Intermediate Accounting Chapter 2

Chapter 2: Review of the Accounting Process

The Basic Model

  • Economic events can be categorized into:

    • External events: Involve an exchange transaction with another entity.

    • Internal events: Do not involve an exchange transaction with another entity.

  • Both types of events cause changes in the financial position of the company.

The Accounting Equation

  • Underlies the processes used to capture the effect of economic events: The Accounting Equation

    • Accounting Equation:
      Assets= Liabilities + Owners’ Equity

    • Total Economic Resources are represented by assets.

    • Total Claims are represented by the sum of liabilities and owners' equity.

    • Each event or transaction has a dual effect on the accounting equation.

Accounting Transactions Examples

  1. Owner Investment

    • An attorney invested $50,000 to open a law office.

      • Assets= Liabilities + Shareholders’ Equity

      • +$50,000 (Assets) = Liabilities + $50,000 (Shareholders’ Equity/ Investment by owner)

      • An investment by the owner causes both assets and shareholders’ (owners’) equity to increase.

  2. Borrowing Money from the Bank

    • $40,000 was borrowed from a bank with a note payable signed.

    • Effect on Accounting Equation:

      • Increases in both assets (cash) and liabilities (notes payable).

      • +40,000ext(Cash=Assets)+40,000ext{(Cash=Assets)}

      • +40,000ext(NotesPayable=Liabilities)+40,000ext{(NotesPayable=Liabilities)}

  3. Supplies Purchased on Account

    • Supplies costing $3,000 purchased on credit.

    • Effect on Accounting Equation:

      • Increases in both assets (supplies) and liabilities (accounts payable).

      • +3,000ext(Supplies=Assets)+3,000ext{(Supplies=Assets)}

      • +3,000ext(AccountsPayable=Liabilities)+3,000ext{(AccountsPayable=Liabilities)}

  4. Services Performed on Account

    • Services were performed on account for $10,000.

    • Effect on Accounting Equation:

      • Increases in assets (accounts receivable) and shareholders' equity (revenue).

      • +10,000ext(AccountsReceivable=Assets)+10,000ext{(AccountsReceivable=Assets)}

      • +10,000ext(Revenue=Shareholders′Equity)+10,000ext{(Revenue=Shareholders^{\prime}Equity)}

  5. Salaries Paid to Employees

    • $5,000 was paid to employees.

    • Effect on Accounting Equation:

      • Decreases in assets (cash) and shareholders' equity (expenses).

      • −5,000ext(Cash=Assets)-5,000ext{(Cash=Assets)}

      • −5,000ext(Expense=Shareholders′Equity)-5,000ext{(Expense=Shareholders^{\prime}Equity)}

  6. Supplies Used

    • $500 of supplies were used.

    • Effect on Accounting Equation:

      • Decreases in assets (supplies) and shareholders' equity (expenses).

      • −500ext(Supplies=Assets)-500ext{(Supplies=Assets)}

      • −500ext(Expense=Shareholders′Equity)-500ext{(Expense=Shareholders^{\prime}Equity)}

  7. Payment on Account to Vendor

    • $1,000 was paid on account to the supplies vendor.

    • Effect on Accounting Equation:

      • Decreases in both assets (cash) and liabilities (accounts payable).

      • −1,000ext(Cash=Assets)-1,000ext{(Cash=Assets)}

      • −1,000ext(AccountsPayable=Liabilities)-1,000ext{(AccountsPayable=Liabilities)}

Accounting Equation for a Corporation

  • Expanded Accounting Equation for Corporations:

  • Assets= Liabilities + Shareholders’ Equity

    • Increases in Shareholders’ Equity: Revenues and Gains

    • Decreases in Shareholders’ Equity: Expenses, Losses, and Dividends.

Account Relationships

  • Double-Entry System: Refers to the dual effect that each transaction has on the accounting equation.

  • Accounts: Represent elements of the accounting equation.

  • General Ledger: Collection of accounts.

  • T-Accounts: Used for instructional purposes instead of formal ledger accounts.

    • Each T-account has:

    • Account title at the top.

    • Two sides for recording increases and decreases.

      • Debits (left side) and Credits (right side).

T-Account Rules

  • For different types of accounts:

    • Assets: Increase with debits, decrease with credits.

    • Liabilities and Shareholders' Equity: Increase with credits, decrease with debits.

General Ledger Accounts

  • Serve as control accounts.

  • Subsidiary accounts: Maintained in separate subsidiary
    ledgers. Example: Individual account receivable
    accounts for each of the company’s credit customers.

  • Classified as:

    • Permanent Accounts: Represent the basic financial position
      elements (Assets, liabilities, and shareholders’ equity)

    • Temporary Accounts: Represent changes in the RE
      component of shareholders’ equity caused by revenue, expense, gain, loss, and dividend transactions.

