Intro to Financial Accounting Exam 1

Chapters 1-4

Accounting

Accounting identifies, records and communicates the economic events of an organization to interested users

Identify

Identify the economic events

Record

Economic events are recorded by keeping a chronological diary of events that also classifies and summarizes the events

Communicate

Collected information is shown to users through accounting reports

Internal users

Managers who plan, organize and run a business

External users

• Individuals and organizations outside a company who want financial information about the company 

  • Investors (owners) use accounting information to decide whether to buy, hold or sell ownership shares of a company 

  • Creditors (suppliers and bankers) use accounting information to evaluate the risks of granting credit or lending money 

Historical cost principle

This dictates that companies record assets at their cost.

• Under GAAP, companies generally use historical cost in their balance sheet 

• Objective and easy to verify 

Fair value principle

This states that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability).

Monetary unit assumption

This requires that companies include in the accounting records only transaction data that can be expressed in money terms.

Economic entity assumption

This requires that activities of the entity be kept separate and distinct from the activities of its owner and all other economic entities

Basic accounting equation

assets = liabilities + stockholders equity

Retained earnings

Revenues - expenses - dividends

Financial statements

• Income statement-presents revenues and expenses and resulting net income or net loss for a specific period

• Retained earnings statement-summarizes changes in retained earnings for a specific period of time

• Balance sheet-reports assets, liabilities and stockholders’ equity of a company at a specific date 

• Statement of cash flows-summarizes information about cash inflows and outflows for a specific period 

Income statement

Presents revenues and expenses and resulting net income or net loss for a specific period

Net income

Total revenue - total expenses

Retained earnings statement

• Reports the changes in retained earnings for a period of time

• Time period is the same as that covered by the income statement 

• Information provided by this statement indicates the reasons why retained earnings increased or decreased during the period 

Balance sheet

• Reports the assets, liabilities and stockholders’ equity at a specific date

• Lists assets at the top, followed by liabilities and stockholders’ equity

• Is a snapshot of the company’s financial condition at a specific moment in time (usually the month-end or year-end)

Statement of cash flows

• Provides financial information about the cash receipts and payments for a specific period of time

The recording process

The recording process

1. Analyze each transaction in terms of its effect on the accounts

2. Enter the transaction information in a journal

3. Transfer the journal information to the appropriate accounts in the ledger

Normal account is debited

Assets, expenses, dividends

Normal account is credited

Liability, common stock, retained earnings, revenues

Time period assumption

Economic life of business is divided into artificial time periods

Fiscal year

Accounting time period that is one year in length

Accrual based accounting

• Companies record transactions that change a company’s financial statements in the periods in which the events occur

  • Recognize revenues when companies perform services (rather than when they receive cash)

  • Recognize expenses when incurred (rather than paid)

Revenue recognition principle

• When a company agrees to perform a service or sell a product to a customer, it has performance obligation → when the company meets this performance obligation, it recognizes revenue

• Companies recognize revenue in the accounting period in which the performance obligation is satisfied/service is performed 

Expense recognition principle

• Matches expenses with revenues in the period when the company makes efforts to generate those revenues

• Let the expenses follow the revenues 

Prepaid expenses

Prepaid expenses (asset)

• Pay for something before you use it 

• Payment of expenses that will benefit more than one accounting period

• Cash payment before expenses record

• Examples-insurance, supplies, advertising, rent, buildings and equipment

Unearned revenue

Unearned revenues

• Receipt of cash that is recorded as a liability because the service has not been performed

• Cash received before revenue earned

• Examples-rent, airline tickets, magazine subscriptions, customer deposits

Accrued revenues

Accrued revenues

• Revenues for services performed but not yet received in cash or recorded

• Service performed before cash received

• Examples-rent, interest, services performed 

Accrued expenses

• Expenses incurred but not yet paid in cash or recorded

• Expenses recorded before cash payment 

• Examples-interest, taxes, salaries

Prepaid expenses accounts before adjustment

Assets overstated. Expenses understated

Unearned revenues accounts before adjustment

Liabilities overstated. Revenues understated

Accrued revenues accounts before adjustment

Assets understated. Revenues understated

Accrued expenses accounts before adjustment

Expenses understated. Liabilities understated

Qualities of useful information

Relevance and faithful representation

Faithful representation

• Information accurately depicts what really happened

• Information must be 

  • Complete (nothing important has been omitted)

