Financial Accounting - Exam 2

periodicity assumption

accounting divides the economic life of a business into artificial time periods (monthly, quarterly, annually)

fiscal year

accounting time period that is one year

performance obligation

when a company agrees to perform a service or sell a product to a customer

revenue recognition principle

principle that companies recognize revenue in the accounting period in which the performance obligation is satisfied

5 step revenue recognition process

1. identify the contract with customers
2. identify the separate performance obligations in the contract
3. determine the transaction price
4. allocate the transaction price to the separate performance obligations
5. recognize revenue when each performance obligation is satisfied

expense recognition principle

principle that dictates the efforts (expenses) be recognized with results (revenues) in the period when the company makes efforts to generate those revenues; requires that companies recognize expenses in the period in which they make efforts (consumer assets or incur liabilities) to generate revenue

GAAP

revenue and expense recognition are in accordance with?

accrual-basis accounting

accounting basis in which transactions that change a company’s financial statement are recorded in the periods in which the events occur, even if cash was not exchanged; follows the revenue and expense recognition principles

cash-basis accounting

accounting basis in which companies record revenue only at the time they receive cash and record an expense only at the time they pay out cash; often produce misleading financial statements

adjusting entries

entries made to ensure that the revenue recognition and expense recognition principles are followed; entries are made at the end of an accounting period

deferrals

expenses or revenues that are recognized at a date later than the point when cash was originally exchanged

prepaid expenses

expenses paid in cash before they are used or consumed; costs that expire either with the passage of time or through use; examples include insurance, supplies, rent,

results in a debt to an expense account and credit to an asset

what is the adjusting entry for prepaid expenses?

assets are overstated and expenses are understated

what will happen when a business does not record adjusting entries for prepaid expenses?

depreciation

process of allocating the cost of an asset to expense over its useful life

not valuation but a means of cost allocation

what is the purpose of depreciation?

straight line depreciation

(cost - estimated salvage) / estimated life

useful life

length of service of a productive asset (buildings, equipment, vehicles)

contra asset

accumulated depreciation is what type of account?

contra asset account

an account that is offset against an asset account on the balance sheet; keeps track of the total amount of depreciation expense taken over the life of the asset

credit

what is the normal balance of a contra asset account?

book value

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

unearned revenue

cash received before services are performed and recorded by crediting the liability; liability account used to recognize the obligation that exists

results in a debit to a liability account and credit to a revenue account

what is the adjusting entry for unearned revenues?

liabilities are overstated and revenues are understated

what will happen when a business does not record adjusting entries for unearned revenue?

accruals

expenses or revenues that are recognized at a date earlier than the point when cash is exchanged

accrued revenue

revenues for services performed but not yet received in cash or recorded

results in a debit to an asset account and credit to a revenue account

what is the adjusting entry for accrued revenues?

assets are understated and revenues are understated

what will happen when a business does not record adjusting entries for accrued revenue?

accrued expenses

expenses incurred but not yet paid or recorded at the statement date; records the obligations that exist at the balance sheet date and recognize the expenses that apply to the current accounting period

results in a debt to an expense account and credit to a liability account

what is the adjusting entry for accrued expenses?

expenses are understated and liabilities are understated

what will happen when a business does not record adjusting entries for accrued expenses?

interest expense equation

principal x rate x time

adjusted trial balance

a list of accounts and their balances after all adjustments have been made; purpose is to prove the equality of the total debit balances and the total credit balances; primary basis for the preparation of financial statements

earnings management

planned timing of revenues, expenses, gains, and losses to reduce volatility in reported net income

quality of earnings

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

high quality of earnings

when a company provides full and transparent information that will not confuse or mislead financial statement users

questionable quality of earnings

when a company misleads investors or creditors, who believe they are relying on relevant information that provides a faithful representation of the company

temporary/nominal accounts

revenue, expense, and dividend accounts whose balances a company transfers to Retained Earnings at the end of an accounting period

permanent/real accounts

balance sheet accounts whose balances are carried forward to the next account period; include all asset, liability, and stockholders’ equity accounts

closing entries

entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders’ equity account, Retained Earnings

zero

closing entries produce balances of what in each temporary account?

income summary

a temporary account used in closing revenue and expense accounts; balance is the net income or loss for the accounting period which is then transferred to Retained Earnings

post-closing trial balance

a list of permanent accounts and their balances after a company has journalized and posted closing entries; purpose is to prove the equality of the total debit balances and total credit balances of the permanent account balance

merchandising companies

buying and selling merchandise rather than perform services as their primary source of revenue

retailers

merchandising companies that purchase and sell directly to consumers

wholesalers

merchandising companies that sell to retailers

sales revenue (sales)

primary source of revenue for merchandising companies through sales merchandise

cost of goods sold

total cost of merchandise sold during the period; this expense is directly related to the revenue recognized from the sale of goods

operating expenses

expenses incurred in the process of earning sales revenue; expenses used to run a business

gross profit

the excess of net sales over the cost of goods sold

gross profit equation

* sales revenue - cost of goods sold
* net sales - cost of goods sold

merchandising

cost of goods sold and gross profit are unique to what companies?

