Accounting 1; Exam 1 ~ Chapters 1, 2, 3, 4

Forms of business organization

Sole proprietorship, partnership, and corporation

Sole proprietorship

- A business owned by 1 person

- Simple to set up

- Owner controlled

- Tax advantages (no double taxation)

- Entity does not pay tax; owner does

- No limit on liability

Partnership

- A business owned by 2 or more persons

- Simple to establish

- Shared control

- Tax advantages

- Broader skills and resources

- Entity does not pay tax; owners do

- Should be formalized in a written partnership agreement

Corporation

- Business organized as a separate legal entity owned by stockholders

- Easier to transfer ownership

+ Shares of stock are easy to sell (transfer

ownership), so buying stock is more attractive

than investing

- Easier to raise funds

+ Individuals can become stockholders by

investing relatively small amounts of money

- Many businesses start as sole proprietorships and partnerships, and then incorporate

- Corporate stockholders generally pay higher taxes, but they have no personal legal liability

Accounting

The information system that identifies, records, and communicates the economic events of an organization to interested users

Internal users

- Managers who plan, organize, and run a business

- Include marketing managers, production supervisors, finance directors, and company officers

- Must answer many important questions in order to run the business --> Need detailed information on a timely basis

External users

- Include

+ Investors (use accounting information to make

decisions regarding stock)

+ Creditors (suppliers and bankers use

accounting info to evaluate the risks of selling

on credit or lending money)

Sarbanes-Oxley Act (SOX)

Passed to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals

Effects:

- Top management must now certify the accuracy of financial information

- Penalties for fraudulent financial activity are more severe

- Increased both the independence of the outside auditors who review the accuracy of corporate financial statements and increased the oversight role of boards of directors

Accounting information system

Keeps track of the results of 3 business activities

--> Financing activities, investing activities, and operating activities

The system of collecting and processing transaction data and communicating financial information to decision makers

Factors that shape this:

The nature of the company's business, the types of transactions, the size of the company, the volume of data, and the information demands of management and others

Financing activities

- 2 primary sources of outside funds for corporations are borrowing money (debt financing) and issuing/selling shares of stock in exchange for cash (equity financing)

- To borrow money, the corporation can take out a loan at a bank, or it can borrow directly from investors by issuing debt securities called bonds

Creditors

Persons or entities to whom a corporation owes money

Liabilities

Amounts owed to creditors (in the form of debt and other obligations)

Note payable

A written promissory note.

A borrower obtains a specific amount of money from a lender and promises to pay it back with interest over a predetermined time period.

Bonds payable

Debt securities sold to investors that must be repaid at a particular date some years in the future.

Common stock

The total amount paid in by stockholders for the shares they purchase.

Difference between creditors and stockholders

- If you lend money to a company, you are one of its creditors

+ Creditors specify a payment schedule

+ Creditors have a legal right to be paid at the

agreed time

+ In the event of nonpayment, creditors can

legally force the company to sell property to

pay its debts

+ In the case of financial difficulty, creditor

claims must be paid before stockholders'

claims

- Stockholders

+ Have no claim to corporate cash until the

claims of creditors are satisfied

+ Payments usually made to stockholders on a

regular basis as long as there is enough cash

to cover required payments to creditors

Dividends

Cash payments to stockholders

Investing activities

Involve the purchase of the resources a company needs in order to operate

Assets

Resources owned by a business

Cash is one of the more important assets

+ If a company has excess cash that it does not

need for a while, it might choose to invest in

securities (stocks or bonds) of other

corporations

Operating activities

Operations.

Includes review of revenues, supplies (assets), expenses, inventory (assets).

Supplies

Assets used in day-to-day operations

Inventory

Goods available for future sales to customers

(also assets)

Expenses

Costs necessary to produce and sell the product.

The cost of assets consumed or services used in the process of generating revenues.

Cost of goods sold

Expenses

Accumulated total of all costs used to create a product or service, which has been sold.

Includes cost of materials.

Accounts payable

Obligations to pay for goods that have been purchased on credit from suppliers

Accounting principles

International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) are similar, but also have some differences.

