Accounting 201 - Finanical Accounting

Chapter 1 — Accounting in Action

Learning Objectives

  • Explain what accounting is and why it is important.

  • Identify users and uses of accounting information.

  • Describe the business types and forms of organization.

  • Explain the basic accounting equation.

  • Analyze business transactions using the accounting equation.

  • Understand financial statements and how they are interrelated.

1. The Role of Accounting

  • Definition: Accounting is the process of identifying, recording, and communicating the economic events of an organization to interested users.

  • Purpose: To provide financial information that is useful for decision-making.

  • Steps in the Accounting Process:

    1. Identify economic events relevant to the business.

    2. Record those events systematically.

    3. Communicate the results to users through financial statements.

2. Users of Accounting Information

  • Internal Users:

    • Management: Responsible for planning, organizing, and controlling operations.

    • Employees: Use information to evaluate company performance and job stability.

  • External Users:

    • Investors: Assess profitability and value of the organization.

    • Creditors: Evaluate liquidity and creditworthiness.

    • Regulatory agencies, tax authorities, customers also rely on accounting information.

3. Business Types and Organizational Forms

  • Business Activities:

    1. Financing Activities: Involves borrowing and owner investments in the business.

    2. Investing Activities: Involves purchasing resources (assets) necessary for operations.

    3. Operating Activities: Generating revenue and incurring expenses in order to conduct business operations.

  • Forms of Business Organization:

    1. Sole Proprietorship:

      • One owner

      • Simple structure

      • Personal liability for the owner.

    2. Partnership:

      • Two or more owners

      • Shared control and risk associated with the business.

    3. Corporation:

      • Separate legal entity

      • Limited liability for owners

      • Ownership can be easily transferred.

4. The Basic Accounting Equation

  • Accounting Equation:
    ext{Assets} = ext{Liabilities} + ext{Owner’s Equity}

  • Definitions:

    • Assets: Resources owned by the business (e.g., cash, equipment, supplies).

    • Liabilities: Debts or obligations the business owes (e.g., accounts payable, notes payable).

    • Owner’s Equity: The residual interest of the owner(s) after all liabilities have been settled.

  • Expanded Equation (for Proprietorship):
    ext{Assets} = ext{Liabilities} + ext{Owner’s Capital} - ext{Owner’s Drawings} + ext{Revenues} - ext{Expenses}

5. Business Transactions and Their Effect

  • Transaction: Any economic event affecting the accounting equation.

  • Each transaction must keep the equation in balance.

  • Examples of Transactions and Their Effects:

    • Owner invests cash: ext{↑ Assets, ↑ Owner’s Capital}

    • Purchase supplies on account: ext{↑ Assets, ↑ Liabilities}

    • Provide services for cash: ext{↑ Assets, ↑ Revenues}

    • Pay rent: ext{↓ Assets, ↑ Expenses}

6. Financial Statements

  • Types of Financial Statements:

    1. Income Statement:

    • Reports revenues and expenses for a specific period.

    • Determines net income or net loss for the period.

    1. Owner’s Equity Statement:

    • Shows changes in the owner’s capital over the period.

    • Format:
      ext{Beginning Capital} + ext{Investments} + ext{Net Income} - ext{Drawings} = ext{Ending Capital}

    1. Balance Sheet:

      • Reports assets, liabilities, and owner’s equity at a specific point in time.

      • Confirms the accounting equation is in balance.

    2. Statement of Cash Flows:

      • Summarizes cash inflows and outflows from operating, investing, and financing activities.

  • Interrelationship of Financial Statements:

    • Net income from the income statement is added to owner's equity.

    • Ending capital from the owner's equity statement appears on the balance sheet.

    • Ending cash balance on the cash flow statement matches the balance sheet cash account.

Key Terms

  • Accounting: An information system that captures and processes financial information for decision-making.

  • Liabilities: Claims by creditors on the organization’s assets.

  • Owner’s Equity: Owner's claim on the organization’s assets.

  • Revenues: Increases in owner’s equity resulting from services rendered or goods sold.

  • Expenses: Decreases in owner's equity due to costs incurred in generating revenues.

  • Drawings: Withdrawals by the owner which reduce equity.

Chapter 2 — The Recording Process

Learning Objectives

  • Explain how accounts, debits, and credits are used in accounting.

