Financial Accounting - Lecture notes 1 PDF

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Chapter 4: Textbook notes: - Accounting divides the economic life of a business into artificial time periods. Recall that this is the periodicity assumption. Accounting time periods are generally a month, a quarter, or a year - Two principles are used as guidelines: the revenue recognition principle and the expense recognition principle. - An accounting time period that is one year long is called a fiscal year. - The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. - In recognizing expenses, a simple rule is followed: “Let the expenses follow the revenues” - The practice of expense recognition is referred to as the expense recognition principle. It dictates that efforts (expenses) be recognized with results (revenues) in the period when the company makes efforts to generate those revenues. - The revenue recognition principle and the expense recognition principle help to ensure that companies report the correct amount of revenues and expenses in a given period. - Accrual-basis accounting means that transactions that change a company's financial statements are recorded in the periods in which the events occur, even if cash was not exchanged - Under cash-basis accounting, companies record revenue at the time they receive cash.The cash basis seems appealing due to its simplicity, but it often produces misleading financial statement - Cash-basis accounting is not in accordance with generally accepted accounting principles (GAAP). - Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. - Adjusting entries are required every time a company prepares financial statements. - every adjusting entry will include one income statement account and one balance sheet account. Deferrals: 1. Prepaid expenses: Expenses paid in cash before they are used or consumed. 2. Unearned revenues: Cash received before services are performed. Accruals:

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1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded. 2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded. Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged The two types of deferrals are prepaid expenses and unearned revenues.

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Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use - companies recognize supplies expense at the end of the accounting period - Due to their nature, adjusting entries have no effect on cash flows. - Companies purchase insurance to protect themselves from losses due to fire, theft, and unforeseen events - A company typically owns a variety of assets that have long lives, such as buildings, equipment, and motor vehicles. The period of service is referred to as the useful life of the asset - Depreciation is the process of allocating the cost of an asset to expense over its useful life. - The acquisition of long-lived assets is essentially a long-term prepayment for the use of an asset. An adjusting entry for depreciation is needed to recognize the cost that has been used (an expense) during the period and to report the unused cost (an asset) at the end of the period. One very important point to understand: Depreciation is an allocation concept, not a valuation concept. That is, depreciation allocates an asset's cost to the periods in which it is used. Depreciation does not attempt to report the actual change in the value of the asset. - All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate. Accumulated Depreciation—Equipment is a contra asset account - It discloses both the original cost of the equipment and the total cost that has expired to date. - Book value is the difference between the cost of any depreciable asset and its related accumulated depreciation - Book value is also referred to as carrying value. - Companies record cash received before services are performed by increasing (crediting) a liability account called unearned revenues. In other words, the company has a performance obligation to transfer a service to one of its customers. - Unearned revenue is a liability - the adjusting entry for unearned revenues results in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account - The second category of adjusting entries is accruals. - Revenues for services performed but not yet recorded at the statement date are accrued revenues. Accrued revenues may accumulate (accrue) with the passing of time, These are unrecorded because the earning of interest does not involve daily transactions. - For accruals, there may have been no prior entry, and the accounts requiring adjustment may both have zero balances prior to adjustment. - Equation analyses summarize the effects of transactions on the three elements of the accounting equation, as well as the effect on cash flows.

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Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses. Interest, taxes, utilities, and salaries are common examples of accrued expenses. In computing interest, we express the time period as a fraction of a year. Interest Payable shows the amount of interest the company owes at the statement date Each adjusting entry affects one balance sheet account and one income statement account. This trial balance is called an adjusted trial balance. It shows the balances of all accounts, including those adjusted, at the end of the accounting period. The purpose of an adjusted trial balance is to prove the equality of the total debit balances and the total credit balances in the ledger after all adjustments. Because the accounts contain all data needed for financial statements, the adjusted trial balance is the primary basis for the preparation of financial statements. Companies can prepare financial statements directly from an adjusted trial balance. Similarly, they derive the retained earnings statement from the Retained Earnings account, Dividends account, and the net income (or net loss) shown in the income statement Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead financial statement users Companies manage earnings in a variety of ways. One way is through the use of one-time items to prop up earnings numbers. Another way is to inflate revenue numbers in the short-run to the detriment of the long-run. Companies also manage earnings through improper adjusting entries. revenue and expense accounts and the Dividends account are subdivisions of retained earnings, because revenues, expenses, and dividends relate only to a given accounting period, they are considered temporary accounts. In contrast, all balance sheet accounts are considered permanent accounts because their balances are carried forward into future accounting periods Temporary accounts are sometimes called nominal accounts, and permanent accounts are sometimes called real accounts. Closing entries transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earnings agrees with the retained earnings statement. closing entries produce a zero balance in each temporary account. Permanent accounts are not closed. Companies close the revenue and expense accounts to another temporary account, Income Summary. The balance in Income Summary is the net income or loss for the accounting period Income Summary is a very descriptive title: Companies close total revenues to Income Summary and total expenses to Income Summary.