Income statement

- Used to show how successfully your business performed during a period of time

- Reports a company's revenues and expenses and resulting net income or loss for a period of time

- Investors are interested in a company's past net income because it provides useful information for predicting future net income (they buy and sell stock based on their beliefs about a company's future performances)

- Creditors use the income statement to predict future earnings

- Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses, so therefore these are not included in the income statement

*Helps users determine if the company's operations are profitable

Retained earnings statement

- Used to indicate how much of a previous income was distributed to you and the other owners of your business in the form of dividends, and how much was retained in the business to allow for future growth

- Shows the amounts and causes of changes in retained earnings for a specific time period (same time period as that of the income statement)

- Company adds net income and deducts dividends to determine the retained earnings at the end of the period (deducts if net loss)

- By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices

- Lenders monitor their corporate customers' dividend payments because any money paid in dividends reduces a company's ability to repay its debts

*Helps users determine the company's policy toward dividends and growth

Balance sheet

- Used to present a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities)

- Reports assets and claims to assets at a specific point in time

- The owner's claim to assets is called stockholders' equity

- Assets = liabilities + stockholders' equity

- Stockholders' equity comprised of common stock and retained earnings

- Creditors analyze a company's balance sheet to determine the likelihood that they will be repaid

- Also used to evaluate the relationship between debt and stockholders' equity to determine whether the company has a satisfactory proportion of debt and common stock financing

*Helps users determine if the company relies on debt or stockholders' equity to finance its assets

Statement of cash flows

- Used to show where your business obtained cash during a period of time and how that cash was used

- To provide financial information about the cash receipts and cash payments of a business for a specific period of time

- Answers these important questions

+ Where did the cash come from during the

period?

+ How was cash used during the period?

+ What was the change in the cash balance

during the period?

(Separated into operating activities, financial activities, and investing activities)

*Helps users determine if the company generates enough cash from operations to fund its investing activities

Accounting equation

Assets = liabilities + stockholders' equity

The accounting equation must always balance.

Used to determine if an accounting transaction has occurred.

Classified balance sheet

Groups together similar assets and similar liabilities, using a number of standard classifications and sections

-generally contains classifications such as current assets, current liabilities, long-term investments, long-term liabilities, property plant and equipment, stockholders' equity, and intangible assets

-helps determine if a company has enough assets to pay its debts, and the claims of short and long term creditors on the company's total assets

Current assets

-Assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer (accounts receivable are current assets)

*usually 1 year

Operating cycle

The average time required to go from cash to cash in producing revenue - to purchase inventory, sell it on account, and collect cash from customers

Long-term investments

3 things:

- investments in stocks and bonds of other corporations that are held for more than 1 year

-long-term assets such as land or buildings that a company is not currently using in its operating activities

-long-term notes receivable

Property, plant, and equipment

Assets with relatively long useful lives that are currently used in operating the business

Includes land, buildings, equipment, delivery vehicles, and furniture

LAND --> BUILDINGS --> EQUIPMENT

Keep in mind of depreciation of these assets

Depreciation

The allocation of the cost of an asset to a number of years

Companies do this by systematically assigning a portion of an asset's cost as an expense each year (rather than expensing the full purchase price in the year of purchase).

Accumulated depreciation shows the total amount of depreciation that the company has expensed thus far in the asset's life.

Intangible assets

Assets that do not have physical substance, but are still often very valuable.

Includes goodwill, patents, copyrights, and trademarks

Keep in mind of amortization of these assets

Amortization

The process of allocating the cost of an intangible asset over a period of time

Current liabilities

Obligations that the company is to pay within the next year or operating cycle, whichever is longer

Includes accounts payable, salaries and wages payable, notes payable, interest payable, and income taxes payable

Also includes current maturities of long term obligations (refers to the portion of a company's long term liabilities that are coming due in the next 12 months)

Long-term liabilities

Obligations that a company expects to pay after one year

Includes bonds payable, mortgages payable, long-term notes payable, lease liabilities, and pension liabilities

Stockholders' equity

Consists of common stock and retained earnings

Companies record as common stock the investments of assets into the business by stockholders.

Companies record as retained earnings the income retained for use in the business.

