Chapter 2 The Accounting Process

Ledger

A "book" containing accounts. For example, there is the general ledger that contains the balance sheet and income statement accounts. There is a subsidiary ledger that contains the detailed, customer account balances for the general ledger account Accounts Receivable.

Accounts Receivable

A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale.

Inventory

A current asset whose ending balance should report the cost of a merchandiser's products awaiting to be sold. The inventory of a manufacturer should report the cost of its raw materials, work-in-process, and finished goods. The cost of inventory should include all costs necessary to acquire the items and to get them ready for sale.

Articles of Incorporation

A document filed when a corporation is formed. Among other things, it lists the number of shares of stock that the corporation is authorized to issue

Trial Balance

A listing of the accounts in the general ledger along with each account's balance in the appropriate debit or credit column. The total of the amounts in the debit column should equal the total of the amounts in the credit column.

Property, Plant and equipment

A major classification on the balance sheet. It is the second long term asset section after current assets. Included are land, buildings, leasehold improvements, equipment, furniture, fixtures, delivery trucks, automobiles, etc. that are owned by the company.

Account

A record in the general ledger that is used to collect and store similar information

Par Value (or legal Capital)

A stated legal amount often appearing on preferred stock, bonds, and some common stock.

Retained Earnings

A stockholders' equity account that generally reports the net income of a corporation from its inception until the balance sheet date less the dividends declared from its inception to the date of the balance sheet.

Accounting Cycle

A term that describes the steps when processing transactions (analyzing, journalizing, posting, preparing trial balances, adjusting, preparing financial statements) in a manual accounting system.

T-account

A visual aid used by accountants to illustrate a journal entry's effect on the general ledger accounts. Debit amounts are entered on the left side of the "T" and credit amounts are entered on the right side.

Temporary accounts

Accounts that are closed at the end of each accounting year. Included are the income statement accounts (revenues, expenses, gains, losses), summary accounts (such as income summary), and a sole proprietor's drawing account.

Permanent Accounts (or balance sheet accounts)

Also referred to as real accounts. Accounts that do not close at the end of the accounting year. The permanent accounts are all of the balance sheet accounts (asset accounts, liability accounts, owner's equity accounts) except for the owner's drawing account.

Noncurrent assets (or long-term assets)

Assets that are not intended to be turned into cash or be consumed within one year of the balance sheet date. Long-term assets include long-term investments, property, plant, equipment, intangible assets, etc.

Current Assets

Cash and other resources that are expected to turn to cash or to be used up within one year of the balance sheet date. (If a company's operating cycle is longer than one year, an item is a current asset if it will turn to cash or be used up within the operating cycle.) Current assets are presented in the order of liquidity, i.e., cash, temporary investments, accounts receivable, inventory, supplies, prepaid insurance.

Cost of goods sold (cost of sales)

Cost of goods sold is usually the largest expense on the income statement of a company selling products or goods. Cost of Goods Sold is a general ledger account under the perpetual inventory system. Under the periodic inventory system there will not be an account entitled Cost of Goods Sold. Instead, the cost of goods sold is computed as follows: cost of beginning inventory + cost of goods purchased (net of any returns or allowances) + freight-in - cost of ending inventory. This account balance or this calculated amount will be matched with the sales amount on the income statement.

Gross Profit (gross margin or gross profit margin)

Net sales revenues minus the cost of goods sold. Others use the term to mean the percentage of gross profit dollars divided by net sales dollars.

Current Liabilities

Obligations due within one year of the balance sheet date. (If a company's operating cycle is longer than one year, an item is a current liability if it is due within the operating cycle.) Another condition is that the item will use cash or it will create another current liability. (This means that if a bond payable is due within one year of the balance sheet date, but the bond will be retired by a bond sinking fund (a long-term restricted asset) the bond will not be reported as a current liability.)

Long-Term Liability

Obligations of the enterprise that are not payable within one year of the balance sheet date. Two examples are bonds payable and long term notes payable.

Operating Expenses (or selling, general and administrative, SG&A, expenses)

Operating expenses consist of selling and administrative expenses. Operating expenses are deducted from gross profit to arrive at income from operations.

Contributed Capital

Sometimes used as a heading in place of paid-in capital.

Liquidity

The ability to generate cash.

Debit

The accounting term that means an entry will be made on the left side of an account.

