Financial Accounting - Lecture notes 1-7 PDF

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Chapter 1: A Framework of Financial Accounting Decisions people make about companies based on Accounting Data 1. Investors decide whether to invest in stock 2. Creditors decide whether to lend money 3. Customers decide whether to purchase products 4. Suppliers decide the customer’s ability to pay for supplies 5. Managers decide production and expansion 6. Employees decide employment opportunities 7. Competitors decide market share and profitability 8. Regulators decide on social welfare 9. Tax Authorities decide on taxation policies 10. Local Communities decide on environmental issues Financial Accounting ● Financial Accounting: Information provided for external users ● Managerial Accounting: Information provided for internal users The Accounting Equation Assets= Liabilities + Stockholders Equity ● Assets: resources of the company ● Liabilities: creditors’ claim to resources ● Stockholders Equity:  owners claim to resources Revenues, Expenses, and Dividends All profits of the company are claimed solely by stockholders. Profit = Revenues – Expenses. ● ● ● ●

Profit is often referred to as net income. Revenues = Sales of products or services to customers. Expenses = Costs of selling products or services. Dividends = Distribution of profit to stockholders

Business Structure: ● Sole Proprietorship:  business owned by one person ● Partnership: business is owned by two or more persons ● Corporation: business is legal separate from its owners Limited liability of stockholders Business Activities: Financing Activities: transactions a company has with investors and creditors Investing Activities: transactions involving the purchase and sale of resources that benefit the company for several years Operating Activities:  transactions that relate to the primary operations of the company

Communicating through financial statements - Primary Financial Statements - Income Statements - Statement of Stockholders Equity - Balance Sheet - Statement of Cash Flows Income Statements -Reports the company's revenues and expenses over an interval of time - If revenues > expenses , then net income - If revenues < expenses , then net loss Statement of Stockholders Equity Summarizes the changes in stockholders’ equity over an interval of time Stockholders’ Equity = Common Stock (External source) + Retained Earnings (internal source) Balance Sheet: (MUST BALANCE) presents the financial position of the company on a particular date Financial position: Resources (assets) = Claim to resources (liabilities and stockholders equity) Statement of Cash flows: Measures activities involving cash receipts and cash payments over an interval of time Operating cash flows:  cash transactions involving revenues and expenses Investing cash flows : cash transactions involving purchasing and sale of long term assets Financing cash flows:  cash transactions involving lenders and stockholders All financial statements are connected Key Point: All transactions that affect revenues or expenses reported in the income statement ultimately affect the balance sheet through the balance in retained earnings Use of Financial Accounting Information in Investing and Lending Decisions Investors and creditors use financial accounting information to make investment choices Rules of Accounting Investors and creditors make their decisions based on financial accounting information which should be based on the formals standards known as Generally Accepted Accounting Principles (GAAP) In the United States the Financial Accounting Standards Board (FASB) is governed by the Securities and Exchange Commission (SEC) -SEC has ultimate authority Globally, the International Accounting Standards Board (IASB) International Financial Recording Statements (IFRS)

Role of Auditors -Trained individuals hired by a company as an independent party to express a professional opinion of the extent to which financial statements are in accordance with GAAP - Help to ensure that management has in fact appropriately applied GAAP in preparing the company’s financial statements -Help investors and creditors in their decisions by adding credibility to the financial statements Objectives of Financial Accounting -Financial Accounting should provide information that: 1. Is useful to investors and creditors in making decisions 2. Help to predict cash flows 3. Tells about economic resources, and claims and changes in them Chapter 2: The Accounting Cycle: During the Period Functions of Financial Accounting 1. Measure business activities of the company a. Step 1: Use source documents to identify accounts affects by an external transaction b. Step 2: Analyze the impact of the transaction on the accounting equation c. Step 3: Assess whether the transaction results in a debit or credit to account balances d. Step 4: Record the transaction in a journal using debits and credits e. Step 5: Post transaction to the T-Account in the general ledger f. Step 6: Prepare a trial balance 2. Communicate measurements to external parties for decision making a. Prepare financial statements Capturing Transactions in Accounts ● Account: Summary of all transactions related to a particular item over a period of time ○ Typical assets include: cash, supplies, and equipment ○ Typical liabilities include: accounts payable, notes payable, utilities payable, wages payable, and taxes payable ○ Stockholders’ equity accounts usually include: common stock, preferred stock, and retained earnings Chart of accounts: a list of all the account names used by a company to record transaction. Effects of Transactions on the Basic Equation ● Each transaction will have a dual effect on the accounting equation ● If the total assets increase, either liabilities and/or stockholders’ equity must also increase For Every Transaction Ask..

