Comprehensive Guide to Accounting Cycle, GAAP, and Financial Statements

What is the primary role of accounting in a business?

To analyze economic activities for their impact on the accounting equation and record the results in the company's books.

What are the five steps in the accounting cycle?

1) Analyze 2) Record 3) Adjust 4) Report 5) Close

What constitutes an accounting transaction?

An economic event that affects any elements of the accounting equation and can be expressed in monetary terms.

What is the accounting equation?

Assets = Liabilities + Shareholders' Equity.

What is the significance of double-entry accounting?

Every accounting transaction impacts at least two elements of the accounting equation, ensuring it remains balanced.

What are the components of Shareholders' Equity in the expanded accounting equation?

Common Stock, Retained Earnings, Revenues, Expenses, and Dividends Paid.

What is the purpose of preparing financial statements?

To provide management with financial data for decision-making and to report to external parties.

What happens to the accounting equation when a transaction occurs?

It must remain in balance after each transaction.

What type of asset is created when Mike's Bikes prepays rent?

A prepaid asset.

How does purchasing inventory on account affect the accounting equation?

It increases assets (inventory) and increases liabilities (accounts payable).

What is the effect of obtaining a bank loan on the accounting equation?

It increases assets (cash) and increases liabilities (note payable).

What is the significance of retained earnings in the accounting equation?

Retained earnings represent the accumulated profits of the company that have not been distributed as dividends.

What is the relationship between revenues, expenses, and dividends in the context of shareholders' equity?

Revenues increase shareholders' equity, while expenses and dividends decrease it.

What does the term 'common stock' refer to in the accounting equation?

It represents the equity stake of the shareholders in the company.

What is the role of adjusting entries in the accounting cycle?

To ensure that the financial statements reflect the true financial position of the company at the end of the accounting period.

What is recorded when Mike hires a part-time employee at $1,000 per month?

Nothing is recorded until the employee is paid.

What is the purpose of T-Accounts in accounting?

To record increases and decreases in specific asset, liability, or shareholders' equity items.

What do the terms DEBIT and CREDIT refer to in accounting?

DEBIT refers to the left side of an account, and CREDIT refers to the right side.

How do assets behave in terms of debits and credits?

Assets increase with debits and decrease with credits.

How do liabilities and shareholders' equity behave in terms of debits and credits?

Liabilities and shareholders' equity increase with credits and decrease with debits.

What is the normal balance of an asset account?

Asset accounts normally have debit balances.

What is the normal balance of a liability or shareholders' equity account?

Liability and shareholders' equity accounts normally have credit balances.

How do revenue accounts affect retained earnings?

Revenue accounts increase retained earnings and increase with credit entries.

How do expense accounts affect retained earnings?

Expense accounts decrease retained earnings and increase with debit entries.

What is the effect of a $15,000 expense on the accounting equation?

It decreases assets and decreases retained earnings.

What is the significance of the $12,000 cash sale in December?

It increases cash and revenues, impacting retained earnings positively.

What happens to retained earnings when expenses are recorded?

Retained earnings decrease when expenses are recorded.

What is the role of prepaid assets in accounting?

Prepaid assets represent payments made in advance for goods or services to be received in the future.

What are the components of shareholders' equity?

Shareholders' equity includes common stock and retained earnings.

What is the relationship between revenues and expenses in accounting?

Revenues increase earnings while expenses decrease earnings.

What is the effect of a debit entry on an expense account?

A debit entry increases the expense account.

What is the effect of a credit entry on a revenue account?

A credit entry increases the revenue account.

What are dividends in accounting?

Distributions of retained earnings (R/E) to shareholders, having the opposite pattern of R/E.

What are the three components of a T-account?

1) Account title (e.g., Cash), 2) Amounts reflecting increases and decreases, 3) Cross-references to other accounting records.

What is the purpose of a journal in accounting?

To record all accounting transactions in chronological order using debits and credits.

How does a general ledger differ from a general journal?

A general ledger organizes transactions by account, while a general journal records them in chronological order.

What is the process of transferring information from the general journal to the general ledger called?

Posting.

What information is included when posting a journal entry to the general ledger?

1) Date, 2) Account titles affected, 3) Dollar amounts, 4) An explanation.

What is a trial balance?

A listing of all accounts from the general ledger with their respective debit or credit balances, prepared at the end of an accounting period.

What must be true about the debit and credit columns in a trial balance?

They must balance, meaning the total of the debit column equals the total of the credit column.

What is the significance of the trial balance in financial reporting?

It is used to prepare the financial statements.

What is the first step in the accounting cycle?

Analyze.

What does purchasing supplies on account involve?

An increase in assets and an increase in liabilities.

What is the correct journal entry for recording cash payment for wage expense?

A credit to cash and a debit to wage expense.

When is a trial balance prepared?

At the end of an accounting period after all transactions have been recorded.

What is the purpose of the general ledger?

To facilitate the preparation of the company's financial statements by organizing transactions by account.

What does the term 'retained earnings' refer to?

The cumulative amount of net income retained in the company rather than distributed as dividends.

What is the role of source documents in accounting?

To analyze and determine the accounts affected and the amounts involved in transactions.

What does a journal entry represent?

An accounting transaction that includes debits and credits to appropriate accounts.

What is the significance of the account titles in a journal entry?

They indicate which accounts are affected by the transaction.

How are transactions recorded in a journal?

In terms of debits and credits, recorded in chronological order.

What is the explanation included in a journal entry?

A brief description of the transaction being recorded.

What are the components of Mike's Bikes unadjusted trial balance?

