ACC 340 Shields Chapter 2 – Accounting Basics (Vocabulary Flashcards)
This chapter provides a comprehensive overview of core accounting concepts, detailing the systematic flow of financial information throughout an organization, and highlighting the critical interrelationships among the primary financial statements. Key topics covered include the fundamental principles of debits and credits, the sequential steps of the accounting cycle, the purpose and execution of adjusting and closing entries, and the methodologies for converting between accrual and cash basis accounting.
The Accounting Equation and Financial Statements
The fundamental accounting equation, ext{Assets} = ext{Liabilities} + ext{Shareholders' Equity}, represents the core relationship that must always hold true among a company's resources, obligations, and owners' claims. It is a snapshot of the company's financial position at a specific point in time, as presented in the Balance Sheet.
Financial statements are integral to understanding a company's financial health and performance:
Balance Sheet: Presents a company's assets, liabilities, and shareholders' equity at a specific point in time, reflecting the accounting equation.
Income Statement: Reports a company's revenues, expenses, and net income (or loss) over a period of time, showing profitability.
Statement of Retained Earnings: Explains changes in retained earnings over a period, linking net income (from the Income Statement) and dividends to the ending retained earnings balance.
Statement of Cash Flows: Details cash inflows and outflows from operating, investing, and financing activities over a period, providing insights into liquidity.
These statements are highly interdependent: Net Income from the Income Statement flows into the Statement of Retained Earnings; the ending balance of Retained Earnings then flows into the Shareholders' Equity section of the Balance Sheet. The ending cash balance from the Statement of Cash Flows must reconcile with the cash balance on the Balance Sheet.
Key Terminology
Permanent (Real) Accounts: These accounts are never closed at the end of an accounting period. Their balances carry forward to the next period. Examples include all Balance Sheet accounts such as Assets (e.g., Cash, Accounts Receivable, Equipment), Liabilities (e.g., Accounts Payable, Notes Payable), and Equity (e.g., Common Stock, Retained Earnings).
Temporary (Nominal) Accounts: These accounts are closed at the end of each accounting period to the Retained Earnings account, resetting their balances to zero for the start of the new period. They include Income Statement accounts (e.g., Revenues, Expenses) and the Dividends account, allowing for the measurement of performance for a specific period.
Adjunct Accounts: These accounts increase the book value of a primary balance sheet account. For instance, Freight-In is an adjunct to Purchases, increasing the cost of inventory.
Contra Accounts: These accounts reduce the book value of a related primary account. Examples include Allowance for Doubtful Accounts (which reduces Accounts Receivable) and Accumulated Depreciation (which reduces the book value of an asset like Equipment).
Debit (DR): Traditionally recorded on the left side of a T-account. Debits increase Asset and Expense accounts and decrease Liability, Equity, and Revenue accounts.
Credit (CR): Traditionally recorded on the right side of a T-account. Credits increase Liability, Equity, and Revenue accounts and decrease Asset and Expense accounts. Understanding the normal balance (the side where increases are recorded) for each account type is essential.
Bookkeeping Essentials: Debits and Credits
All financial transactions adhere to the double-entry accounting system, meaning every transaction affects at least two accounts, with total debits always equaling total credits. This ensures the accounting equation remains in balance.
The expanded accounting equation, ext{Assets} = ext{Liabilities} + ext{Stock} + ext{Retained Earnings} + ext{Revenues} - ext{Expenses}, helps illustrate the debit/credit rules. Assets and Expenses typically have debit balances, while Liabilities, Stock, Retained Earnings, and Revenues typically have credit balances.
The Accounting Cycle
This systematic, twelve-step process ensures all financial transactions are properly identified, recorded, and summarized to prepare accurate financial statements:
Analyze Transactions: Identify and analyze source documents.
Journal Entries: Record financial transactions chronologically in the General Journal.
Posting to the General Ledger: Transfer journal entry information to individual T-accounts in the General Ledger.
Prepare an Unadjusted Trial Balance: List all account balances to verify total debits equal total credits.
Make Adjusting Entries: Record unrecorded revenues earned and expenses incurred during the period (deferrals and accruals).