Ratio analysis

Expresses the relationship among selected items of financial statement data

Profitability ratios

Measure the income or operating success of a company for a given period of time

Liquidity ratios

Measure short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash

Solvency ratios

Measure the ability of the company to survive over a long period of time

Intracompany comparisons

Covering 2 years for the same company

Industry-average comparisons

Based on average ratios for particular industries

Intercompany comparisons

Based on comparisons with a competitor in the same industry

Earnings per share (EPS)

Measures the net income earned on each share of common stock

Earnings per share = (net income - preferred dividends) / (weight average common shares outstanding)

By comparing earnings per share of a single company over time, we can evaluate its relative earnings performance from the perspective of a stockholder; on a share basis.

EPS helps users compare a company's performance with that of previous years.

*Using the income statement and measuring profitability

Working capital

The difference between the amounts of current assets and current liabilities

Working capital = current assets - current liabilities

Positive working capital means there is a greater likelihood the company will pay its liabilities.

*Using a classified balance sheet and measure liquidity

Current ratio

Computed as current assets / current liabilities

Potential weakness: doesn't take into account the composition of the current assets

Helps users determine if a company can meet its near-term obligations

*Using a classified balance sheet and a more dependable indicator of liquidity than working capital

Debt to assets ratio

Measures the percentage of total financing provided by creditors rather than stockholders

Debt to assets ratio = (total liabilities / total assets)

The higher the percentage of debt financing, the riskier the company

Helps users determine if a company can meet its long-term obligations

*Using a classified balance sheet and measuring solvency

Free cash flow

Describes the net cash provided by operating activities after adjusting for capital expenditures and dividends paid

Free cash flow = (net cash provided by operating activities) - (capital expenditures) - (cash dividends)

Companies can use free cash flow to purchase new assets to expand the business, pay off debts, or increase its dividend distribution

*Using the statement of cash flows

Generally accepted accounting principles (GAAP)

A set of accounting standards that have substantial authoritative support and which guide accounting professionals

Qualities of useful information

Relevance

- materiality (whether an item is large enough to likely influence the decision of an investor or creditor) is a company-specific aspect of relevance

Faithful representation

- information must be complete, neutral, and free from error

Enhancing qualities

Comparability: when different companies use the same accounting principles

Consistency: a company uses the same accounting principles and methods from year to year

Verifiable: if independent observers, using the same methods, obtain similar results

Understandability: information is presented in a clear and concise fashion

Timeliness: in time for the information to be relevant

Assumptions in financial reporting

Monetary unit assumption

Economic entity assumption: every economic entity can be separately identified and accounted for

Periodicity assumption: the life of a business can be divided into artificial time periods and that useful reports covering those periods can be prepared for the business

Going concern assumption: the business will remain in operation for the foreseeable future

Principles in financial reporting

Historical cost principle: companies record assets at their cost

Fair value principle: Assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability) (don't need to memorize this)

Full disclosure principle: Companies disclose all circumstances and events that would make a difference to financial statement users

Cost constraint principle

Accounting standard setters weigh the cost that companies will incur to provide the information against the benefit that financial statement users will gain from having the info available.

Types of accounts

Asset

Liability

Equity (common stock)

Revenue

Expense

Accounting transactions

Economic events that require recording because they affect assets, liabilities, or stockholders' equity

Something isn't a transaction until an exchange of goods has been made.

Transaction analysis

The process of identifying the specific effects of economic events on the account equation.

Each transaction has a dual (double-sided) effect on the equation.

Account

An individual accounting record of increases and decreases in a specific asset, liability, stockholders' equity, revenue, or expense item

Consists of 3 parts:

1) title of the account

2) a left or debit side

3) a right or credit side

---> forms a t-account

Debit

-Indicates the left side of an account

-Abbreviated as Dr.

Credit

-Indicates the right side of an account

-Abbreviated as Cr.

Debit balance

If the total debit amounts exceeds the credits

Credit balance

If the total credit amounts exceed the debits

Double-entry system

The two-sided effect of each transaction is recorded in appropriate accounts

Summary of debit/credit rules

See figure 3.16 in textbook

Assets = liabilities + common stock + retained earnings + revenues - expenses - dividends

Source document

Where the evidence of a transaction comes from, such as a sales slip, a check, a bill, or a cash register document

Journal

An accounting record in which transactions are initially recorded in chronological order

For each transaction, the journal shows the debit and credit effects on specific accounts.

