Financial Accounting Chapter 3 Key Concepts

Annual Financial Statement

Financial statements covering a one-year period; often based on a calendar year, but any consecutive 12-month (or 52-week) period is acceptable.

Interim Financial Statement

Financial statements covering periods of less than one year; usually based on one-, three- or six-month periods.

Adjusting Entry

Journal entry at the end of an accounting period to bring an asset or liability account to its proper amount and update the related expense or revenue account.

Accounting Period

Length of time covered by financial statements; also called reporting period.

Adjusted Trial Balance

List of accounts and balances prepared after period-end adjustments are recorded and posted. Each adjustment will have one or several letters that links it to an adjusting entry explained earlier.

Unadjusted Trial Balance

List of accounts and balances prepared before accounting adjustments are recorded and posted.

Post-Closing Trial Balance

List of permanent accounts and their balances from the ledger after all closing entries are journalized and posted. It lists balances for all accounts NOT closed to verify that 1) total debits = total credits

Intangible Assets

Long-term assets (resources) used to produce or sell products or services; usually lack physical form and have uncertain benefits.

Long-term Investments

Long-term, or noncurrent, assets not used in operating activities such as notes receivable and investments in stocks and bonds. I.e. Land held for future expansion because it is not used in operations.

Straight-line Depreciation

Method that allocates an equal portion of the depreciable cost of plant asset (cost minus salvage) to each accounting period in its useful life.

Closing Process

Necessary end-of-period steps to prepare the accounts for recording the transactions of the next period. (1) Identify accounts for closing (2) record and post the closing entries (3) prepare a post-closing trial balance Purposes: 1) resets revenue, expense, and dividends account balances to zero at the end of each period, also updating Retained Earnings 2) helps summarize a period's revenues and expenses The closing process applies only to temporary accounts.

Operating Cycle

Normal time between paying cash for merchandise or employee services and receiving cash from customers

Current Liabilities

Obligations due to paid or settled within one year or the company's operating cycle, whichever is longer.

Long-term Liabilities

Obligations not due to be paid within one year or the operating cycle, whichever is longer.

Plant Assets

Tangible, long-lived assets used to produce or sell products and services; also called property, plant, and equipment (PP&E) or fixed assets. all plant assets except land eventually wear out and become less useful

Income Summary

Temporary account used only in the closing process to which the balances of revenue and expense accounts (including any gains or losses) are transferred; its balance is transferred to the capital account (or retained earnings for a corporation)

Natural Business Year

Twelve-month period that ends when a company's sales activities are at their lowest point.

Time Period Assumption

Assumption that an organization's activities can be divided into specific time periods such as months, quarters, or years.

Financial Statements are Prepared in the Following Order:

(1) Income statement (2) statement of retained earnings (3) balance sheet Statement of cash flows is usually the final statement prepared.

10-Step Accounting Cycle

1. Analyze transactions 2. Journalize 3. Post 4. Prepare unadjusted trial balance 5. Adjust and post accounts 6. Prepare adjusted trial balance 7. Prepare financial statements 8. Close accounts 9. Prepare post-closing trial balance 10. Reverse and post (optional)

Four-Step Closing Process

1. Close income statement credit balances 2. Close income statement debit balances 3. Close Income Summary account 4. Close dividends account

List of Accounts on a Classified Balance Sheet in Order of Appearance

1. Current Assets 2. Long-term Investments 3. Plant Assets 4. Intangible Assets 5. Current Liabilities 6. Long-term Liabilities 7. Equity

Contra Account

Account linked with another account and having an opposite normal balance; reported as a subtraction from the other account's balance.

Cash Basis Accounting

Accounting system that recognizes revenues when cash is received and records expenses when cash is paid; shown like a one-time payment for a continued service like prepaid insurance that spans a certain amount of time.

Accrual Basis Accounting

Accounting system that recognizes revenues when goods or services are provided and expenses when incurred; the basis for GAAP. Shown as a consistent or monthly bill of a certain amount on accrual basis balance sheet that spans a certain amount of time and is calculated every year.

Permanent Accounts

Accounts that reflect activities related to one or more future periods; balance sheet accounts whose balances are not closed. Permanent accounts are not closed each period and carry their end balance into future periods.

Temporary Accounts

Accounts used to record revenues, expenses, and withdrawals (dividends for a corporation); they are closed at the end of each period.

Future Cash Payment of Accrued Expenses

Accrued expenses at the end of one accounting period

Unclassified Balance Sheet

Balance sheet that broadly groups assets, liabilities, and equity accounts.

Classified Balance Sheet

Balance sheet that presents assets and liabilities in relevant subgroups, including current and noncurrent classifications

Current Assets

Cash and other assets expected to be sold, collected, or used within one year or the company's operating cycle, whichever is longer. I.e. cash, short-term investments, accounts receivable, short-term notes receivable, office supplies goods for sale (merchandise or inventory), prepaid expenses.

Fiscal Year

Consecutive 12-month (or 52-week) period chosen as the organization's annual accounting period.

Accrued Expense

Costs incurred in a period that are both unpaid and unrecorded; adjusting entries for recording accrued expenses involve increasing expenses and increasing liabilities. Also called accrued liabilities.

Accumulated Depreciation

Cumulative sum of all depreciation expense recorded for an asset. Has a normal credit balance; it decreases the asset's reported value. The net cost of equipment is also called depreciable basis.

