Financial Accounting Midterm 1

Why is Accounting the Language of Business

Accounting is an information system that:

-measures business activities

-processes data into financial statements and reports

-communicates results to decison-makers

Financial Statements

the business documents companies use to report the results of their activities

Four Basic Financial Statements:

Income Statements, Statements of Retained Earnings, Balance Sheet, Statement of Cash Flows

Decision Makers

individuals, regulatory bodies, investors & creditors, non-profit organizations

Accounting Equation

Assets = Liabilities + Stockholder’s Equity

Entity Assumption

the organization is a separate unit from others (economic unit)

Continuity (Going-Concern) Assumption

continue to operate at forseeable future

Historical Cost Principle

assets should be recorded at actual cost on date of purchase

Assets

economic resources that are expected to produce a benefit in the future

ex: cash, inventory, property, plant equipment

Liabilities

debts owed to people & organizations outside of creditors

ex: accounts payable, notes payable, income tax, long term debt

Stockholder’s Equity

represents owner’s claims

ex: capital, owner’s equity, common stock, stockholder’s equity

Retained Earnings and Components

the amount of earned income kept for use in the business

Components: net income (revenue, expenses), dividends

Income Statement

reports revenues & expenses, statement of operations, bottom line is net income

Net Income= Total Revenue - Total ExpensesS

Statement of Retained Earnings

portion of net income reinvested.

Net Income increases retained earnings

Net Losses & Dividends retained earnings

Balance Sheet

statement of financial position

Assets, Liabilities, Equity

position at one specific time

Current Assets vs. Long-Term Assets

Current: used or converted into cash within one business cycle

ex: cash, receivables, inventories, prepaid expenses

Long-Term: expected to benefit the company beyond fiscal year

ex: property, plant equipment, long-term investments, intangible assets

Current Liabilities vs. Long-Term Liabilities

Current: debts due within one year

ex: accounts payable, salaries payable, short-term debts, notes payable, accrued liability

Long-Term: debts payable after one year

ex: long term notes payable, bonds payable

Statement of Cash Flows

cash receipts & cash statements

-Operating Activities: selling good & services

-Investing Activities: purchasing & selling long-term assets

-Financial Activities: borrowing & repaying funds or equity transactions

American Institute of Certified Public Accountants (AICPA) principles

responsibilities, public interest, integrity, objectivity and independence, due care, scope and nature of services

Three Factors that Influence Business and Accounting Decisons

Economic: decision should maximize the economic benefits

Legal: free societies are governed by laws written to provide clarity and prevent abuse if other’s rights

Ethical: recognizes that even when economically profitable and legal, some actions still may not be right

Transaction

any event of financial impact on the business and can be measuring reliability

-something is given, something is returned

-accounting records both sides of the transaction

Account

record of all changes in a particular asset, liability, or stockholder’s equity during a period

Asset: Cash

money including bank account balances, paper currency, coins, certificate or deposits, and checks

Asset: Accounts Recievable

promise for future cash for goods and services

Asset: Notes Recievable

amounts other parties must pay the business because they signed a promissory note

Asset: Inventory

goods the company sells to customers

Asset: Prepaid Expenses

expenses paid on advance, such as insurance or rent

Asset: Film & Television Costs

production costs, production overhead, interest, and development costs for film &tv programs

Asset: Investments

Interests purchased and held in other companies

Asset: Property, Plant, and Equipment

cost of land, buildings, and equipment owned by a company

Liability: Accounts Payable

promise to pay debt

Liability: Notes Payable

signed notes promising to pay a future amount

Liability: Accrued Liability

liability for an expense you have not yet paid

Stockholder’s Equity: Common Stock

owner’s investment in the corporation through stock

Stockholder’s Equity: Retained Earnings

cumulative net income minus net losses and dividends over the company’s life

Dividends

distribution of the company’s earnings to its shareholders

T-Account

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

Credit/Debit: Asset

Increases: Debit

Decreases: Credit

Credit/Debit: Liabilities

Increases: Credit

Decreases: Debit

Credit/Debit: Common Stock

Increases:Credit

Decreases: Debit

Credit/Debit: Retained Earnings

Increases: Credit

Decreases: Debit

Credit/Debit: Dividends

Increases: Debit

Decreases: Credit

Credit/Debit: Revenues

Increases: Credit

Decreases: Debit

Credit/Debit: Expenses

Increases: Debit

Decreases: Credit

Journal Entries

chronological order of transactions

Journal Entries Steps

1. specify accounts

2. debit or credit

3. journalize transactions

Ledger

all individual accounts added up

Compound Entry

more than 2 accounts affected

Trial Balance

-lists all accounts with balances

-shows credits = debits

-assets, then liabilities, then stockholder’s equity

Chart of Accounts

tracks what, and how many accounts a company ahs

Normal Trial Balances

-Assets: debit

-Liabilities: credit

-Stockholder’s Equity (overall): credit

—Common Stock: credit

—Retained Earnings: credit

—Dividends: debit

—Revenue: credit

—Expenses: debit

Accrual Accounting

-records impact of transactions

-required by U.S. GAAP (Generally Accepted Accounting Principles)

-records revenue and expenses

Cash-Basis

-only cash transactions (receipts & payments)

-ignores important information

-leads to incomplete financial statements

-only used by small businesses

Cash Transactions

-collecting cash from customers

-receiving cash from interest earned

-paying salaries, rent, and other expenses

-borrowing money

-paying off my loans

-issuing stock

Non-Cash Transactions

-sales on account

-purchases of inventory on account

-accrual of expenses incurred but not yet paid

-depreciation expense

-usage of prepaid rent, insurance and supplies

-earning of revenue when cash is collected in advance

The Time-Period Concept

ensures that accounting information is reported at Regular intervals

-basic accounting period: one year

-around 60% of large companies use the Calendar year from January 1 -December 31

-fiscal year may end on a date other than Dec 31.

