Accounting

Chapter 2 & 3 - Comprehensive Accounting Cycle Problem

These chapters cover the entire accounting cycle, which includes recording financial transactions, adjusting entries, preparing financial statements, and closing the books. The following steps will guide you through these processes.

1. Journal Entries

What to know: You must be able to recognize and record various transactions in the general journal. Journal entries are used to record the financial effects of business transactions. Each entry will typically involve at least one debit and one credit.

Key Concepts:

  • Debits: Increase assets, decrease liabilities and equity.

  • Credits: Decrease assets, increase liabilities and equity.

Example:

  • Purchase of inventory:
    Inventory (debit) 10,000
    Accounts Payable (credit) 10,000

2. T-Accounts

T-accounts are used to visualize the effects of transactions on individual accounts. For each journal entry, record the corresponding amounts in T-accounts to keep track of the balances.

How to Set Up:

  • Draw a "T" for each account.

  • Record the debits on the left and credits on the right.

Example:
For the journal entry above:

  • Inventory T-account:

    • Debit 10,000 (left side)

  • Accounts Payable T-account:

    • Credit 10,000 (right side)

3. Adjusting Entries

What to know: Adjusting entries are necessary at the end of an accounting period to bring accounts up to date before preparing financial statements. Common adjustments include accruals, deferrals, depreciation, and allowances for uncollectible accounts.

Example: Adjusting for prepaid expenses:

  • Prepaid insurance is originally recorded as an asset, but as time passes, part of it is used up.
    Insurance Expense (debit) 500
    Prepaid Insurance (credit) 500

4. Closing Entries

What to know: After the accounting period ends, closing entries are made to transfer balances from temporary accounts (revenues, expenses) to permanent accounts (retained earnings).

Steps:

  1. Close revenues to Income Summary:

    • Debit revenue accounts and credit Income Summary.

  2. Close expenses to Income Summary:

    • Credit expense accounts and debit Income Summary.

  3. Close Income Summary to Retained Earnings:

    • The balance in Income Summary is transferred to Retained Earnings.

  4. Close dividends to Retained Earnings:

    • Debit Retained Earnings and credit Dividends.

Example:

  • Closing revenue:
    Service Revenue (debit) 5,000
    Income Summary (credit) 5,000

5. Preparing Financial Statements

The core financial statements prepared after journalizing, adjusting, and closing entries are:

Balance Sheet

The balance sheet shows the company’s assets, liabilities, and equity at a specific point in time. It must balance, meaning assets = liabilities + equity.

Format:

  • Assets (Current Assets + Non-Current Assets)

  • Liabilities (Current Liabilities + Long-Term Liabilities)

  • Equity (Common Stock, Retained Earnings)

Example:
Assets = 100,000
Liabilities = 50,000
Equity = 50,000 (Assets = Liabilities + Equity)

Income Statement

The income statement summarizes a company’s revenues, expenses, and profits over a period.

Format:

  • Revenues: Total income from sales of goods or services.

  • Expenses: Costs incurred to generate revenue.

  • Net Income: Revenue - Expenses.

Example:
Revenue = 10,000
Expenses = 7,000
Net Income = 3,000

Statement of Retained Earnings

This statement shows changes in retained earnings over a period.

Format:
Beginning Retained Earnings + Net Income - Dividends = Ending Retained Earnings

Example:
Beginning Retained Earnings = 20,000
Net Income = 3,000
Dividends = 1,000
Ending Retained Earnings = 22,000

Chapter 10 - Stock Issuance, Treasury Stock, Dividends

1. Journal Entries for Issuance of Stock

Issuing Common Stock:

  • When stock is issued at par value:
    Cash (debit) Amount
    Common Stock (credit) Par Value

  • When issued above par (at premium):
    Cash (debit) Amount
    Common Stock (credit) Par Value
    Additional Paid-In Capital (credit) Premium

2. Journal Entries for Treasury Stock

  • When treasury stock is purchased:
    Treasury Stock (debit) Amount Paid
    Cash (credit) Amount Paid

  • When treasury stock is resold:
    Cash (debit) Amount Received
    Treasury Stock (credit) Cost of Stock

    • If sold for more than cost:
      Additional Paid-In Capital (credit) Excess

3. Journal Entries for Dividends

  • For cash dividends:
    Retained Earnings (debit) Dividend Amount
    Cash (credit) Dividend Amount

  • For stock dividends:
    Retained Earnings (debit) Market Value
    Common Stock (credit) Par Value
    Additional Paid-In Capital (credit) Excess

Chapter 11 - Cash Flow Statements (Direct and Indirect Methods)

Direct Method

  • Operating Activities: Cash inflows and outflows from operating activities
    Receipts
    Payment
    net cash

  • Investing Activities: Cash inflows and outflows related to long-term assets (purchase/sale of property, equipment, investments).

  • Financing Activities: Cash inflows and outflows related to debt and equity (issuing stock, repaying debt).

Indirect Method

Starts with Net Income and adjusts for:
net income
adjustments
adjusted net income

  • Non-cash expenses (e.g., depreciation, amortization)

  • Changes in working capital accounts (e.g., accounts receivable, inventory)

  • Gains or losses on asset sales.

  1. Non-cash items: Depreciation, Amortization, Gains/Losses on sales of assets.

  2. Changes in working capital accounts: Accounts Receivable, Accounts Payable, Inventory.

Operating Activities Example:
Net Income = 10,000
Add: Depreciation = 2,000
Add: Decrease in Accounts Receivable = 1,000
Net Cash from Operating Activities = 13,000

Chapter 12 - Financial Ratios and Analysis

Key Ratios and What They Tell You:

  1. Current Ratio:
    Current Ratio = Current Assets / Current Liabilities

    • Measures the ability to pay short-term obligations.

  2. Inventory Turnover:
    Inventory Turnover = COGS / Average Inventory

    • Shows how many times inventory is sold and replaced during a period.

  3. Days Inventory Outstanding:
    DIO = 365 / Inventory Turnover

    • Measures how many days inventory sits before being sold.

  4. Accounts Receivable Turnover:
    Receivables Turnover = Net Credit Sales / Average Accounts Receivable

    • Measures how efficiently receivables are collected.

  5. Debt Ratio:
    Debt Ratio = Total Liabilities / Total Assets

    • Indicates the proportion of assets financed by debt.

  6. Times-Interest-Earned Ratio:
    TIE = EBIT / Interest Expense

    • Measures the ability to cover interest payments with operating income.

  7. Return on Assets (ROA):
    ROA = Net Income / Total Assets

    • Shows how well assets are used to generate profit.

  8. Return on Equity (ROE):
    ROE = Net Income / Shareholder's Equity

    • Measures profitability relative to shareholders' equity.