Cash, Merchandise inventory, Prepaid rent, Equipment, Accounts payable, Notes payable, Common stock, Sales revenue, Wages expense.

What does the term 'debit' mean in accounting?

An entry on the left side of an account that increases assets or expenses and decreases liabilities or equity.

What does the term 'credit' mean in accounting?

An entry on the right side of an account that decreases assets or expenses and increases liabilities or equity.

What accounting basis is required by Generally Accepted Accounting Principles (GAAP)?

Accrual basis accounting.

How does accrual basis accounting differ from cash basis accounting?

Accrual basis accounting measures and reports transactions without requiring cash to be received or paid.

What are the two primary principles of accrual basis accounting?

Revenue recognition and expense recognition (matching principle).

What is the first step in the revenue recognition process?

Identify the contract with the customer.

What is the final step in the revenue recognition process?

Recognize revenue at the point the performance obligations have been satisfied.

When is sales revenue typically recognized in a business?

At the time that goods and services are delivered to the customer.

What accounting entries are made when revenue is earned and cash is received?

Debit Cash and credit Sales Revenue.

What accounting entries are made when revenue is earned before cash is received?

Debit Cash and credit Accounts Receivable.

What accounting entries are made when revenue is earned after cash is received?

Debit Cash and credit Unearned Revenue.

What does the matching principle require regarding expenses?

Expenses incurred to generate revenues must be recognized in the same period as the revenues.

How can the recognition of expenses occur in relation to cash payment?

Expenses can be recognized prior to, simultaneously with, or subsequent to the payment of cash.

What happens if an expense is incurred but not paid?

A liability is recorded for the amount owed.

What is the purpose of adjusting entries in the accounting cycle?

To bring unadjusted accounts to their proper balance at the end of each reporting period.

In the example of Mike's Bikes, what adjustment must be made for prepaid rent at the end of December?

The prepaid rent account should reflect only the remaining 11 months that are prepaid.

What is the third step of the accounting cycle?

Adjusting.

What is the effect on the accounting equation when prepaid rent is recorded?

Assets increase by the amount of prepaid rent.

What type of account is prepaid rent classified as?

An asset.

What must a company do when preparing financial statements regarding account balances?

Review account balances and make necessary end-of-period adjustments.

What is the significance of recognizing expenses in the same period as revenues?

It ensures that the income statement accurately reflects the company's financial performance.

What is the relationship between incurred expenses and cash payments in accrual accounting?

Incurred expenses do not necessarily mean that cash has been paid.

What is the role of performance obligations in revenue recognition?

They define the promises made in the contract that must be satisfied to recognize revenue.

What does GAAP stand for?

Generally Accepted Accounting Principles.

What are the four types of accounting adjustments made at the end of an accounting period?

Deferrals and Accruals.

What are deferrals in accounting?

Deferrals are adjustments where cash is received or paid before revenue is earned or an expense is incurred.

What is a prepaid expense?

A prepaid expense is an asset that represents payment made for expenses that will be incurred in the future, such as prepaid rent.

What is unearned revenue?

Unearned revenue is money received for goods or services that have not yet been delivered or performed.

What are accruals in accounting?

Accruals are adjustments where cash is received or paid after revenue is earned or an expense is incurred.

What is an accrued expense?

An accrued expense is an expense that has been incurred but not yet paid or recorded, such as wages owed to employees.

What is accrued revenue?

Accrued revenue is revenue that has been earned but not yet received or recorded, such as interest on a loan.

What is the purpose of adjusting entries for prepaid expenses?

To allocate previously recorded assets to expenses to reflect the proper expenses incurred during the period.

How is the adjustment for prepaid rent recorded?

Debit Rent Expense and credit Prepaid Rent to record the rent expense for the month used.

What is the monthly depreciation expense for equipment purchased at $15,000 with a useful life of five years?

$250 per month, calculated as $15,000 divided by 60 months.

How is interest expense recorded for a loan?

Debit Interest Expense and credit Interest Payable to record interest owed for the month.

What adjustment is made when a sale is made on account but payment is received later?

Debit Accounts Receivable and credit Sales Revenue to record the sale.

What is the significance of an unadjusted trial balance?

It shows the balances of all accounts before any adjustments are made at the end of the accounting period.

What entry is made to adjust for the use of inventory in sales?

Debit Cost of Goods Sold and credit Inventory to reflect the amount of inventory used.

What does the adjustment for accrued expenses reflect?

It reflects operating expenses that have not yet been paid or recorded during the period.

What does the adjustment for accrued revenues reflect?

It reflects revenues that have not yet been received or recorded during the period.

What is the total amount of prepaid rent for Mike's Bikes for one year?

$6,000, which is $500 per month.

What is the total interest expense for a $20,000 loan at 6% annual interest for one month?

$100, calculated as $20,000 x 0.06 x 1/12.

What is the purpose of adjusting entries for unearned revenues?

To allocate previously recorded unearned revenue to revenue to reflect revenue earned during the period.

What is the impact of recording depreciation expense on financial statements?

It reduces the book value of the asset and reflects the expense on the income statement.

What does the term 'adjustment' refer to in accounting?

Adjustments are entries made at the end of an accounting period to update account balances.

What is the purpose of an Adjusted Trial Balance?

To prepare financial statements after end-of-period adjustments are made.

What accounts are included in Mike's Bikes Unadjusted Trial Balance as of December 31, 2020?

Cash, Merchandise inventory, Prepaid rent, Equipment, Accounts payable, Notes payable, Common stock, Sales revenue, Wages expense.