  • Describe the steps involved in the recording process.

  • Prepare a trial balance.

1. The Account

  • Definition: An account is a record summarizing all increases and decreases in a specific asset, liability, or equity item.

  • Components of an Account:

    1. Title of the account.

    2. Left side (debit) - records increases in assets, expenses, and drawings.

    3. Right side (credit) - records increases in liabilities, owner's capital, and revenues.

  • Debits and Credits:

    • Debit (Dr): Left side, used to increase assets, expenses, and drawings.

    • Credit (Cr): Right side, used to increase liabilities, owner's capital, and revenues.

2. The Double-Entry System

  • Every transaction affects at least two accounts, demonstrating the dual effect of accounting entries.

  • The fundamental rule is that total debits must equal total credits for each transaction, maintaining the balance of the accounting equation.

  • Account Type Normal Balances:

    • Assets: Debit

    • Liabilities: Credit

    • Owner’s Capital: Credit

    • Owner’s Drawings: Debit

    • Revenues: Credit

    • Expenses: Debit

3. The Recording Process

  • Steps Involved in the Recording Process:

    1. Analyze each transaction to determine its impact on the accounting equation.

    2. Enter the transaction in the journal (a chronological record of all transactions).

    3. Post entries to the ledger (collection of accounts).

  • Example of a Journal Entry:

Cash .................... 10,000  
      Owner’s Capital .................... 10,000

  • Ledger: Contains all accounts used by the business, providing details on the balances of individual accounts.

  • Chart of Accounts: A listing of all accounts used by a company to organize financial information.

4. The Trial Balance

  • Definition: A trial balance is a listing of all accounts and their balances at a given time.

  • Purpose of Trial Balance: It is used primarily to ensure that total debits equal total credits in the accounting records, helping to verify the accuracy of the recorded transactions.

  • Limitation: While a trial balance can detect some errors (e.g., mathematical errors), it may not catch others, such as omitted entries or double postings.

Chapter 3 — Adjusting the Accounts

Learning Objectives

  • Explain the concept of accrual accounting and the revenue recognition principle.

  • Identify the major types of adjusting entries.

  • Prepare an adjusted trial balance and financial statements.

1. The Accrual Basis of Accounting

  • Revenue Recognition Principle: Revenues are recognized when earned, regardless of when cash is received.

  • Expense Recognition Principle (Matching): Expenses are recognized in the same period as the revenues they helped generate.

  • Accrual Accounting recognizes transactions when they occur, not when cash changes hands.

2. Types of Adjusting Entries

  1. Prepaid Expenses:

    • Expenses paid in advance (e.g., rent, insurance, supplies).

    • Adjusting entry transfers the cost from an asset to an expense account.

    • Example Entry:

   Rent Expense  ...... XXX  
   Prepaid Rent  .............. XXX

  1. Unearned Revenues:

    • Cash received before services are performed.

    • Adjusting entry recognizes revenue upon service performance.

    • Example Entry:

   Unearned Revenue  .... XXX  
   Revenue  ....................... XXX

  1. Accrued Revenues:

    • Revenues earned but not yet recorded.

    • Example Entry:

   Accounts Receivable  ... XXX  
   Service Revenue  ............. XXX

  1. Accrued Expenses:

    • Expenses incurred but not paid by the end of the accounting period.

    • Example Entry:

   Salaries Expense  ... XXX  
   Salaries Payable  ............. XXX

  1. Depreciation:

    • Allocation of the cost of a long-term asset over its useful life.

    • Example Entry:

   Depreciation Expense  ...... XXX  
   Accumulated Depreciation  ...... XXX

3. Adjusted Trial Balance

  • Definition: An adjusted trial balance is prepared after all adjusting entries are journalized and posted.

  • Purpose: It serves as the basis for the preparation of the financial statements, ensuring accuracy post-adjustments.

Chapter 4 — Completing the Accounting Cycle

Learning Objectives

  • Prepare closing entries.

  • Prepare a post-closing trial balance.

  • Describe the classified balance sheet.

1. Closing the Books

  • Temporary Accounts: These include revenues, expenses, and drawings, which are closed at the end of the accounting period to prepare for the next period.

  • Permanent Accounts: These include assets, liabilities, and owner’s capital, which are not closed.