1. What account is affected by the transaction? - Does this account increase or decrease? 2. What other account is affected by the transaction? - Does this account increase or decrease? 3. Do assets equal liabilities plus stockholders’ equity? - THEY MUST!!! EVERY TIME!!! Transactions: transactions 1. issue common stock: sell shares of stock for 25K to obtain funds necessary to start business i. Cash increases (+ 25k); stockholders’ equity ---- common stock increases (+ 25k) Earn 25K in revenue - cash +, retained earnings + 2. borrow from the bank: borrowing 10K from bank and sign a note promising to repay in 3 yrs i. Cash +10k; liabilities ---- notes payable +10k 3. purchase equipment purchase equipment for 24k a. Cash -24k, equipment +24k 4. pay one yr of rent in advance 6k a. Cash -6k, prepaid rent +6k i. When you pay for something in advance (ex season tickets) is called prepaid ______ and its an asset 5. Purchase supplies on account 2.3k a. Supplies +2.3k, accounts payable +2.3k b. Notes payable is a signed contract, like borrowing money for a car, or a house signing a note; but if you are just calling up a vendor and they are issuing an invoice it is considered accounts payable Retained earnings (cumulative earnings since beginning of time) = revenue - expenses - dividends Net income (over a period of time, ex: 1 month, 1 yr) = rev - expenses ● Revenues increase retained earnings ● Expenses decrease retained earnings ● Dividends decrease retained earnings ● Retained earnings is a component of stockholders’ equity 6. Provide services for cash for 2k a. Cash +2k; service rev (under retained earnings) +2k 7. provide gold training services for 2k on account a. Accounts receivable +2k; service revenue +2k 8. Receive cash in advance from customers for lessons to be given in the future 600 a. Cash +600; deferred revenue (liability) +600 b. Deferred rev indicated that the company has yet to provide services even though it has collected the customers’ cash. The company owes the customer a service, which is a liability

9. Pay salaries to employees 2.8K a. Cash -2.8K, salaries exp (retained earnings) -2.8k 10. Pay cash for dividends a. Cash decreases, retained earnings decreases) Transaction 1: Borrow from the bank Borrow $10000 from the local bank and sign a note promising to repay the full amount of debt in 3 years. - Add 10000 to liabilities and assets. Expanded Accounting Equation Assets= Liabilities + stockholders’ equity - Stockholders’ equity is made up of common stock + retained earnings - Retained earnings is made up of revenues - expenses - dividends - Revenues increase retained earnings - Expenses decrease retained earnings - Dividends decrease retained earnings - Net Income= Revenues - expenses - Retained earnings represents the cumulative amount from day one of operations, Net income is over a period of time (month, year. etc.) Debit and credit effects on the accounts in the basic accounting equations DEBIT = LEFT CREDIT = RIGHT

1. Left side- assets increase with debit 2. Right side- liabilities and stockholders’ equity increase with credits - The opposite is true to decrease the balance of any of these accounts

Debit and credit effects on the accounts in the expanded accounting equation

- Since revenues increase retained earnings, you credit rev when you increase - Sinces expenses and dividends decrease retained earnings, it is opposite, you debit these accounts when you increase