      • Balances are closed or zeroed out—closing process

Steps of the Accounting Processing Cycle

During the Accounting Period:

  1. Obtain information about external transactions from source documents.

  2. Analyze the transaction.

  3. Record the transaction in a journal.

  4. Post from the journal to the general ledger accounts.

At the End of the Accounting Period:

  1. Prepare an unadjusted trial balance.

  2. Record adjusting entries and post to the general ledger accounts.

  3. Prepare an adjusted trial balance.

  4. Prepare financial statements.

At the End of the Year:

  1. Close the temporary accounts to retained earnings.

  2. Prepare a post-closing trial balance.

Recording Transactions

  • Journal Entry Example for Borrowing from Bank:

    • Journal Entry:

    • Debit: Cash $40,000

    • Credit: Notes Payable $40,000

Periodic Inventory System

  • Perpetual Inventory System: Inventory and cost of goods sold accounts are continuously updated for purchase, sale, and return of merchandise.

  • Periodic Inventory System: Inventory and cost of goods sold are updated at the end of the reporting period.

Adjusting Entries

  • Includes:

    • Prepayments: Prepaid Expenses and Deferred Revenues

    • Accrual: Accrued Liabilities and Accrued Receivables

    • Estimates

Prepayments

  • Occur when the cash precedes either expense or revenue recognition
    • Sometimes referred to as deferrals
    • Includes:
    – Prepaid expenses
    – Deferred revenues

Prepaid Expenses

  • Costs of assets acquired in one period and expensed in a future period.

  • Adjusting Entries:

    • Prepaid Expenses: Assets= Credit and Expense= Debit

    • Financial Statement Effects: Income decreases on Income Statement and Assets decrease on Balance Sheet

Deferred Revenues

  • Cash received from customers in advance represents the company's obligation to provide goods or services in the future.

  • Example: Sublease with a jewelry store results in prepaid rent recorded as Deferred Rent Revenue.

Accruals

  • Involve cash flows that occur after either expense or revenue recognition

  • Includes: Accrued Liabilities and Accrued Receivables

  • Many accruals involve external transactions that automatically are recorded from a source document

  • Some accruals involve internal transactions and require adjusting entries

Accrued Liabilities

  • Liabilities recorded when an expense has been incurred prior to cash payment.

  • Adjusting Entries:

    • Accrued Expenses: Expense= Debit and Liability= Credit

    • Financial Statement Effects: Income decreases in Income Statement and Liabilities increase for Balance Sheet.

Accrued Receivables

  • Involve situations when revenue is recognized in a period prior to the cash receipt.

  • Adjusting Entries

    • Accrued Receivables: Assets= Debit and Revenue= Credit

    • Financial Statement Effects: Income increases in Income Statement and Assets increase for Balance Sheet.

Estimates

  • Third classification of adjusting entries

  • Example:

    • Depreciation Expense: Requires an estimate of expected useful life and expected residual value

    • Bad Debt Expense: Requires estimate of amount of accounts receivable that will not be collected.

Adjusted Trial Balance

  • The adjusted trial balance shows total debits and credits ensuring accuracy after adjusting entries are recorded.

Preparation of Financial Statements

  • The financial statements prepared include:

    • Income Statement: A change statement that reports the change in shareholders’ equity (retained earnings) that occurred during the period as a result of revenues, expenses, gains, and losses

    • Statement of Comprehensive Income: Reports the changes in shareholders’ equity during the period that were not a result of transactions with owners.

    • Balance Sheet: Presents the financial position of a company.

      • Organized list of assets, liabilities, and shareholders’ equity at a point in time

    • Statement of Cash Flows: Provides information about cash receipts and cash disbursements.

      • Cash refers to cash plus cash equivalents

    • Statement of Shareholders’ Equity: Discloses the sources of the changes in the various permanent shareholders’ equity accounts from:

      • Investments by owners

      • Distributions to owners

      • Net income

      • Other comprehensive income

Closing Process

  1. Temporary accounts are reduced to zero balances

    1. Ready to measure activity in the upcoming accounting period

  2. Temporary accounts are closed (transferred) to retain earnings

    1. To reflect the changes that have occurred during the period

Post-Closing Trial Balance

  • Prepared to verify that all closing entries have been made, ensuring that the accounts shown are in balance at the end of accounting periods.

Conversion from Cash Basis to Accrual Basis

  • Cash Basis Accounting: Produces a measure called net operating cash flow that is calculated as cash receipts minus cash disbursements (from operating activities)

  • Accrual Basis Accounting: Measures an entity’s accomplishments and resource sacrifices during the period, regardless of when cash is received or paid.

Use of a Worksheet

  • Often used to organize the accounting information needed to prepare adjusting and closing entries and the financial statements.

Subsidiary Ledger and Control Account Example

  • A general ledger control account would contain a group of individual subsidiary accounts associated with it. The balance in the control account would equal the sum of the balances in the subsidiary ledger accounts

    • Accounts receivable, accounts payable, property and equipment, investments and other accounts

Special Journals

  • Used to capture the dual effect of repetitive transactions in debit/credit form.

    • Cash receipts journal, cash disbursements journal, sales journal, purchases journal

  • Simplify the recording process:

    1. Journalizing is made more efficient through the use of specifically designed formats

    2. Individual transactions are not posted to the general ledger accounts, they are accumulated and a summary posting is made periodically

    3. Responsibility for recording entries for repetitive transactions is placed on individuals with specialized training