  • Steps in Closing Entries:

    1. Close Revenues → Income Summary

    2. Close Expenses → Income Summary

    3. Close Income Summary → Owner’s Capital

    4. Close Drawings → Owner’s Capital

2. Post-Closing Trial Balance

  • Definition: A post-closing trial balance is prepared after all closing entries are recorded.

  • Contents: It lists only permanent accounts to ensure that debits equal credits at the beginning of the next accounting period.

3. Classified Balance Sheet

  • Definition: A classified balance sheet groups assets and liabilities into meaningful categories to provide enhanced clarity.

  • Categories of the Classified Balance Sheet:

    • Assets:

    • Current Assets

    • Long-term Investments

    • Property/Plant/Equipment

    • Intangible Assets

    • Liabilities:

    • Current Liabilities

    • Long-term Liabilities

    • Owner’s Equity:

    • Capital account

Chapter 5 — Accounting for Merchandising Operations

Learning Objectives

  • Explain merchandising operations and inventory systems.

  • Record purchase and sale of merchandise.

  • Prepare income statements for a merchandiser.

1. Merchandising vs. Service Business

  • Definition of Merchandisers: Merchandisers are entities that buy and sell goods.

  • Accounts for Merchandisers:

    • Have inventory and cost of goods sold (COGS) accounts, which are used to track merchandise.

  • Formula for Net Income:
    ext{Net Income} = ext{Sales} - ext{COGS} - ext{Operating Expenses}

2. Inventory Systems

  • Perpetual System:

    • Maintains a continuous record of inventory and COGS in real-time.

  • Periodic System:

    • COGS is computed at the end of the accounting period.

  • COGS Calculation:
    ext{COGS} = ext{Beginning Inventory} + ext{Purchases} - ext{Ending Inventory}

3. Recording Transactions

  • Purchases:

  Inventory  ............ XXX  
  Accounts Payable  ............ XXX

  • Sales (requires two entries):

  Accounts Receivable  ..... XXX  
  Sales Revenue  ................... XXX  
  Cost of Goods Sold  ........ XXX  
  Inventory  ............................... XXX

4. Financial Statements

  • Multiple-Step Income Statement:

    • This format shows gross profit and operating income separately.

  • Gross Profit Calculation:
    ext{Gross Profit} = ext{Net Sales} - ext{COGS}

Chapter 6 — Inventories

Learning Objectives

  • Explain inventory valuation methods.

  • Compute and analyze cost flow assumptions.

1. Inventory Costing Methods

  1. Specific Identification:

    • Tracks each item individually.

  2. FIFO (First-In, First-Out):

    • Assumes earliest goods purchased are the first sold.

  3. LIFO (Last-In, First-Out):

    • Assumes latest goods purchased are the first sold.

  4. Average-Cost:

    • Determines a weighted average cost per unit.

2. Lower-of-Cost-or-Net Realizable Value (LCNRV)

  • Definition: Inventory must be reported at the lower of its cost or its expected selling price to reflect true market value.

3. Inventory Management and Analysis

  • Inventory Turnover Ratio:
    ext{Inventory Turnover} = rac{ ext{COGS}}{ ext{Average Inventory}}

  • Days in Inventory:
    ext{Days in Inventory} = rac{365}{ ext{Inventory Turnover}}

Chapter 7 — Fraud, Internal Control, and Cash

Learning Objectives

  • Understand fraud and the Sarbanes–Oxley Act (SOX).

  • Explain principles of internal control.

  • Apply internal control to cash management.

  • Prepare bank reconciliation.

1. Fraud and Internal Control

  • Definition of Fraud:

    • An intentional act to mislead or deceive for personal gain.

  • Fraud Triangle Components:

    • Opportunity, Financial Pressure, Rationalization.

  • Sarbanes–Oxley Act (SOX):

    • Established stronger corporate governance practices and requires management to certify financial statements.

2. Principles of Internal Control

  1. Establishment of Responsibility:

    • Assign specific responsibilities to employees to enhance accountability.

  2. Segregation of Duties:

    • Separate responsibilities for authorization, record keeping, and custody.

  3. Documentation Procedures:

    • Use prenumbered documents and timely recording to ensure accuracy.

  4. Physical Controls:

    • Use safes, passwords, security alarms, and locks to protect assets.

  5. Independent Internal Verification:

    • Regular reviews and examinations performed by individuals independent of the operations.