T-Accounts - Simplified version of general ledger - Includes the account title at the top, left side for recording debits and right side for recording credits Memory Trick!! DEALOR Dividends, E  xpenses, A  ssets (increase on the left) L  iabilities, Owners’ equity, Revenue  (increase on right) Recording Transactions - Journal: provides a chronological recording of all transactions - Journal entry: format used when journalizing - Debits ALWAYS have to equal credits Posting Postings: process of transferring the debit and credit information from the the journal to the individual accounts in the general ledger General Ledger: provides in a single location the list of transactions affecting each account and the account’s balance ( also called “the book of final entry”) Trial Balance: - A list of all accounts and their balances at a particular date - Shows that total debits equal total credits - Assist in preparing adjusting entries - Used for internal purposes only - Not published to external parties - Not required to follow an order of listings Assets 1st, liabilities 2nd, stockholders’ equity 3rd, revenues and expenses last Debits always must equal credits The Accounting Cycle: End of Period Accrual-basis accounting - Revenue and Expense Reporting

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Revenue Recognition 1. Revenues are recorded in the period in which the goods or services are provided to customer 2. You ignore the cash and focus on the transaction- a promise to pay (ieaccounts receivable) is treated the same way Expense Recognition (Matching) 1. Expenses are reported in the same period as the revenues they help to generate 2. You recognize the expense when you recognize the revenue- remember “Expenses trigger/cause revenues”

Difference

Accrual-Basis

Cash Basis

Revenue Recognition

When goods and services are provided to customers

When cash is received

Expense Recognition

When costs are incurred to produce revenue (In the period costs are used to help produce revenues)

When cash is paid

GAAP

Recognized by GAAP (part of GAAP)

Considered an error by GAAP (Not a part of GAAP)

During the year: Record and post external transactions End of Year: Record and post adjusting entries (measurement process) Prepare financial statements (reporting process) Record and post post closing entries (Closing Process) Types of Adjusting entries - Some transactions have occurred during the period but have not been recorded by the end of the period - Often include activities that occur daily - Four Types: - Prepayments/Deferrals: - Prepaid expense: pay cash (or have an obligation to pay cash) to purchase an asset in the current period that will be recorded as an expense in a future period - Deferred revenues: receive cash in the current period that will be recorded as a revenue in the future period - Accruals: - Accrued Expenses: record and expense in the current period that will be paid in cash in a future period

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Accrued revenues: record a revenue in the current period that will be collected in cash in a future period

Deferred Revenue: - Deferred Revenues are the exact opposite of Prepaids- they occur when a company receives cash in advance from customers - Cash received is initially recorded as a liability because there is an obligation to the customer - Once the obligation is met, revenue is recorded - Adjusting the entry: debit a liability account and credit a revenue account Accrued Expenses: - Accrued expenses are recorded when a company has a cost hasn’t yet paid cash for that cost - Cost is recorded as an expense, and the amount owed is recorded as a liability - The most common example of this is wage expense for wages earned but not yet paid - Adjusting entry: Debit an expense account and credit a liability account Adjusting Trial Balances: -

Financial Statements are prepared from the adjusted trial balance Income statement: Net income = revenues - expenses Statement of Stockholders’ equity: Stockholders’ equity= common stock + retained earning (Beg rev+ NI - div) - Balance sheet: assets= liabilities + stockholders’ equity Statement of Cash flows: - Measures activities involving cash receipts Closing Entries: - To transfer the balances of all temporary accounts to the balance of Retained Earnings - To reduce the balances of these temporary accounts to zero to prepare them for the next period - How to close rev: debit service revenue and credit retained earnings - How to close expense: credit all expense and debit the total expense - How to close dividends: credit dividends debit retained earnings Permanent accounts (DON’T CLOSE OUT): Retained Earnings Balance sheet Cash Temp. accts (ALWAYS CLOSE OUT): Revenues Expense Dividends Post closing trial balance: The totals on this balance won’t equal the totals on the adjusted trial balance- it will still balance - List all account balances after updating for closing entries

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Helps to verify that closing entries were prepared

Chapter 4: Cash and Internal Control - Internal Controls: These are a series or set of policies and procedures to safeguard assets and help insure the accuracy of a company’s financial statements - Incorrect financial statements - Two Primary reasons: - Errors: accidental errors while recording transactions or applying accounting principles - Fraud: a person intentionally deceives another person for personal gain - Occupational fraud: the use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the employer’s resources -

