ACCT Ch 1-3 Important Terms/Ideas

Who are external users of accounting?

Shareholders, lenders, external auditors, non-managerial employees, and regulators

Who are internal users of accounting?

Purchasing managers, HR managers, production managers, research and development managers, and marketing managers

Is financial accounting associated with external or internal users?

EXTERNAL

Is managerial accounting associated with external or internal users?

INTERNAL

Fraud triangle

1. Opportunity (low risk of getting caught)

2. Pressure (incentive)

3. Rationalization (justification)

GAAP

Generally Accepted Accounting Principle

• Financial accounting is governed by concepted and rules that specify acceptable accounting practices

GOALS

1. Relevance

2. Faithful representation

FASB

Financial Accounting Standards Board

• responsible for setting the GAAP from the SEC

SEC

Securities and Exchange Commission

• A US gov agency that oversees proper use of GAAP by companies that sell stock and debt to the public

IASB

International Accounting Standards Board

• issues IFRS (International Financial Reporting Standards)

• standards identify preferred accounting processes

  • similar to GAAP

4 Principles of GAAP

1. Measurement (cost) Principle: accounting info is based on actual cost (cost is considered objective)

2. Revenue Recognition Principle: revenue is recognized when G&S are provided to customers AND at the amount expected to be received from customers

3. Expense Recognition/Matching Principle: a company records its expenses incurred to generate the revenue reported

4. Full Disclosure Principle: a company reports the details behind financial statements that may impact user's’ decisions in the notes to the financial staements

4 Accounting Assumptions

1. Going-concern: the business is presumed to continue operating instead of being closed or sold

2. Monetary unit: transactions and events are expressed in monetary units (ex: US dollars)

3. Time period: life of a company can be divided into time periods (ex: months, years)

4. Business entity: a business is accounted for seperately than other business entities and its owner

4 Types of Financial Statements

1. Income Statement

   1. revenue-expenses=net income

2. Statement of Retained Earnings

   1. beg. retained earnings+net income-dividend= end retained earnings

3. Balance Sheet

   1. assets= liabilites +equity

4. Statement of Cash Flows

   1. summation of operating, investing, and financial cash flows = change in cash

Return on Assets (ROA)

ROA=(net income) / (average total assets)

4 Business Entities and their unique attributes

1. Sole Proprietorship

   1. 1 owner

   2. NO add. business tax

   3. Unlimited liability

   4. NOT a sperate legal entity

   5. Business ends with death or choice

2. Partnership

   1. 2+ owners

   2. NO add. business tax

   3. Unlimited liability

   4. NOT a separate legal entity

   5. Business ends with death or choice

3. Corporation

   1. 1+ shareholders

   2. ADDITIONAL CORPORATE INCOME TAX

   3. Limited liability

   4. Separate entity

   5. Indefinite business life

4. Limited Liability Company (LLC)

   1. 1+ Owners

   2. NO add. business tax

   3. Limited liability

   4. Separate entity

   5. Indefinite business life

5 Steps to go from Transactions to Financial Statements

1. Identify each transaction from source documents

2. Analyze each transaction and event using accounting equation

3. Record relevant transations and events in a journal

4. Post journal information to ledger accounts

5. Prepare and analyze trial balance and financial statements

Source documents

identify and describe transactions and events entering accounting system

• can be hard copy or electronic form

• ex: sales receipt, checks, purchase orders, bills, payroll records, and bank statements

Account definition

a record of increases and decreases in a specific asset, liability, equity, revenue, or expense

General Ledger

a record of ALL accounts and their balances

• often in electronic form

Chart of Accounts

a list of ALL LEDGER accounts with an identification number assigned to each account

• a company’s size and diversity of operations affects number of accounts needed

• DOES NOT SHOW BALANCES

T-Account

represents a ledger account and is used to show the effects of transactions

DEBIT ALWAYS ON LEFT

CREDIT ALWAYS ON RIGHT

Double-Entry Accounting

Demands that the accounting equation remain in balance so for each transaction:

1. At least 2 accounts are involved, with at least 1 debit and 1 credit

2. Total amount debited = Total amount credited for ALL ENTRIES

Debit (LEFT side of equation)

Increases: asset, expenses, dividends

Decreases: liabilities, revenue, common stock

Credit (RIGHT side of equation)

Increases: Liabilites, revenues, common stock

Decreases: Assets, expenses, dividends

Journal

complete record of each transaction in one place

• shows debits and credits for each transaction

Journalizing

Recording transactions in a journal

General Journal

All-purpose journal for recording the debits and credits of transactions and events

Steps to Record Journal Entries

1. Date transaction on 1st line

2. On 1st line, enter title of accounts debited and then enter amounts in the debit column on the same line

3. On 2nd line, enter titles of accounts credited and then enter amounts in the credit column on the same line

4. Enter a brief description of the transaction below the entry

Trial Balance

list of all ledger accounts and their balances at a POINT IN TIME

• NOT a financial statement

Debt Ratio

Total Liabilities/Total Assets

Financial Statement Analysis Focuses on 4 Main Things

1. Liquidity: ability to meet short-term obligations and generate revenues

2. Profitability: ability to provide financial rewards to investors and to attract and retain financing

3. Solvency: ability to meet long-term obligations and generate future revenues

4. Market Prospects: ability to generate positive market expectations

Time Period Assumption

Presumes an organization’s activities can be divided into specific time periods (month, 3 month quarter, 6 month interval, or year)