Four Types of Adjustments

Deferral of expense Deferral of revenue Accrued expense Accrued revenue

Closing Entries

Entries recorded at the end of each accounting period to transfer end-of-period balances in revenue, gain, expense, loss, and withdrawals (dividends for a corporation) accounts to the capital account (or retained earnings for a corporation). If Apple did not make closing entries, prior-year revenue from iPhone sales would be included with current-year revenue.

Depreciation

Expense created by allocating the cost of plant and equipment to periods in which they are used; represents the expense of using the asset. Depreciation does not necessarily measure decline in market value.

Expense Recognition (or Matching) Principle

Prescribes expenses to be reported in the same period as the revenues that were earned as a result of the expenses. Recording expense early understates current-period income; recording it late overstates current-period income.

Formula for Computing Accrued Interest

Principle amount owed X Annual interest rate X Fraction of year since last payment Interest computations use a 360-day year, called the banker's rule. If a company has a $6,000 loan from bank at 5% annual interest, then 30 days' accrued interest expense is $25 : 6,000 x 0.05 x 30/360

Current Ratio

Ratio used to evaluate a company's ability to pay its short-term obligations, calculated by dividing current assets by current liabilities.

Accounting Cycle

Recurring steps performed each accounting period, starting with analyzing transactions and continuing through the post-closing trial balance (or optional reversing entries).

Accrued Revenues

Revenues earned in a period that are both unrecorded and not yet received in cash (or other assets); adjusting entries for recording accrued revenues involve increasing assets and increasing revenues.

Three-Step Process for Adjusting Entries

Step 1: Determine what the current account balance equals Step 2: Determine what the current account balance should equal Step 3: Record an adjusting entry to get from step 1 to step 2.

The Supplies account has a $900 debit balance at the beginning of December, and $4,100 of supplies were purchased during December. The December 31 physical count showed $300 of supplies available.

Step 1: Determine what the current account balance equals. balance in Supplies before adjustment is $5,000 (900+4.1k); Step 2: Determine what the current account balance should equal. Balance should equal $300, the amount of supplies still on hand. Step 3: Record an adjusting entry to get from step 1 to step 2. credit the asset account, Supplies, $4,700(5k-300). debit Supplies Expense, $4,700.

The company has a bank loan and has incurred (but not recorded) interest expense of $1,400 for the year ended December 31. The company will pay the interest on January 5 of the following year.

The balance in Interest Payable is currently $0. The year-end balance in Interest Payable needs to be $1,400, the amount that's owed as of December 31. The adjusting entry needs to credit Interest Payable, $1,400. And, since we're crediting the balance sheet, we need to debit the income statement. We debit Interest Expense, $1,400.

Wage expenses of $900 have been incurred but are not paid as of December 31.

The balance in Wages Payable is currently $0. The balance at December 31 represents the amount that has been earned by employees but not yet paid, $900. credit Wages Payable, $900, and if we credit the balance sheet account, debit the income statement account, debiting Wages Expense, $900.

The Prepaid Rent account had a $3,500 debit balance on December 31 of the current year, before adjusting for the costs of prepaid rent expired. An analysis of the rental agreement showed that $2,200 of prepaid rent had expired.

The current account balance is $3,500. The balance in Prepaid Rent represents the unexpired portion. Since $2,200 has expired, the unexpired amount is $1,300. ($3,500-$2,200) credit the asset account, crediting Prepaid Rent for the expired amount, debit the income statement account, Rent Expense, $2,200.

The company has earned (but not recorded) $800 of interest from investments in CDs for the year ended December 31. The interest revenue will be received on January 10 of the following year.

The current balance in Interest Receivable is $0. We need the balance in Interest Receivable to equal the amount that has been earned, but not yet received, $800. increase the balance in the asset account, debiting Interest Receivable, $800, and since we're debiting the balance sheet, we credit the income statement, crediting Interest Revenue for $800.

Revenue Recognition Principle

The principle prescribing that revenue is recognized when goods or services are delivered to customers. Recording revenue early overstates current-period income; recording it late understates current-period income.

Two-thirds of the work related to $24,000 of cash received in advance was performed this period.

Unearned Revenue, the liability account, has a credit balance of $24,000. Determine what the current account balance should equal. Since 2/3 of the work related to the cash received in advance has already been performed, the remaining liability is 1/3 of $24,000, 24/3= $8,000 x 2 = $16,000. debit the liability account, debiting Unearned Revenue, $16,000, crediting the Revenue account, $16,000.

The Prepaid Insurance account had a $4,000 debit balance at December 31, before adjusting for the costs of any expired coverage. An analysis of the company's insurance policies showed that $1,500 of unexpired insurance coverage remains.

We need to reduce the balance in Prepaid Insurance, crediting the balance sheet account, Prepaid Insurance, $2,500 (4k-1.5k), and if we credit the balance sheet account, we need to debit an income statement account, Insurance Expense.

Depreciation on the company's equipment for the year is computed to be $20,000.

We reduce the value of the equipment using a contra asset account called Accumulated Depreciation. debit the income statement account, Depreciation Expense, we need to credit the balance sheet account, Accumulated Depreciation.

Salvage Value

an asset's expected value at the end of its useful life

Prepaid Expenses

or deferred expenses; items paid for in advance of receiving their benefits; classified as assets.

Unearned Revenue

or deferred revenues; Liability created when customers pay in advance for products or services; earned when the products or services are later delivered.

Book Value

or net amount; Asset's acquisition costs less its accumulated depreciation (or depletion, or amortization) also sometimes used synonymously as the carrying value of an account; also called asset book value.

Profit Margin

or return on sales; Ratio of a company's net income to its net sales; the percent of income in each dollar of revenue; also called net profit margin.