  6. Human Resource Controls:

    • Implement background checks, bonding, and mandatory vacations to reduce fraud risk.

3. Cash Controls

  • Cash Receipts Controls:

    • Controls for over-the-counter cash receipts and mail receipts.

  • Cash Disbursements Controls:

    • Utilize checks, preapproval processes, and proper documentation for cash disbursements.

4. Bank Reconciliation

  • Purpose:

    • Reconcile the bank statement balance with the company’s cash balance to ensure accuracy and detect discrepancies.

  • Reconciling Items:

    • Include deposits in transit, outstanding checks, bank errors, and company errors to adjust balances.

    • The adjusted balance on both sides should match.

Chapter 8 — Accounting for Receivables

Learning Objectives

  • Identify types of receivables.

  • Explain accounting for uncollectible accounts.

  • Compute interest on notes receivable.

1. Types of Receivables

  • Accounts Receivable: Amounts owed by customers for goods or services rendered.

  • Notes Receivable: Written promises to pay a specified amount with interest.

  • Other Receivables: Include interest receivable, advances, etc.

2. Uncollectible Accounts

  • Direct Write-Off Method:
    Example Entry:

  Bad Debt Expense  ........ XXX  
  Accounts Receivable  ........ XXX

  • Note: This method is not GAAP compliant.

    • Allowance Method (GAAP):

  • Estimate uncollectible accounts in advance.
    Example Entry:

  Bad Debt Expense  ................. XXX  
  Allowance for Doubtful Accounts  ..... XXX

  • To write off uncollectible accounts:

  Allowance for Doubtful Accounts  ..... XXX  
  Accounts Receivable  ...................... XXX

3. Notes Receivable

  • Interest Calculation Formula:
    ext{Interest} = ext{Principal} imes ext{Rate} imes ext{Time}

  • Maturity Value:
    ext{Maturity Value} = ext{Principal} + ext{Interest}

Chapter 9 — Plant Assets, Natural Resources, and Intangible Assets

Learning Objectives

  • Identify the cost of plant assets.

  • Compute depreciation for those assets.

  • Account for natural resources and intangible assets.

1. Plant Assets

  • Definition: Physical assets used in operations (e.g., land, buildings, equipment).

  • Cost Calculation:

    • Includes the purchase price and any expenditures necessary to prepare the asset for use in operations.

2. Depreciation

  • Purpose:

    • To allocate the cost of an asset over its useful life to reflect the consumption of its economic benefits.

  • Depreciation Methods:

    1. Straight-Line Method:
      ext{Depreciation Expense} = rac{ ext{Cost} - ext{Salvage Value}}{ ext{Useful Life}}

    2. Declining Balance Method:

    • An accelerated depreciation method that results in higher depreciation expenses in the early years of asset usage.

    1. Units-of-Activity Method:

    • Depreciation based on output or usage of the asset.

3. Disposal of Plant Assets

  • Steps for Disposal:

    1. Update the depreciation amounts as of the disposal date.

    2. Remove the asset and its accumulated depreciation from the records.

    3. Recognize any gain or loss from the disposal.

4. Natural Resources

  • Examples: Natural resources include oil, timber, and minerals.

  • Depletion:

    • The allocation of cost to expense over time for natural resources extracted or harvested.

5. Intangible Assets

  • Definition: Intangible assets have no physical substance (e.g., patents, copyrights, trademarks, goodwill).

  • Amortization:

    • The systematic write-off of the cost of intangible assets over their useful lives.

Chapter 10 — Liabilities

Learning Objectives

  • Define current and long-term liabilities.

  • Account for notes payable and payroll.

  • Describe bonds payable.

1. Current Liabilities

  • Definition: Liabilities that are due within one year or the operating cycle of the business.

  • Examples:

    • Accounts payable

    • Notes payable

    • Unearned revenues

    • Payroll taxes

  • Interest Calculation for Notes Payable:
    ext{Interest} = ext{Face Value} imes ext{Rate} imes ext{Time}

2. Payroll Liabilities

  • Net Pay Calculation:
    ext{Gross Pay} - ext{Deductions} = ext{Net Pay}

  • Common Deductions Include:

    • FICA taxes

    • Income taxes

    • Health insurance premiums

  • Employer Payroll Taxes: Employers match FICA contributions and pay unemployment taxes.