• Annual financial statement: 1 year period

• Interim financial statement: 1,3, or 6 month periods

• Fiscal year: any consecutive 12-month period

• Natural business year: 12 month period that ends when a company’s sale activities are at their lowest point

Accrual Basis Accounting

records revenues when services and products are delivered and records expenses when incurred

• most believe that this better reflects business performance

• required by GAAP

Cash Basis Accounting

records revenues when cash is received and records expenses when cash is paid

2 Principles Used in Adjusting Process

1. Revenue Recognition Principle: requires revenue be recorded when G/S are provided to customers and at an amount expected to be received from customers

2. Expense Recognition (matching) Principle: requires that expenses be recorded in same accounting period as the revenues that are recognized as a result of those expenses

Plant Asset

tangible long-lived assets used to produce or sell products and services

• AKA property, plant, and equipment (PP&E) or fixed assets

• Ex: Buildings, machine, vehicles, and equipment

• ALL provide benefit for more than 1 period

• Cost is gradually reported as expenses over benefit periods

Depreciation Expense

the allocation of the costs of plant assets over their expected useful lives

• FORMULA: (Asset Cost - Salvage Value) / (Useful Life)

• Normal DEBIT balance

Accumulated Depreciation Expense

a separate contra account and has a normal CREDIT balance

Contra Account

an account linked with another account, has an OPPOSITE normal balance and is reported as a subtraction from that other account’s balance

Book Value

Asset’s costs - accumulated depreciation

Accrued Interest Expense

FORMULA: (Principal Amount Owed) x (Annual Int. Rate) x (Fraction of Year Since Last Payment)

Order of Preparing Financial Statements

1. Prepare INCOME STATEMENT using revenue and expense accounts from adjusted trial balance

2. Prepare STATEMENT OF RETAINED EARNINGS (beginning retained earnings + net income - dividends)

3. Prepare BALANCE SHEET using assets, liabilities, common stock

4. Prepare STATEMENT OF CASH FLOWS

2 Purposes of Closing Process

1. Resets revenue, expense, and dividend account balances to 0 at the end of the period

2. Updates retained earnings account to match that reported in the balance sheet and statement of retained earnings

Temporary Accounts

• Accounts used to record REVENUES, EXPENSES, and DIVIDENDS

• INCOME SUMMARY

• Closed at end of each period

Permanent Accounts

Accounts that reflect activities related to 1 or more future periods

Includes: ASSETS, LIABILITIES, COMMON STOCK, RETAINED EARNINGS

• NOT CLOSED at end of each period and balances carry over into future periods

4 Steps to Recording Closing Entries

1. Close credit balances by debiting REVENUE accounts

2. Close debit balances by crediting EXPENSE accounts

3. Close income summary account to RETAINED EARNINGS

4. Close (subtract) dividends to retained earnings

Post-closing Trial Balance

list of permanent accounts and their balances AFTER closing entries

Accounting Cycle (10 steps)

1. Analyze transactions

2. Journal: record accounts (including debits and credits) in a journal

3. Post: transfer from journal to ledger

4. Prepare unadjusted trial balance

5. Adjust and post

6. Prepare adjusted trial balance

7. Prepare financial statements

8. Close accounts

9. Prepare post-closing trial balance

10. OPTIONAL: reverse and post

Classified balance sheet

organizes assets and liabilities into SUBGROUPS

• Current items are expected to come due (either collected or owed) within 1 year or the company’s operating cycle (whichever is longer)

• List current items first, non-current items second

Operating Cycle

time span from when cash is used to acquire goods and services until cash is received from the sale of goods and services

• assume 1 year operating cycle unless stated otherwise

Profit Margin

Net Income / Net Sales

Current Ratio

Current Assets / Current Liabilities

Work Sheet

document that is used internally by companies to help with adjusting and closing accounts and with preparing financial statements

• NOT a substitute for financial statements, journals, or ledgers

• Reduces risk of errors

• NOT REQUIRED

4 Types of Adjusting Entries

PREPAYMENTS/DEFERRALS:

• Deferral of Expense

  • If you are the BUYER and receiving G/S

  • Expenses PAID but G/S NOT RECEIVED

  • Ex: prepaid insurance, prepaid rent, etc

• Deferral of Revenue

  • If you are the SELLER and providing G/s

  • Income RECEIVED but G/S NOT YET PROVIDED

  • Ex: unearned revenue, revenue

FUTURE PAYMENTS/ACCRUALS:

• Accrued Expense

  • If you are the BUYER and receiving G/S

  • Expenses incurred (used) but NOT YET PAID

  • Ex: salaries, wages, interest payable

  • You have USED something (employee’s work) but have not yet paid

• Accrued Revenue

  • If you are the SELLER and providing G/S

  • Income EARNED but NOT YET RECEIVED

  • Ex: Accounts receivable, service revenue

  • As you do the work, decrease unearned revenue and increase revenue