inventory

merchandise that companies buy and sell to customers; reported as a current asset on the balance sheet

cost of goods available for sale equation

beginning inventory + cost of goods purchased

ending inventory

goods that are not sold by the end of the accounting period

cost of goods sold equation

* cost of goods available for sale - ending inventory
* beginning inventory + cost of goods purchased - ending inventory

two systems to account for cost of inventory

* perpetual inventory system
* periodic inventory system

perpetual inventory system

a detailed inventory system in which a company maintains the cost of each inventory item and records continuously show the inventory that should be on hand; company determines the cost of goods sold each time a sale occurs

larger companies

which companies typically use a perpetual inventory system? larger or smaller?

periodic system

an inventory system in which a company does NOT maintain detailed inventory records of goods on hand throughout the period and determines the cost of goods sold only at the end of the accounting period; companies take a physical inventory count

smaller

which companies typically use the periodic system? larger or smaller?

purchase invoice

documentation that your company bought inventory; provides support for each credit purchase

transaction entry for the buyer purchasing inventory on account from the seller

inventory is debited and accounts payable is credited

freight terms

an agreement that indicates who is responsible for paying the freight charges (shipping costs) and who is responsible for the risk of loss or damage to the merchandise during transport

transaction entry when the buyer incurs the transportation costs (pays for the shipping)

inventory is debited and cash is credited

transaction entry when the seller incurs the freight costs

freight-out (delivery expense) is debited and cash is credited

purchase return

a return of goods from the buyer to the seller for a cash refund if the purchase was for cash or credit if the sale was made on credit

purchase allowance

a deduction made to the selling price of merchandise, granted by the seller, so that the buyer will keep the merchandise

transaction entry when the buyer returns goods that were purchased on credit to the seller

accounts payable is debited and inventory is credited

transaction entry when the buyer decides to keep the goods when the seller provides an allowance

accounts payable will be debited and inventory is credited for the amount of the allowance

purchase discount

a cash discount claimed by a buyer for prompt payment of a balance due

credit terms

specify the amount of the cash discount and time period in which it is offered; indicates the time period in which the purchaser is expected to pay the full invoice if the discount is not taken

the buyer may take a 2% cash discount on the invoice price if payment is made within 10 days of the invoice date; otherwise, the invoice price is due 30 days from the invoice date

if credit terms in the sales invoice are 2/10, n/30, what does that mean?

transaction entry when the buyer gets a cash discount on the invoice price

accounts payable is debited by the original balance owed, inventory is credited by the discount amount, and cash is credited for the amount that is paid after the discount

business document

documentation that supports every sales transaction to provide written evidence of the sale

sales invoice

document that provides support for each credit sale; shows the date of sale, customer name, total sale price, etc.

transaction entry for the seller to record a sale being made

* record revenue: cash is debited (or accounts receivable if sale is on credit) and sales revenue is credited
* record expense: cost of goods sold is debited and inventory is credit (now there is less in inventory)

sales returns and allowances

transactions in which the seller either accepts good back from the purchaser (a return) or grants a reduction in the purchase price (allowance) so the buyer will keep the goods

transaction entry for the seller to record returned goods

* debit to sales returns and allowances and credit to accounts receivable for the selling price to the buyer
* debit to inventory and credit cost of goods for the price of how much each item was to buy for the seller

transaction entry for the seller if the buyer returns an item but the seller grants an allowance

debit to sales returns and allowance and credit to accounts receivable (no impact on inventory or cost of goods because nothing was returned to the seller)

contra revenue account

an account that is offset against a revenue account on the income statement

contra revenue account

sales returns and allowances and sales discounts is an example of what type of account?

sales discount

a reduction given by the seller for prompt payment of a credit sale

transaction entry for the seller for a sales discount

* cash is debited by the new balance (original price - discount)
* sales discount is debited by the discount price (original price x discount percent)
* accounts receivable is credited by the original price

transaction entry for the seller if the buyer does not take the sales discount

debit cash and credit accounts receivable for the original price

single-step income statement

only one step, subtracting total expenses from total revenue, is required in determining net income or net loss

multiple-step income statement

highlights three important components throughout the income statement

net sales equation

sales revenue - (sales returns and allowances + sales discounts)

income from operations equation

gross profit - operating expenses

net income/loss equation

* income from operations +/- nonoperating activities
* gross profit - operating expenses

nonoperating activities

consist of various revenue and expenses and gains and losses that are unrelated to the company’s main line of operations; non a part of the day to day operations of the business

income before income taxes equation

income from operations +/- net amount resulting from other revenues and gains and other expenses and losses

income tax expense equations

income before income taxes x company’s corporate income tax rate

net income of taxes equation

income before income taxes - income tax expense

gross profit rate equation

gross profit/net sales

profit margin

measures the percentage of each dollar of sales that results in net income

profit margin equation

net income/net sales (revenue)

manufacturers

companies who make the products

merchandisers

companies who buy products from manufacturers to sell to customers