3 significant contributions to the recording process:

1) It discloses in one place the complete effect of a transaction

2) It provides a chronological record of transactions

3) It helps to prevent or locate errors because the debit and credit amounts for each entry can be readily compared

Ledger

The group of accounts maintained by a company

Provides the balance in each of the accounts as well as keeps track of changes in these balances

Chart of accounts

A list of the company's accounts

Posting

The procedure of transferring journal entry amounts to the ledger accounts

Trial balance

Lists accounts and their balances at a given time

A company usually prepares a trial balance at the end of an accounting period.

Accounts are listed in the order in which they appear in the ledger.

Proves the mathematical equality of debits and credits after posting

May uncover errors in journalizing and posting

Limitations in the trial balance

A trial balance may balance even when the following occurs:

- A transaction is not journalized

- A correct journal entry is not posted

- A journal entry is posted twice

- Incorrect accounts are used in journalizing or posting

- Offsetting errors are made in recording the amount of a transaction

Fiscal year

An accounting time period that is one year long

Revenue recognition principle

Companies recognize revenue in the accounting period in which the performance obligation is satisfied.

Expense recognition principle

Dictates that efforts (expenses) be matched with results (revenues)

Tied to revenue recognition principle

Accrual based accounting

Transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged.

Cash based accounting

Companies record revenue at the time they receive cash

Record expense at the time they pay out cash

Often produces misleading financial statements

Not in accordance with GAAP

Adjusting entries

Ensure that the revenue recognition and expense recognition principles are followed

Necessary because trial balance may not contain up to date and complete data

Required every time a company prepares financial statements

Every entry will include one income statement account and one balance sheet account

Have no effect on cash flows

Types of adjusting entries

Deferrals

1. Prepaid expenses

2. Unearned revenues

Accruals

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded

Prepaid expenses

Expenses paid in cash before they are used or consumed

When expenses are prepaid, an asset account is increased to show the service or benefit that the company will receive in the future.

Costs that expire either with the passage of time (rent and insurance) or through use (supplies)

- Expiration of these costs do not require daily entry.

- Companies postpone the recognition of such cost expirations until they prepare financial statements.

+ At each statement date, they make adjusting

entries to record the expenses applicable to

the current accounting period and to show the

remaining amounts in the asset accounts.

Supplies expense

Companies recognize supplies expense at the end of the accounting period, which is when the company counts the remaining supplies.

Type of prepaid expense

Insurance

At the financial statement date, companies increase (debit) Insurance Expense and decrease (credit) Prepaid Expense for the cost of insurance that has expired during the period.

Type of prepaid expense

Depreciation expense

An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period to report the unused cost (an asset) at the end of the period.

The purpose of depreciation is not valuation, but a means of cost allocation.

Type of prepaid expense

Useful life

The length of service of a productive asset

Contra-asset account

An account that is offset against an asset account on the balance sheet

Ex: accumulated depreciation - building

Book value

The difference between the cost of any depreciable asset and its related accumulated depreciation

Unearned revenue

Cash received and a liability recorded before services are performed

Accrued revenues

Revenues for services performed but not yet recorded at the statement date

May accumulate (accrue) with the passing of time, as in the case of interest revenue

- Interest revenue is unrecorded because the earning of interest does not involve daily transactions

An adjusting entry for accrued revenues results in an increase (a debit) to an asset account and an increase (a credit) to a revenue account

Accrued expenses

Expenses incurred but not yet paid or recorded at the statement date

Ex. Salaries expense

Make adjustments for accrued expenses to record the obligations that exist at the balance sheet date and to recognize the expenses that apply to the current accounting period

An adjusting entry for accrued expenses results in an increase (debit) to an expense account and an increase (credit) to a liability account

Types of accrued expenses

Accrued interest

- Face value x annual interest rate x time in terms of one year = interest

Accrued salaries

-Employee salaries and wages paid after the services have been performed

Summary of basic relationships of deferrals and accruals

See illustration 4.23

Adjusted trial balance

A list of accounts and their balances after all adjustments have been made

Used to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments

The primary basis for the preparation of financial statements

Earnings management

The planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income

Quality of earnings

Indicates the level of full and transparent information that a company provides to users of its financial statements

Companies manage earnings by

- using one time items to prop up earnings numbers

- inflating revenue numbers in the short run to the detriment of the long run

- improper adjusting entries

Temporary accounts

Revenue, expenses, and dividend accounts whose balances a company transfers to retained earnings at the end of an account period