  • Neutral (is not biased)

  • Free from error 

Enhancing qualities of useful information

• Comparability results when different companies use the same accounting principles 

• Information is verifiable if independent observers, using the same methods, obtain similar results

• Information has the quality of understandability if it is presented in a clear and concise fashion

• Consistency means that a company uses the same accounting principles and methods from year to year

• For accounting information to have relevance, it must be timely 

Relevance

• Make a difference in a business decision

• Provides information that has predictive value and confirmatory value 

• Materiality is a company specific aspect of relevance 

  • Item is material when its size makes it likely to influence the decision of an investor or creditor

Materiality

• Materiality is a company specific aspect of relevance 

  • Item is material when its size makes it likely to influence the decision of an investor or creditor

Comparability

This results when different companies use the same accounting principles

When is information verifiable?

If independent observers, using the same methods, obtain similar results

When does information have the quality of understandability?

If it is presented in a clear and concise fashion

Consistency

It means that a company uses the same accounting principles and methods from year to year

For accounting information to have relevance, it must be ________

timely

Monetary unit

Requires that only things that can be expressed in money are included in accounting records

Economic entity

States that every economic entity can be separately identified and accounted for

Going concern

Business will remain in operation for the foreseeable future

Historical cost vs fair value

Historical cost

• Dictates that companies record assets at their cost

Fair value

• Indicates that assets and liabilities should be reported at fair value (the price received to sell an asset or settle a liability)

Revenue recognition principle

Requires that 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

Full disclosure principle

Requires that companies disclose all circumstances and events that would make a difference to financial statement users

Cost constraint

Accounting standard-setters weigh the cost the cost that companies will incur to provide the information against the benefit that financial statements users will gain from having the information 

Sarbanes Oxley Act

Law that was passed in an effort to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals

Cash basis accounting

Reporting income when the cash is received and expenses when the cash is paid.

Not in line with GAAP

Accrual basis accounting

Reporting income when it is earned and expenses when they are incurred

Steps in the accounting cycle

1. Analyze business transactions

2. Journalize the transactions

3. Post to ledger accounts

4. Prepare a trial balance

5. Journalize and post adjusting entries

6. Prepare an adjusted trial balance

7. Prepare financial statements

8. Journalize and post closing entries

9. Prepare a post-closing trial balance

Current assets

Assets that a company expects to convert to cash or use up within one year or its operating cycle, whichever is longer

• Cash and cash equivalents

• Short term investments

• Accounts receivable

• Inventories

• Prepaid insurance/expenses

Long term investments

• Investments in stocks and bonds of other companies

• Investments in long-term assets such as land or buildings that are not currently being used in operating activities 

• Long term notes receivable 

Property, plant and equipment

• Sometimes called fixed assets or plant assets 

• Long useful lives

• Currently used in operations

• Depreciation-allocating the cost of assets to a number of years

• Accumulated depreciation-total amount of depreciation expenses thus far in the assets life 

Intangible assets

Long lived assets that do not have physical substance

Examples include:

• trademarks

• Goodwill

• FCC licenses

Current liabilities

Obligations the company is to pay within the coming year or its operating cycle, whichever is longer.

• Usually list notes payable first, followed by accounts payable

• Examples are accounts payable, salaries and wages payable, notes payable, interest payable, income taxes payable, and current maturities of long-term obligations.

Long term liabilities

Obligations a company expects to pay after one year

• bonds payable

• notes payable

• deferred income taxes and other

What things are closed to a zero balance and not on the post-closing balance?

Revenue accounts, expense accounts, dividends, and income statement

The proper order of steps in the accounting cycle is:

Journalize transactions, post to ledger accounts, prepare unadjusted trial balance, journalize and post adjusting entries

depreciable cost

cost - salvage value

formula for straight line method

cost - salvage value = depreciable cost —> depreciable cost/useful life = depreciation expense

formula for units of activity method

depreciable cost / total units of activity = depreciable cost per unit —> depreciable cost per unit x units of activity during the year = depreciation expense

formula for declining balance method

depreciation rate = 2 x straight line rate

book value = cost - accumulated depreciation

double declining balance depreciation rate x book value at beginning of 2023 = depreciation expense for 2023

book value at beginning of 2023 = equipment price - depreciation in 2022