business

Explain the expense recognition principle.

Requires that expenses be recorded when incurred in earning revenue - Expenses are matched to the period in which the revenues are earned. EX. The cost of inventory sold during a period is recorded in the same period as the sale, not when the goods are produced and held for sale.

Briefly explain the responsibility of company management in the accounting communication process.

Responsible for: --Preparing the financial statements and other information contained in the annual report --For the maintenance of a system of internal accounting policies, procedures, and controls - These measures are intended to provide reasonable assurance that: --Transactions are processed in accordance with company authorization as well as --Properly recorded and reported in the financial statements --Assets are adequately safeguarded

Cumulative earnings of a company that are not distributed to the owners.

Retained earnings

Accrued revenues

Revenues that have been earned by the end of the accounting period but which will be collected in a future accounting period EX. Recording Interest Receivable for interest revenues not yet collected

SEC

Securities and Exchange Commission

Business transactions are accounted for separately from the transactions of the owners.

Separate entity assumption

An unincorporated business owned by one person

Sole proprietorship

Financing provided by owners and by business operations.

Stockholders' equity

Retained earnings

The cumulative earnings of a company that are not distributed to the owners and are reinvested in the business

Compare the purposes of the income statement, the balance sheet, and the statement of cash flows.

The income statement reports revenues earned and expenses incurred during a period of time. It is prepared on an accrual basis. The balance sheet reports the assets, liabilities, and equity of a business at a point in time. The statement of cash flows reports cash receipts and cash payments of a business, from three broad categories of business activities: operating, investing, and financing.

Additional paid-in capital

The owner-provided financing to the business that represents the excess of the amount received when the common stock was issued over the par value of the common stock

What is the primary objective of financial reporting for external users?

To provide financial information to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity

An exchange between an entity and other parties.

Transaction

Measurement of information about an entity in terms of the dollar or other national monetary unit

Unit of measure

Securities and Exchange Commission (SEC)

Works closely with the accounting profession to work out the detailed rules that have become known as GAAP - Concerned with the completion of the 4 basic financial statements - Concerned with the most appropriate manner to report transactions and disclosures