AFM 211 Financial Accounting 1
Overview of Financial Accounting
Principles (Part I) 1. Accounting in Action What is accounting? * Accounting
consists of three basic activities: it identifies, records, and communicates
the economic events of an organization to interested users. Q. Business
(economic) vs. Accounting Events?=> whether affects the accounting equation.
That is, an event which affects the accounting equation is an accounting event.
Generally, an accounting system only journalizes accounting events. * GAAPs and
IFRS: SEC indicated that it will allow some U.S. companies to adopt IFRS as
early as 2009. The SEC also laid out a roadmap by which all U.S. companies will
be required to switch to IFRS by 2016.
The Accounting Equation * Assets = Liabilities + Stockholders’ Equity = Liabilities + Common Stock + Retained Earnings (ending) = Liabilities + C/S + R/E(beginning) + change of R/E = Liabilities + C/S + R/E(beginning) + Revenue – Expenses - Dividends * Assets have the capacity to provide future services or benefits. Liabilities are claims against assets. Stockholders’ equity (residual equity) is equal to total assets minus total liabilities.
The Accounting Equation * Assets = Liabilities + Stockholders’ Equity = Liabilities + Common Stock + Retained Earnings (ending) = Liabilities + C/S + R/E(beginning) + change of R/E = Liabilities + C/S + R/E(beginning) + Revenue – Expenses - Dividends * Assets have the capacity to provide future services or benefits. Liabilities are claims against assets. Stockholders’ equity (residual equity) is equal to total assets minus total liabilities.
You
are required to suggest:
Financial Statements * Four financial statements: 1. An income statement
presents the revenues and expenses and resulting net income or net loss of a
company for a specific period of time. 2. A retained earnings statement summarizes
the changes in retained earnings for a specific period of time. 3. A balance
sheet reports the assets, liabilities, and stockholders’ equity of a company at
a specific date. 4. A statement of cash flows summarizes information concerning
the cash inflows and outflows for a specific period of time. 2. The Recording
Process The Account * An account is an accounting record of increases and
decreases in a specific asset, liability, or owner’s equity item. * * Because
the format of an account resembles the letter T, we refer to it as a T account.
The terms debit and credit are directional signals: Debit indicates left, and
credit indicates
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right. * For each transaction, debits must equal credits in the accounts. The equality of debits and credits provides the basis for the double-entry system of recording transactions. Assets = Liabilities + C/S + R/E(beginning) + Revenue – Expenses - Dividends Assets + Expenses + Dividends = Liabilities + C/S + R/E + Revenue Debit (increase) Credit (increase)
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Steps in the Recording Process * Three basic steps in the recording process: 1. Analyze each transaction for its effects on the accounts 2. Enter the transaction information in a journal 3. Transfer the journal information to the appropriate accounts in the ledger * * The journal is referred to as the book of original entry. A general journal has spaces for dates, account titles and explanations, references, and two amount columns. . The entire group of accounts maintained by a company is the ledger. A general ledger contains all the asset, liability, and stockholders’ equity accounts. Transferring journal entries to the ledger accounts is called posting.
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The Recording Process Illustrated * Transaction 1: Investment by Stockholders ($10,000) Cash 10,000 Common Stock 10,000 Transaction 2: Purchase of Equipment for Cash ($4,000) Equipment 4,000 Cash 4,000
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Or Use Notes Payable Equipment Notes Payable *
4,000 4,000
Transaction 3: Purchase of Supplies on Credit ($200) Supplies 200 Accounts Payable 200 Transaction 4: Services Provided for Cash ($1,200)
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Cash Service Revenue *
1,200 1,200
Transaction 5: Purchase of Advertising on Credit ($300) Adv. Exp. 300 Accounts Payable 300 Transaction 6: Services Rendered for Cash ($1,200) and Credit ($1,600) Cash 1,200 Accounts Receivable 1,600 Service Revenue 2,800 Transaction 7: Pay Cash for expenses (Rent $500, Salaries $1,000, Utilities $800) Rent exp. 500 Salaries exp. 1,000 Utilities exp. 800 Cash 2,300 Transaction 8: Pay Cash for A/P ($300, adv.) Accounts Payable 300 Cash 300 Transaction 9: Received Cash from A/R ($600) Cash 600 Accounts Receivable 600
Transaction 10: Cash Dividends ($1,000) Dividends 1,000 Cash 1,000
Receives $1,200 cash advance from a client for future service Cash 1,200 Unearned revenue 1,200 Pays $600 for a one-year insurance policy Prepaid insurance 600 Cash 600
The Trial Balance * A trial balance is a list of accounts and their balances at a given time. * Trial balance = Balance sheet (beginning) + transactions in the period (B/S or I/S items)
* The primary purpose of a trial balance is to prove (check) that the debits equal the credits after posting. * Limitations of a Trial Balance: A trial balance does not guarantee freedom from recording errors. The trial balance may balance even when 1. a transaction is not journalized, 2. a correct journal entry is not posted, 3. a journal entry is posted twice, 4. incorrect accounts are used in journalizing or posting, 5. offsetting errors are made in recording the amount of a transaction. 3. Adjusting the Accounts Timing Issues * Accounting time periods are generally a month, a quarter, or a year. An accounting time period that is one year in length is a fiscal year. Most businesses use the calendar year (January 1 to December 31) as their accounting period. * Accrual vs. Cash Basis Accounting Under the accrual basis, companies record transactions that change a company’s financial statements in the periods in which the events occur. Under cash basis accounting, companies record revenue when they receive cash. Note: Cash basis accounting is NOT in accordance with GAAPs. Recognizing Revenues and Expenses: The revenue recognition principle dictates that companies recognize revenue in the accounting period in which it is earned. 1. Service: performed 2. Products: delivered. The expense recognition principle (matching principle) dictates that efforts (expenses) be matched with accomplishments (revenues).
