Accounting Principles, Adjusting Entries, and Merchandising Operations

Accrual basis accounting

Records revenues when earned and expenses when incurred, regardless of when cash moves; required by GAAP.

Cash basis accounting

Records revenue when cash is received and expenses when cash is paid; not GAAP.

Revenue recognition principle

Recognize revenue in the accounting period in which the performance obligation is satisfied.

Expense recognition (matching) principle

Recognize expenses in the period the company makes efforts to generate revenue.

Periodicity assumption

The economic life of a business can be divided into artificial time periods for reporting.

Fiscal year

An accounting period that is one year in length.

Adjusting entries

End-of-period entries that update accounts so revenue and expense recognition rules are followed; one income statement and one balance sheet account.

Deferral

Cash is exchanged before the expense or revenue is recognized; includes prepaid expenses and unearned revenues.

Accrual

Expense or revenue is recognized before cash is exchanged; includes accrued revenues and accrued expenses.

Prepaid expense adjusting entry

Debit an expense and credit an asset (or contra asset).

Unearned revenue adjusting entry

Debit a liability (Unearned Revenue) and credit a revenue.

Accrued revenue adjusting entry

Debit an asset (Receivable) and credit a revenue.

Accrued expense adjusting entry

Debit an expense and credit a liability (Payable).

Depreciation

Allocating the cost of a long-lived asset to expense over its useful life; an allocation concept, not a valuation concept.

Accumulated Depreciation

Contra asset account showing total depreciation expensed to date.

Book value

Cost minus accumulated depreciation; also called carrying value.

Accrued interest formula

Interest = Face value × annual interest rate × time in terms of one year.

Adjusted trial balance

Prepared after all adjusting entries are journalized and posted; proves debit-credit equality and is the primary basis for the financial statements.

Temporary (nominal) accounts

Revenues, expenses, and dividends; closed to zero at the end of the period.

Permanent (real) accounts

Assets, liabilities, and stockholders' equity; balances are carried forward.

Closing entries

Entries that transfer temporary account balances to Retained Earnings and produce zero balances in temporary accounts.

Order of closing entries

1) Revenues to Income Summary 2) Expenses to Income Summary 3) Income Summary to Retained Earnings 4) Dividends to Retained Earnings.

Post-closing trial balance

Prepared after closing; contains only permanent balance sheet accounts and proves equality.

Five-step revenue recognition

1) Identify contract 2) Identify performance obligations 3) Determine transaction price 4) Allocate price 5) Recognize revenue when each obligation is satisfied.

Performance obligation satisfied

Occurs when a good or service is transferred to the customer.

Merchandising company

Purchases and sells merchandise; primary source of revenue is sales revenue.

Retailer

Merchandising company that sells directly to consumers.

Wholesaler

Merchandising company that sells to retailers.

Cost of goods sold

Total cost of merchandise sold during the period; directly related to sales revenue.

Gross profit

Net sales minus cost of goods sold; also called gross margin.

Perpetual inventory system

Maintains detailed records of each purchase and sale; COGS is recorded at each sale.

Periodic inventory system

No detailed records during the period; COGS is determined at period end from a physical count.

Purchase of inventory on account

Debit Inventory and credit Accounts Payable.

Freight-in paid by buyer

Debit Inventory and credit Cash; added to the cost of inventory.

Freight-out / Delivery Expense

Seller's operating expense for outgoing merchandise; debit Freight-Out and credit Cash.

FOB shipping point

Buyer owns goods when the carrier accepts them; buyer pays freight.

FOB destination

Seller owns goods until they reach the buyer; seller pays freight.

Purchase return

Debit Accounts Payable and credit Inventory.

Purchase allowance

Reduction in purchase price while the buyer keeps the goods; debit Accounts Payable and credit Inventory.

Purchase discount

Discount for early payment; reduces the cost of Inventory.

Credit terms 2/10, n/30

2% discount if paid within 10 days; otherwise full amount due within 30 days.

Sale on account under perpetual system

Two entries: debit Accounts Receivable and credit Sales Revenue; debit Cost of Goods Sold and credit Inventory.

Sales Returns and Allowances

Contra-revenue account with a normal debit balance; subtracted from sales revenue.

Sales Discounts

Contra-revenue account with a normal debit balance; subtracted from sales revenue.