-companies also prepare financial statements from interim periods (less than a year)

Revenue Principle

addresses two issues:

1. when to record (recognize) revenue

2. what amount of revenue to record

Expense Recognition Principle

addresses two issues:

1. identify all expenses incurred during the period

2. measure the expenses and recognize them in the sane period in which any related revenues are earned

Deferrals

an adjustment for payment of an item or receipt of cash in advance

Depreciation

allocates the cost of a plant asset to expense over the assets useful life

Accruals

the opposite of deferrals

Plant Assets

are long-lived tangible assets, such as land, buildings, furniture and equipment

Depreciation

is the process of allocating cost to expense, for a long-term plant asset

-decline in usefulness

-spread the cost of the plant asset over its useful life

-exception: LAND does not decline in usefulness

Straight Line Depreciation: w/ example

divide cost of asset by its useful life

ex:

COST: $24,000

LIFE: 5 years

Annual Depreciation: 24,000/5 = $4,800 a year

Monthly Depreciation: 24,000/60 = $400 a year

Accumulated Depreciation

Sum of all Depreciation Expenses

-balance increases over asset’s life

-contra asset account, a normal credit balance

Contra Asset Account

1. always has a companion account

2. normal balance is opposite that of the companion account

Accrued Expenses

a liability that arises from an expense that has not yet been paid

-not recorded daily or weekly, but not rather at the end of the period as an adjusting entires

Accrued Revenue

a revenue that has been earned but not yet collected

Unearned Service Revenue

a liability created when a company receives cash before earning the revenue

Closing the Books

prepares the accounts for the next period’s transactions

Closing Entries

set temporary accounts back to zero

Temporary Accounts

are related to a limited period of time

• Revenue

• Expenses

• Dividends

Permanent Accounts

are not closed

• Assets

• Liabilities

• Stockholder’s Equity

Closing Entries Steps

1. debit each revenue for the amount of its credit balance: credit retained earnings

2. credit each expense for the amount of debit balance: debit retained earnings

3. credit dividends: debit retained earnings

Liquidity

how quickly an item can be converted to cash

• cash: most liquid

• accounts receivable: relatively liquid

• inventory: less liquid

• equipment and building: least liquid

Net Working Capital

represents operating liquidity

Total Current Assets > Total Current Liabilities

Current Ratio

-represents operating liquidity

-prefer a high current ratio

TOTAL CURRENT ASSETS/ TOTAL CURRENT LIABILTIIES

Debt Ratio

-measures debt-paying ability

-the proportion of company’s assets financed with debt

-a low debt ratio is safer than a higher one

TOTAL LIABILITIES / TOTAL ASSETS

Fraud

intentional misrepresentation of fact

• for purpose of persuading another party to act in a certain way

• causes injury & damage

• growing problem throughout the world, through economic

• two types: misappropriation of assets and fraudulent financial reporting

• ex: insurance, check forgery, medicare fraud, credit card fraud, identify theft

Misappropriation of Assets

• committed by employees

• theft of money or inventory

• bribery & kickback schemes

• overstate expense reimbursements

Fraudulent Financial Reporting

• committed by managers

• false or misleading journal entries

• deceive investors &creditors

Internal Control

plan of organization & procedures implemented to accomplish 5 objectives

1. safeguard assets

2. encourage employees to follow company policy

3. promote operational efficiency

4. ensure accurate, reliable accounting records

5. comply with legal requirements

Components of Internal Control

• control environment

• risk assessment

• information system

• control procedures

• monitoring controls

Control Environment

component of internal control

• tone at the top

• code of ethics

Risk Assessment

component of internal control

• identify business risks

• establish procedures to deal with risks

Information System

component of internal control

• means which accounting information enters & exits

• accurately track assets, profits, and losses

Control Procedures

component of internal control

• means by which companies gain access to the 5 objectives of internal controls

Monitoring Controls

components of internal control

• usually programmed into technology

• internal and external auditors

Internal Control Procedures

• smart hiring practices

• separation of duties

• comparison & compliance monitoring

• adequate records

• limited access

• proper approvals

• accounting systems

Smart Hiring Practices

internal control procedure

• background checks

• training & supervision

• competitive salaries

• clear employee responsibility

Separation of Duties

internal control procedure

• asset handling

• record keeping

• transaction approval

Comparison & Compliance Monitoring

internal control procedure

• operating & cash budgets

• expectation reporting

• audits

Adequate Records

internal control procedure

• details of business transactions

• hard copy documents & electronics

• pre-numbered documents

Limited Access

internal control procedure

• limit access employees have to assets based on responsibilities

• lock & key

• physical access controls

• password & encryption

Proper Approvals

internal control procedure

• managements general or specific approval

  • management may delegate approval to a specific department

• purchasing department

  • only buy from approved vendors

  • based on competitive bids

Accounting Systems

internal control procedure

• continue to rely less on manual procedures and more information technology

• ex: sensors and barcodes

Safeguard Controls

• important documents in fireproof vaults

• burglar alarms & security cameras

• loss prevention

• fidelity bonds on cashiers

• mandatory vacations & job rotation

Internal Control: E-Commerce

Risks

• stolen credit card numbers

• malicious software

• phishing expeditions

Security Measures

• encryption

• firewalls

Cash Receipts Over the Counter

-point of sale terminals

-receipt: proof of purchase

-sales associate turns in cash drawer

• cash is deposited

-accounting dept. reconciles sales per terminal to cash in drawer

Cash Receipts: Point-of-Sale Terminals

• provide control over cash receipts

• record sale, cost of item sold, reduction of inventory

• effective inventory control