Prepare an Adjusted Trial Balance: List all account balances after adjusting entries have been posted.
Prepare Financial Statements: Generate the Income Statement, Statement of Retained Earnings, and Balance Sheet from the adjusted trial balance.
Make Closing Entries: Zero out temporary accounts (revenues, expenses, dividends) and transfer their balances to Retained Earnings.
Prepare a Post-Closing Trial Balance: List only permanent accounts to ensure debits equal credits after closing entries.
Reverse Entries (Optional): If desired, reverse certain adjusting entries to simplify subsequent period recordings.
Converting from Accrual to Cash Basis (Direct Method)
This conversion method is primarily used to prepare the operating activities section of the Statement of Cash Flows. It directly converts accrual-basis revenues and expenses into cash receipts and cash payments. This is achieved by adjusting accrual figures for changes in related balance sheet accounts:
Cash Receipts from Customers: Start with Sales Revenue (accrual) and adjust for changes in Accounts Receivable (subtract increase, add decrease).
Cash Paid for COGS/Purchases: Start with Cost of Goods Sold and adjust for changes in Inventory (add increase, subtract decrease) and Accounts Payable (subtract increase, add decrease).
Cash Paid for Operating Expenses: Start with individual operating expenses and adjust for related Prepaid Expenses (subtract increase, add decrease) and Accrued Liabilities (add increase, subtract decrease).
Converting Cash Basis to Accrual Basis
This process involves making necessary year-end accrual adjustments to transform financial records initially kept on a cash basis into formal accrual financial statements. This is crucial for compliance with GAAP/IFRS and for providing a more accurate picture of a company's financial performance. Adjustments typically include:
Recording accounts receivable for revenue earned but not yet received in cash.
Recording accounts payable for expenses incurred but not yet paid in cash.
Adjusting prepaid expenses (e.g., insurance, rent) to reflect the portion consumed during the period.
Adjusting unearned revenues (e.g., customer deposits) to reflect the portion earned during the period.
Accounting for inventory movements to determine Cost of Goods Sold.
Reversing Entries
Reversing entries are optional general journal entries made at the beginning of a new accounting period, after closing entries have been posted. Their primary purpose is to simplify the recording of subsequent period transactions, particularly for recurring accruals (e.g., accrued salaries, accrued interest revenue) and deferrals (e.g., prepaid expenses, unearned revenue that were initially recorded as expenses/revenues).
By reversing an adjusting entry, the accounting system effectively sets up the accounts to automatically record the cash transaction in the normal manner during the next period, without requiring an offsetting adjustment.
Key Formulas and Concepts to Remember
Accrual Basis Accounting: Recognizes revenues when they are earned (when goods are delivered or services are rendered), regardless of when cash is received. Expenses are recognized when they are incurred (when resources are used to generate revenue), regardless of when cash is paid. This method provides a more accurate view of a company's financial performance over a period.
Cash Basis Accounting: Recognizes revenues only when cash is received and expenses only when cash is paid. This method is simpler but does not always match revenues and expenses to the period in which they economic activity occurred, making it less suitable for complex businesses or external reporting.
Adjusting Entries: These are critical for ensuring financial statements adhere to the accrual basis of accounting and the matching principle. They are categorized as:
Deferrals: Cash has already flowed, but the related revenue has not yet been earned or the expense has not yet been incurred (e.g., Prepaid Expenses, Unearned Revenues).
Accruals: The event has been recognized, but cash has not yet flowed (e.g., Accrued Expenses like salaries payable, Accrued Revenues like interest receivable).
Common Depreciation Methods allocate the cost of a tangible asset over its useful life:
Straight-Line Depreciation: Allocates an equal amount of depreciation expense to each period over the asset's useful life. The formula is rac{( ext{Cost} - ext{Residual Value})}{ ext{Useful Life}}.
Double-Declining Balance Depreciation: An accelerated depreciation method that allocates a larger amount of depreciation expense in the earlier years of an asset's life and smaller amounts in later years. The rate is double the straight-line rate applied to the asset's book value (not cost less residual value).
These concepts and their proper application are vital for preparing accurate, reliable, and compliant financial statements that provide meaningful insights into an entity's economic activities.