Amortization Expense

The allocation to expenses of the cost of an intangible asset such as a patent, goodwill, bond issue costs, etc.

Accrued Liabilities

The amount a company owes for expenses or losses incurred that have not yet been paid nor recorded through a routine transaction

Accumulated Depreciation

The amount of a long-term asset's cost that has been allocated to Depreciation Expense since the time that the asset was acquired. Accumulated Depreciation is a long-term contra asset account (an asset account with a credit balance) that is reported on the balance sheet under the heading Property, Plant, and Equipment.

Income Tax Expense (or provision for income tax)

The amount of income tax that is associated with (matches) the net income reported on the company's income statement. This amount will likely be different than the income taxes actually payable, since some of the revenues and expenses reported on the tax return will be different from the amounts on the income statement. For example, a corporation is likely to use straight-line depreciation on its income statement, but will use accelerated depreciation on its income tax return.

Note Payable

The amount of principal due on a formal written promise to pay. Loans from banks are included in this account.

Book Value (or carrying value, net value)

The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner's or stockholders' equity. The book value of bonds payable is the combination of the accounts Bonds Payable and Discount on Bonds Payable or the combination of Bonds Payable and Premium on Bonds Payable.

Cash Flows from Operating activities (CFOs)

The cash from operating activities is compared to the company's net income. If the cash from operating activities is consistently greater than the net income, the company's net income or earnings are said to be of a "high quality". If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash

Journal Entries

The entry made in a journal. It will contain the date, the account name and amount to be debited, and the account name and amount to be credited. Each journal entry must have the dollars of debits equal to the dollars of credits.

Depreciation Expense

The income statement account which contains a portion of the cost of plant and equipment that is being matched to the time interval shown in the heading of the income statement. (There is no depreciation expense for land.)

Journal

The record of journal entries appearing in order by date. Some refer to the journal as the book of original entry, since the entries are first recorded in a journal. From the journal the entries will be posted to the designated accounts in the general ledger. With manual systems there are likely to be a sales journal, purchases journal, cash receipts journal, cash disbursements journal, and the general journal. With computerized accounting systems, it is likely that the general journal will be used sparingly. The software is likely to record the other transactions automatically as invoices are entered, checks are prepared, receipts processed, etc.

Income from Operations (or operating income)

The result of subtracting operating expenses from gross profit. Income from operations is the amount before non-operating items (such as gains and losses on the sale of assets, interest revenue, and interest expense).

Closing Process

These journal entries are made after the financial statements have been prepared at the end of the accounting year. Most of the closing entries involve the income statement accounts (revenues, expenses, gains, losses, and summary/clearing accounts) whose balances will be transferred to the owner's capital account or the corporation's retained earnings account. A closing entry also transfers the owner's drawing account (a temporary balance sheet account) balance to the owner's capital account. The closing entries will mean that the temporary accounts (income statement accounts and drawing account) will start the new accounting year with zero balances.

Interest (or Financial) Expense

This account is a non-operating or "other" expense for the cost of borrowed money or other credit. The amount of interest expense appearing on the income statement is the cost of the money that was used during the time interval shown in the heading of the income statement, not the amount of interest paid during that period of time.

Earnings Per Share (EPS)

This financial statistic is the net income of a corporation after income tax (less any preferred dividends) divided by the weighted average number of shares of common stock outstanding during the same period of time.

Credit

To enter an amount on the right side of an account. Normal entries to revenue accounts are credits. Liabilities normally have credit balances.

Dual-Entry System of Accounting

Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a "debit" entry, meaning the amount will be entered on the left side of that account. Another account will receive a "credit" entry, meaning the amount will be entered on the right side of that account. The initial challenge with double-entry is to know which account should be debited and which account should be credited

Contra-Asset (or negative asset)

is a negative asset account that offsets the balance in the asset account with which it is paired. The purpose of a contra asset account is to store a reserve that reduces the balance in the paired account.

Adjusting Entries

ournal entries usually dated the last day of the accounting period to bring the balance sheet and income statement up to date on an accrual basis (as required by the matching principle and the revenue recognition principle). Adjusting entries are made to report (1) revenues that have been earned but not yet entered into the accounting records, (2) expenses that have been incurred but have not yet been entered into the accounting records, (3) revenues already recorded that involve more than the current accounting period, or (4) expenses already recorded that involve more than the current accounting period.