Chapter 2 Financial Statements and the Accounting System

What users are used for analyzing financial statements?

both internal and external users

When assessing company results, what standards (benchmarks) are used for comparisons?

intracompany, intercompany, industry, and guidelines (rules of thumb)

intracompnay

comparing results across two or more periods

intercompany

comparing results across competitors

industry

comparing results to industry norms

guidelines (rules of thumb)

comparing results to standards based on experience

What are the four building blocks of analysis?

liquidity, solvency, profitability, and market prospects

liquidity

ability to meet short-term obligations and generate revenues

solvency

ability to meet long-term obligations and generate revenues

profitability

ability to provide financial rewards to attract and retain financing

market prospects

ability to generate positive market expectations

What is the process to go from transactions and events to financial statements?

1. identify each transactions and event from source documents

2. analyze each transaction and event using the accounting equation

3. record relevant transaction and event in a journal

4. post journal information to ledger accounts

5. prepare and analyze the trial balance and financial statements

source documents

identify and describe transactions and events entering the accounting system

account

a record of increases and decreases in specific asset, liability, equity, revenue, or expense. Accounts categories: assets, liabilities, and equity

assets

resources owned or controlled by a company that have future economic benefit. Examples include cash, accounts receivable, note receivable, prepaid expenses, prepaid insurance, supplies, store supplies, equipment, building, and land

liabilities

claims (by creditors) against assets, which means they are obligations to transfer or provide products or series to others. Examples include accounts payable, note payable, unearned revenues, and accrued liabilities

equity/owner’s equity

an owner’s claim on a company’s assets. Examples include common stock, dividends (decreases equity), revenues form providing goods or services; i.e., sales, fees earned, (increases equity), and expenses from assets or services used in operation; i.e., supplies, (decreases equity)

accounts receivable

promises of payment from customers

prepaid accounts

assets from prepayments of future expenses expected to be incurred future accounting periods

accounts payable

promises to pay later, usually arising from purchase of inventory or other assets

notes payable

written promissory not to pay a future amount

unearned revenue

revenue collected before it is earned/before services or good are provided

accrued liabilities

amounts owed that re not yet paid

ledger/general ledger

a collection of all accounts and their balances for an accounting system

chart of accounts

a list of all accounts in the ledger with their identification number

double-entry accounting

demands the accounting equation remain in balance. This means that for each transaction (1) at least two accounts are involved with at least one debit and one credit and (2) total amount debited must equal the total amount credited

T-account

represents a ledger account and is used to understand the effect of one or more transactions. It is shaped like the letter T withe account title on top

debit

the left side of the T-account

credit

the right side of the T-account

account balance

the difference between the total debits and the total credits recorded in the account. When total debits exceed totals credits, the account has a debit balance. When total credits exceed total debits. the account has a credit balance. When total debits equal total credits, the account has a zero balance

How can you increase an account?

place an amount on the balance side

How can you decrease an account?

place an amount on the side opposite its assigned balance side

double-entry system

requires that each transaction affect, and be recorded in, at least two accounts. The total debits must equal the total credits for each transaction

What side are assets placed in double-entry?

since assets are on the left side of the accounting equation, therefore, assets should be placed on the left side for double-entry or the debit side

What side are liabilities and equities placed in double-entry?

since liabilities and equities are on the right side of the accounting equation, therefore, liabilities and equities should be placed on the right side for double-entry or the credit side

What side should revenues be in double-entry?

since revenues accounts really represent increases in equity, therefore, they are assigned credit balances

What side should expenses be in double-entry?

since withdrawals and expenses accounts really represent decreases in equity, therefore, they are assigned debit balances

What are the four steps in processing transactions?

1. identify transactions and source documents

2. analyze transactions using the accounting equation. Apply double-entry accounting to determine account to be debited and credited

3. record journal entry-recorded chronologically. a journal gives us a record of each transaction in one place

   1. a general journal is the most flexible type of journal because it can be used to record any type of transaction

   2. when a transaction is recorded in the general journal, it is called a journal entry. a journal entry that affects more than tow accounts is called copout journal entry

   3. each journal entry must contain equal debits and credits

4. post entry to ledger—process of transferring entries from the journal to the ledger

   1. debits are posted as debit, and credits as credits to the accounts identified in the journal entry

   2. actual accounting systems use balance column accounts rather than t-accounts in the ledger

   3. a balance column account has debit and credit columns for recording entries and a third column for showing the balance of the account after each entry is posted

trial balance

a list of all ledger accounts and their balances (either debit or credit) at a point in time. Account balances are reported in their appropriate debit or credit columns of the trial balance

What are the three steps to prepare and trial balance?

1. list each account and its amount (from the ledger) in the trial balance

2. compute the total of debit balances and the total of credit balances

3. verify (prove) total debit balances equal total credit balances

When a trial balances does not balance, an error must be corrected. What are the steps to follow?

1. verify that the trial balance columns are correctly added

2. verify that account balances are accurately entered from the ledger

3. see whether a debit (or credit) balance is mistakenly listed in the trial balance as a credit (or debit)

4. recompute each account balance in the ledger

5. verify that each journal entry is properly posted

6. verify that the original journal entry has equal debits and credits