3. Long-Term Liabilities

  • Definition: Obligations that are due beyond one year (e.g., bonds payable).

4. Bonds

  • Types of Bonds:

    • Secured vs. Unsecured

    • Term vs. Serial

    • Convertible or Callable Bonds

  • Bond Issuance: When bonds are issued they can be of varying values:

    • At Face Value, Discount, or Premium, depending on the existing market interest rates compared to the bond's stated interest rate.

  • Amortization Methods for Discounts or Premiums:

    • Straight-line method or effective interest method.

Chapter 11 — Corporations: Organization, Stock Transactions, and Stockholders’ Equity

Learning Objectives

  • Describe the characteristics of corporations.

  • Record stock transactions.

  • Explain dividends and retained earnings.

1. Characteristics of Corporations

  • Key Attributes:

    • Separate legal existence from owners.

    • Limited liability for shareholders.

    • Transferable ownership rights.

    • Continuous life that is not affected by changes in ownership.

    • Subject to double taxation (on corporate profits and on dividends).

2. Stockholders’ Equity

  • Components:

    • Paid-in Capital: Includes common and preferred stock.

    • Retained Earnings: Accumulated profits not distributed as dividends.

3. Stock Transactions

  • Example of Issuing Stock:

  Cash  ........... XXX  
  Common Stock  ........... XXX

  • Treasury Stock: Represents repurchased shares by the company, which reduces overall equity.

4. Dividends

  • Types of Dividends:

    • Cash Dividends: Declared, recorded, and paid to shareholders.

    • Stock Dividends: Distribution of additional shares to existing shareholders.

  • Key Dates Related to Dividends:

    1. Declaration Date

    2. Record Date

    3. Payment Date

  • Retained Earnings Statement Formula:
    ext{Beginning RE} + ext{Net Income} - ext{Dividends} = ext{Ending RE}

Chapter 12 — Statement of Cash Flows

Learning Objectives

  • Explain the purpose of the cash flow statement.

  • Classify cash flows into operating, investing, and financing activities.

  • Prepare a statement of cash flows using the indirect method.

1. Purpose of the Cash Flow Statement

  • Definition: This statement explains the sources and uses of cash within the organization.

  • Assessment Areas:

    • Ability to generate cash.

    • Capacity to pay dividends.

    • Need for financing.

2. Classification of Cash Flows

  1. Operating Activities:

    • Cash flows from day-to-day operations and adjustments related to net income.

  2. Investing Activities:

    • Cash flows from the purchase and sale of long-term assets or other investments.

  3. Financing Activities:

    • Cash flows from borrowing, issuing stock, or paying dividends.

3. Indirect Method (Most Common)

  • Starting Point: Begin with net income and adjust for additional factors including:

    • Noncash expenses (e.g., add back depreciation).

    • Gains and losses from investing activities.

    • Changes in current assets and liabilities.

4. Cash Flow Equation

  • Equation:
    ext{Net Increase (Decrease) in Cash} + ext{Beginning Cash} = ext{Ending Cash}

Chapter 13 — Financial Analysis: The Big Picture

Learning Objectives

  • Explain the purpose of financial statement analysis.

  • Use ratio analysis to evaluate performance metrics.

  • Understand the limitations of financial analysis.

1. Tools of Financial Analysis

  1. Horizontal Analysis:

    • Evaluates trends over multiple periods.

    • Calculation Formula:
      ext{Percentage Change} = rac{ ext{Current} - ext{Prior}}{ ext{Prior}} imes 100

  2. Vertical Analysis:

    • Shows each item as a percentage of a base figure (e.g., total assets or sales).

  3. Ratio Analysis:

    • Provides comparisons among various financial statement data to assess performance.

2. Types of Ratios**

  • Category:

  • Example Ratios:

  • Purpose:

    • Liquidity Ratios: Current Ratio, Quick Ratio; indicators of short-term financial health.

    • Solvency Ratios: Debt-to-Assets Ratio, Times Interest Earned; reflect long-term stability.

    • Profitability Ratios: Profit Margin, Return on Assets (ROA), Return on Equity (ROE); measure earnings performance.

3. Limitations of Financial Analysis

  • Financial comparisons may be affected by discrepancies arising from different accounting methods or estimates used.

  • No single ratio is conclusive on its own; a comprehensive analysis requires considering trends and benchmarks.