Net sales

Sales revenue minus sales returns and allowances minus sales discounts.

Income from operations

Gross profit minus operating expenses.

Nonoperating activities

Revenues, gains, expenses, and losses unrelated to the company's main line of operations.

Operating vs nonoperating income

Operating income is viewed as sustainable; analysts place more weight on it when forecasting future income.

Single-step income statement

Subtracts total expenses from total revenues; classifies data into only two categories.

Multiple-step income statement

Highlights net sales, gross profit, income from operations, income before income taxes, and net income.

Gross profit rate

Gross profit ÷ net sales; cents of gross profit per dollar of sales.

Profit margin

Net income ÷ net sales; percentage of each sales dollar that results in net income.

Periodic COGS formula

Beginning inventory + cost of goods purchased − ending inventory = cost of goods sold.

Merchandise inventory

Inventory of a merchandising company; reported as a current asset.

Manufacturing inventory types

Raw materials, work in process, and finished goods.

Purpose of physical count in perpetual system

Check accuracy of inventory records and determine inventory lost to waste, shoplifting, or theft.

Purpose of physical count in periodic system

Determine ending inventory on hand and cost of goods sold for the period.

Goods in transit ownership

Determined by the FOB terms of the sale.

Consigned goods

Goods held for sale by one party but owned by another; not included in the holder's inventory.

Specific identification

Method that tracks the actual cost of the specific items sold and remaining in ending inventory.

FIFO

Assumes the earliest goods purchased are the first to be sold.

LIFO

Assumes the latest goods purchased are the first to be sold.

Average-cost method

Allocates cost of goods available for sale using a weighted-average unit cost.

FIFO ending inventory costing

Start with the most recent purchase cost and work backward until all ending units are costed.

LIFO ending inventory costing

Start with the earliest cost and work forward until all ending units are costed.

Rising prices: FIFO effects

Higher ending inventory, lower COGS, higher net income, higher income taxes.

Rising prices: LIFO effects

Lower ending inventory, higher COGS, lower net income, lower income taxes.

Why some companies choose LIFO

Lower income taxes when prices rise, which saves cash; better matching of current costs with current revenue.

Consistency concept

Companies use the same accounting principles and methods from year to year.

LIFO reserve

Difference between inventory reported under LIFO and under FIFO; disclosed in the financial statement notes.

Lower-of-cost-or-net realizable value (LCNRV)

Write inventory down when net realizable value is less than cost; applies conservatism.

Net realizable value

Net amount a company expects to realize from the sale of inventory.

Inventory turnover

Cost of goods sold ÷ average inventory; number of times inventory is sold during the period.

Days in inventory

365 ÷ inventory turnover; average number of days inventory is held before it is sold.

Average inventory

(Beginning inventory + ending inventory) ÷ 2.

Accounting equation

Assets = Liabilities + Stockholders' Equity.

Expanded accounting equation

Assets = Liabilities + Common Stock + Retained Earnings + Revenues − Expenses − Dividends.

Normal balance of assets

Debit.

Normal balance of liabilities

Credit.

Normal balance of revenues

Credit.

Normal balance of expenses

Debit.

Normal balance of dividends

Debit.

Current assets

Assets expected to be converted to cash or used up within one year or the operating cycle, whichever is longer.

Current liabilities

Obligations due within one year or the operating cycle, whichever is longer.

Current ratio

Current assets ÷ current liabilities.

Debt to assets ratio

Total liabilities ÷ total assets.

Earnings per share

(Net income − preferred dividends) ÷ weighted-average common shares outstanding.

Journal

Chronological record of transactions showing debit and credit effects on specific accounts.

Trial balance

List of accounts and balances at a given time; proves total debits equal total credits.

Contra asset account

Asset account with a credit balance that offsets a related asset; example: Accumulated Depreciation.

Contra-revenue account

Revenue account with a debit balance that reduces sales; examples: Sales Returns and Allowances, Sales Discounts.

Unearned revenue

A liability created when cash is received before services are performed.

Prepaid expense

An asset created when cash is paid before the expense is incurred.

Accrued revenue

Revenue earned but not yet recorded or received in cash.

Accrued expense

Expense incurred but not yet paid or recorded.

Operating cycle

Average time it takes to purchase inventory, sell it on account, and collect cash from customers.