Financial Accounting Midterm

1. The Accounting Equation (A = L + SE) and Financial Statements

• Assets (A) = What the company owns (cash, inventory, equipment).

• Liabilities (L) = What the company owes (loans, accounts payable).

• Stockholders’ Equity (SE) = Owner’s claim on the company (common stock + retained earnings).

• Transactions always affect at least two accounts while keeping the equation balanced.

• Relationship between financial statements:

  • Income Statement → Calculates net income (Revenue - Expenses).

  • Statement of Retained Earnings → Begins with previous retained earnings, adds net income, subtracts dividends.

  • Balance Sheet → Shows financial position using A = L + SE, where retained earnings from the previous statement show up in SE.

2. Classified Balance Sheet, Multistep Income Statement, and Statement of Retained Earnings

• Classified Balance Sheet: Separates assets and liabilities into current (short-term) and non-current (long-term).

• Multistep Income Statement: Breaks down revenue and expenses into multiple sections (Gross Profit, Operating Income, Net Income).

• Statement of Retained Earnings: Reports retained earnings over time:
  Beginning RE + Net Income – Dividends = Ending RE

• Statement of Cash Flows: You don’t need to prepare this but should understand:

  • Operating Activities: Day-to-day transactions (sales, expenses).

  • Investing Activities: Buying/selling assets.

  • Financing Activities: Borrowing/repaying debt, issuing stock.

3. Fundamental Accounting Assumptions

• Revenue Recognition Principle: Revenue is recorded when earned, not when cash is received.

• Expense Recognition (Matching) Principle: Expenses are recorded when incurred, not when paid.

• Historical Cost Principle: Assets are recorded at the price paid, not current market value.

• Monetary Unit Assumption: Only transactions in a stable currency are recorded.

• Time Period Assumption: Financial reports are prepared at regular intervals (monthly, quarterly, yearly).

4. Debit and Credit Framework

• Debits (Left side of T-Accounts):

  • Increase Assets, Expenses, Dividends.

  • Decrease Liabilities, Revenue, Stockholders’ Equity.

• Credits (Right side of T-Accounts):

  • Increase Liabilities, Revenue, Stockholders’ Equity.

  • Decrease Assets, Expenses, Dividends.

• Example Journal Entry: Paying rent ($500) with cash

  • Rent Expense (Dr.) 500

  • Cash (Cr.) 500

5. Posting Journal Entries and Trial Balance

• After journal entries are made, they are posted to the general ledger (T-accounts).

• Trial Balance: A list of all accounts to check if debits = credits before preparing financial statements.

6. Accrual Accounting and Adjusting Entries

• Accrual Accounting: Recognizes revenue and expenses when they happen, not when cash is exchanged.

• Adjusting Entries: Used at the end of the period to ensure accurate reporting.

  • Accrued Revenues (earned but not received):

    • Accounts Receivable (Dr.)

    • Revenue (Cr.)

  • Accrued Expenses (incurred but not paid):

    • Expense (Dr.)

    • Accounts Payable (Cr.)

  • Depreciation:

    • Depreciation Expense (Dr.)

    • Accumulated Depreciation (Cr.)

  • Unearned Revenue (Deferred Revenue):

    • Cash (Dr.)

    • Unearned Revenue (Cr.) (initially)

    • Unearned Revenue (Dr.)

    • Revenue (Cr.) (when earned)

7. Closing Process

• At the end of the period, temporary accounts (revenues, expenses, dividends) are closed to retained earnings.

• Steps:

  1. Close revenues (debit revenue, credit income summary).

  2. Close expenses (credit expenses, debit income summary).

  3. Close income summary (debit if net income, credit retained earnings).

  4. Close dividends (credit dividends, debit retained earnings).

8. Journal Entries for Perpetual Inventory

• Purchases:

  • Inventory (Dr.)

  • Accounts Payable (Cr.)

• Sales:

  • Accounts Receivable (Dr.)

  • Sales Revenue (Cr.)

  • Cost of Goods Sold (Dr.)

  • Inventory (Cr.)

• Returns:

  • Sales Returns & Allowances (Dr.)

  • Accounts Receivable (Cr.)

  • Inventory (Dr.)

  • Cost of Goods Sold (Cr.)

9. Credit Terms and Purchase Discounts

• Example: "2/10, n/30"

  • "2/10" → 2% discount if paid within 10 days.

  • "n/30" → Full amount due in 30 days.

• Journal Entry for Purchase with Discount:

  • Accounts Payable (Dr.) Full Amount

  • Cash (Cr.) Discounted Amount

  • Inventory (Cr.) Discount Amount

10. Cost of Goods Sold (COGS) and Gross Profit

• COGS Formula:
  Beginning Inventory + Purchases – Ending Inventory = COGS

• Gross Profit Formula:
  Revenue – COGS = Gross Profit