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After a company journalizes and posts all closing entries, it prepares another trial balance, called a post-closing trial balance, from the ledger. A post-closing trial balance is a list of all permanent accounts and their balances after closing entries are journalized and posted. The purpose of this trial balance is to prove the equality of the total debit balances and total credit balances of the permanent account balances that the company carries forward into the next accounting period. Since all temporary accounts will have zero balances, the post-closing trial balance will contain only permanent—balance sheet—accounts. You can see that the cycle begins with the analysis of business transactions and ends with the preparation of a post-closing trial balance. Companies perform the steps in the cycle in sequence and repeat them in each accounting period. Some companies reverse certain adjusting entries at the beginning of a new accounting period. The company makes a reversing entry at the beginning of the next accounting period. This entry is the exact opposite of the adjusting entry made in the previous period. A worksheet is a multiple-column form that may be used in the adjustment process and in preparing financial statements. A worksheet is not a permanent accounting record; it is neither a journal nor a part of the general ledger. The worksheet is merely a supplemental device used to make it easier to prepare adjusting entries and the financial statements.

Periodicity assumption: Accountant divide the economic life of a business into artificial time periods generally a month, quarter, or year - Quarterly and annual financial statements - Prepared by most large companies - Reporting periods can be - Calendar year from january 1srt to december 31st Accrual basis and revenue recognition Revenue recognition principle - Recognize revenue in the accounting period in which the performance obligation is satisfied 1) Identify the contract with the customers 2) Identify the separate performance obligations in the contract 3) Determine the transaction price 4) Allocate the transaction price to separate performance obligation 5) Recognize revenue recognition

Expense recognition principle

Companies recognize expenses in the period in which they make efforts (consume assets or incur liabilities) to generate revenue “Let the expenses follow the revenues” Revenue and expense recognition m Periodicity assumption - economic life of business can be divided into artificial time periods Expense recognition principle- recognize expenses with revenues in the period when the company makes efforts to generate those revenues Revenue recognition principle - recognize revenue in the accounting period in which the performance obligation is satisfied Revenue and expense recognition - in accordance with GAAP Accrual versus cash basis accounting Accrual- basis accounting - Transactions recorded in the period in which the event occur - Companies recognize revenues when they perform services rather than when they receive cash - Expenses are recognized when incurred rather than when paid - In accordance with generally accepted accounting principles (GAAP) Cash basis accounting - Revenues recognized when cash is receives - Expenses recognized when cash is paid - Cash basis accounting is not in accordance with generally accepted accounting principles (GAAP) Categories of adjusting entries Deferrals - Prepaid expenses - unearned revenues Accruals - Accrued revenues - Accrued expenses Accrual basis accounting - companies record transactions in the period in which the events occur Calendar year- an accounting time period that starts on january 1st and ends on december 31st

Deferrals are costs or revenues that are recognized at a date later than the point when cash was originally exchanged Prepaid expenses Payments of expenses that are recorded as an asset to show the service or benefit the company will receive in the future Cash payment before expense recorded Prepayments often occur in regard to insurance, rent, supplies, equipment, advertising, buildings Expire either with the passage of time or through use ****Adjusting entry*** Increase (debit) to an expense account and Decrease (credit) to an asset account Depreciation Buildings, equipment, and motor vehicles are recorded as assets, rather than an expense on the date acquired Depreciation is the process of allocating the cost of an asset to expense over its useful life Unearned revenues Receipt of cash before the service is performed is recorded as a liability - unearned revenue Cash receipt before revenue recorded Unearned revenues occur in regard to rent, airline tickets, magazine subscriptions, etc. Adjusting entry is made to record the revenue for services performed during the period and to show the liability that remains at the end of the period Results in a decrease to a liability account and increase the revenue account Accruals are made to record Revenues for services performed but not yet recorded at the statement date Expenses incurred but not yet paid Accrued revenues Revenues for services performed but not yet received in cash or recorded Revenue recorded before cash receipt Accrued revenues occur for interest earned, services performed, rent rentals Adjusting entry record the receivable that exists and record the revenues for services performed

Adjusting entry: - In creases and asset account with a debit - Increases a revenue account with a credit Accrued expenses Expenses incurred but not yet paid in cash or recorded Expenses recorded before cash payment Accrued expenses are often recognized for rent, taxes, interest, salaries Adjusting entry records the obligation and recognizes the expense - Increase an expense account with a debit - Increase a liability account with a credit *****Summary of adjustments slide #54***** Nature of the adjusted trial balance - Prepared after adjusting entries are journalized and posted - Proves equality of debit and credit balances - Basis for the preparation of financial statements Financial statements are prepared directly from the adjusted trial balance Closing the books At the end of the accounting period, the company makes the accounts ready for the next period