The Fraud Triangle: Opportunity, Motivation, Rationalization - Opportunity: the situation allows the fraud to occur - Motivation: someone feels the need to commit fraud, such as the need for money - Rationalization: justification for the deceptive act by the one committing the fraud

… Account for Employee Purchases - Petty Cash Fund: small amounts of cash kept on hand to pay minor purchases - Accounting for the petty cash fund involves:

Credit Sales Accounts Receivable - Cash owed to the company by its customers from sales Other types of receivables - Non-trade receivable: receivables that originate from sources than customers - Tax refund claims, interest receivable, and loans by the company to other entities, - Notes receivable Trade Discount: - Reduction in the list price of a product or service - Used to provide incentives to larger customers or certain customer groups - Recognized by recording revenue for the lower amount (record the net amount db, accounts rec. Cr, service rev) Sales Return and Allowances - Customers are sometimes dissatisfied with a product or service - Sales return: customer returns a product - Seller issues a cash refund if original sale was for cash - Seller reduces balance of accounts receivable if the original sale was on account

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Sales allowance: customer does not return the product sales returns or sales allowances - Contra revenue accounts - Reported with total revenues in the income statement, but with negative balances Sales Discount - Offer a customer a reduction if payment is made within a specified period of time - Link dental offers dee terms of 2/10, n/30 on the $350 owed; dee pays on march 10 (within 10 days) - 2/10 is 2% off if paid within 10 days - Debit: cash 343, sales discount 7 - Credit: accounts receivable 350 - Sales discount: contra revenue accounts Allowance method - Some accounts receivable will not be collected - Companies are required to: - Estimate future uncollectible accounts - Record estimates in the current year - Estimated uncollectible accounts: - Reduce assets (accounts receivable) - Increase expenses (bad debt expense) - At the end of 2018 kimzey is owed $20 million from customers and estimates that 30% will not be collected - December 31, 2018 - Bad debt expense 6 - Allowance for uncollectible 6

Chapter 5: Receivables and Sales Credit sales - Products or services are provided to a customer today and expect to collect cash in the future - Also known as sales on account or services on account or simply “sales” - Common for many business transactions Accounts Receivable - Cash owed to the company by its customers from sales or services at the time - Recorded at the time of the sale or service - Sometimes referred to as trade receivables Key Point: c ompanies record an asset (accounts receivable) and revenue when they sell products or services on account, expecting payment in the future. Other types of Receivable: - Nontrade receivables: receivables that originate from sources other than customers

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Tax refund claims, interest receivable, and loans by the company to other entities, including stockholders and employees. - Notes receivable: formal credit arrangements evidenced by written debt instruments (or “notes”) Trade Discounts - Reduction in list price of a product or service. Often used to provide incentive to larger customers or certain consumer groups (senior citizens, military) - Recognized by recording revenue for lower amount Sales Returns and Allowances Chapter 6: Inventory and Cost of Goods Sold Inventory (Some Basic Definitions) - Inventory includes items a company intends for sale to customers - Also includes items that are not yet finished products - Generally reported as a current asset in the balance sheet - Cost of Goods Sold is the cost of the inventory that is sold during the period - Reported as an expense in the income statement Managing and Merchandising Companies

Key Point: service companies record revenues when providing services to customers. Merchandising and manufacturing companies record revenues when selling inventory to customers Relationship between Inventory and Cost of Goods Sold

Key Point: Inventory is a current asset reported in the balance sheet and represents the cost of inventory not yet sold at the end of the period. Cost of goods sold is an expense reported in the income statement and represents the cost of inventory sold. Multiple-Step Income Statement - revenues (net of returns, allowances, and discounts) - Cost of goods sold - Gross profit - Selling, general, and administrative expenses (includes advertising, salaries, rent, utilities, supplies, depreciation, and other operating expense) - Operating income - Other Income (expenses): investment income and other interest expense - Income before income taxes - Income tax expense - Net income Key Point: A multiple-step income reports multiple levels of profitability. Gross profit = net revenues (or net sales) - cost of goods sold. Operating income = gross profit - operating expenses Income before income taxes = operating income + non-operating revenues - non-operating expenses Net income = all revenues - all expense...