Temporary and permanent accounts Temporary - these accounts are closed - All revenue accounts - All expense accounts - Dividends Permanent- these accounts are not closed - All asset accounts - All liability accounts - Stockholders equity accounts

Chapter 5 Textbook Notes: -

Merchandising companies that purchase and sell directly to consumers are called retailers. Merchandising companies that sell to retailers are known as wholesalers - The primary source of revenue for merchandising companies is the sale of merchandise, often referred to simply as sales revenue or sales. A merchandising company has two categories of expenses: cost of goods sold and operating expenses. - Cost of goods sold is the total cost of merchandise sold during the period - Companies report inventory as a current asset on the balance sheet. - The flow of costs for a merchandising company is as follows. Beginning inventory plus the cost of goods purchased is the cost of goods available for sale - Companies use one of two systems to account for inventory: a perpetual inventory system or a periodic inventory system. - In a perpetual inventory system, companies keep detailed records of the cost of each inventory purchase and sale. Under a perpetual inventory system, a company determines the cost of goods sold each time a sale occurs. Even under perpetual inventory systems, companies take a physical inventory count. This is done as a control procedure to verify inventory levels, in order to detect theft or “shrinkage.” - In a Periodic inventory system, companies do not keep detailed inventory records of the goods on hand throughout the period. Instead, they determine the cost of goods sold only at the end of the accounting period—that is, periodically. At that point, the company takes a physical inventory count to determine the cost of goods on hand. - To determine the cost of goods sold under a periodic inventory system, the following steps are necessary: 1. Determine the cost of goods on hand at the beginning of the accounting period. 2. Add to it the cost of goods purchased. 3. 3. Subtract the cost of goods on hand as determined by the physical inventory count at the end of the accounting period. - The perpetual inventory system is so named because the accounting records continuously—perpetually—show the quantity and cost of the inventory that should be on hand at any time. - A perpetual inventory system provides better control over inventories than a periodic system. - Companies purchase inventory using cash or credit (on account). - Companies record cash purchases by an increase in Inventory and a decrease in Cash. - A purchase invoice should support each credit purchase - Not all purchases are debited to Inventory, - The sales agreement should indicate who—the seller or the buyer—is to pay for transporting the goods to the buyer's place of business - The letters FOB mean free on board. Thus, FOB shipping point means that the seller places the goods free on board the carrier, and the buyer pays the freight costs. Conversely, FOB destination means that the seller places the goods free on board to the buyer's place of business, and the seller pays the freight

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In contrast, freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller. These costs increase an expense account titled Freight-Out (sometimes called Delivery Expense) The credit terms of a purchase on account may permit the buyer to claim a cash discount for prompt payment. The buyer calls this cash discount a purchase discount. This incentive offers advantages to both parties. The purchaser saves money, and the seller is able to shorten the operating cycle by converting the accounts receivable into cash. Credit terms specify the amount of the cash discount and time period in which it is offered. They also indicate the time period in which the purchaser is expected to pay the full invoice price The term net in “net 30” means the remaining amount due after subtracting any sales returns and allowances and partial payments. Passing up the discount may be viewed as paying interest for use of the money. A business document should support every sales transaction, to provide written evidence of the sale. Cash register documents provide evidence of cash sales. A sales invoice, provides support for a credit sale. The original copy of the invoice goes to the customer, and the seller keeps a copy for use in recording the sale The seller makes two entries for each sale. The first entry records the sale: The seller increases (debits) Cash (or Accounts Receivable if a credit sale) and also increases (credits) Sales Revenue. The second entry records the cost of the merchandise sold: The seller increases (debits) Cost of Goods Sold and also decreases (credits) Inventory for the cost of those goods. As a result, the Inventory account will show at all times the amount of inventory that should be on hand. We now look at the “flip side” of purchase returns and allowances, which the seller records as sales returns and allowances. These are transactions where the seller either accepts goods back from the buyer (a return) or grants a reduction in the purchase price (an allowance) so the buyer will keep the goods. Sales Returns and Allowances is a contra revenue account to Sales Revenue. This means that it is off set against a revenue account on the income statement Sales Discounts is a contra revenue account to Sales Revenue. Its normal balance is a debit. sales discounts are offered to customers to encourage early payment of receivables In a single-step statement, all data are classified into two categories: (1) revenues, which include both operating revenues and nonoperating revenues and gains (for example, interest revenue and gain on sale of equipment); and (2) expenses, which include cost of goods sold, operating expenses, and nonoperating expenses and losses There are two ...