The Basics of Adjusting Entries * In order for revenues and expenses to be reported in the correct period, companies make adjusting entries at the end of the accounting period. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. * A company must make adjusting entries every time it prepares financial statements. It analyzes each account in the trial balance to determine whether it is complete and up-to-date. Adjusting entries are classified as either deferrals or accruals. 1. Deferrals: (1) Prepaid Expenses: Expenses paid in cash and recorded as assets before they are used or consumed.
(2) Unearned Revenues: Cash received and recorded as liabilities before revenue is earned. 2. Accruals: (1) Accrued Revenues: Revenues earned but not yet received in cash or recorded. (2) Accrued Expenses: Expenses incurred but not yet paid in cash or recorded. Adjusting Entries for Deferrals 1. Prepaid Expenses * Prepaid expenses are costs that expire either with the passage of time (e.g., rent and insurance) or through use (e.g., supplies). The expiration of these costs does not require daily journal entries. At each statement date, they make adjusting entries: (1) to record the expenses that apply to the current accounting period, and (2) to show the unexpired costs n the asset accounts. Supplies * Jan. 1. Office supplies: $1,200. Then, the company purchased office supplies $3,000 for cash. Supplies 3,000 Cash 3,000 Jan. 31. Physically count the office supplies: $600. Office supplies expenses 3,600 Supplies 3,600 Insurance * Jan. 1. Paid $1,200 insurance premium for a one year policy. Prepaid Insurance 1,200 Cash 1,200 Jan. 31. Adjusting entries. Insurance expenses Prepaid Insurance
100 100
Depreciation * Depreciation is the process of allocating the cost of an asset to expense over its useful life in a rational and systematic manner. Depreciation is an estimate rather than a factual measurement of expired cost. Straight-line method: Depreciation = (Cost – Salvage)/Useful Life
Jan. 1. Purchase equipment with 3 year life for cash of $36,000. Equipment 36,000 Cash 36,000
Jan. 31. Adjusting entries. Depreciation Expenses Accumulated Depreciation – Equipment *
1,000 1,000
Accumulated Depreciation – Equipment is a contra-asset account. Office Equipment $36,000 Less Accumulated Depreciation 1,000 Book value: $35,000
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2. Unearned Revenues Companies record cash received before revenue is earned by increasing a liability account called unearned revenues. Jan. 1. A client prepaid $600 for service in the next three months. Cash 600 Unearned Revenues 600 Jan. 31. Adjusting entries. Unearned Revenues Service Revenue
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200 200
Adjusting Entries for Accruals 1. Accrual Revenues * Accrued revenues may accumulated (accrue) with the passing of time, as in the case of interest revenue and rent revenue. Or they may result from services that have been performed but are neither billed nor collected. The former are unrecorded because the earning process (e.g., of interest and rent) does not involve daily transactions. The latter may be unrecorded because the company has provided only a portion of the total service. Accrued Interest Revenue * Jan. 1. Purchase a bond $10,000 with an annual interest rate of 12%. Debt Investment 10,000 Cash 10,000 Jan. 31. Accrued interest: $10,000 x 12% ÷12=100. Interest Receivable 100 Interest Revenue 100 2. Accrual Expenses Expenses incurred but not yet paid or recorded at the statement date are accrued expenses. Interest, rent, taxes, and salaries are typical accrued expenses.
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Accrued Rents * Jan. 1. Rent an equipment for $450 per month.
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Jan. 31. Accrue rent $450. Rent Expenses Rent Payable
450 450
Accrued Salaries * Jan. 1. Workers’ salaries are $3,200 per month. Jan. 16. $1,800 was paid in cash. Salaries Expenses 1,800 Cash Jan. 31. $1,400 was not paid yet. Salaries Expenses 1,400 Salaries Payable
1,800
1,400
4. Completing the Accounting Cycle Closing the Books * At the end of the accounting period, the company makes the accounts ready for the next period. This is called closing the books. * Temporary accounts vs. permanent accounts. 1. Temporary accounts: relate only to a given accounting period. They include all income statement accounts and the dividends account. The company closes all temporary accounts at the end of the period. 2. Permanent accounts: relate to one or more future accounting periods. They consist of all balance sheet accounts, including the stockholders’ equity accounts. The company carries forward the balances of permanent accounts into the next accounting period. Closing entries formally recognize in the ledger the transfer of net income/loss and Dividends to Retained Earnings. Closing entries also produce a zero balance in each temporary account. In preparing closing entries, companies could close each income statement account directly to Retained Earnings. However, to do so would result in excessive detail in the Retained Earnings account. Instead, companies close the revenue and expense accounts to another temporary account, Income Summary, and they transfer the resulting net income or net loss from this account to Retained Earnings. Companies record closing entries in the general journal. Companies could prepare separate closing entries for each nominal account, but the following four entries accomplish the desired result more efficiently: 1. Debit each revenue account for its balance, and credit income Summary for total revenues.
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2. Debit Income Summary for total expenses, and credit each expense account for its balance. 3. Debit Income Summary and credit Retained Earnings for the amount of net income. 4. Debit Retained Earnings (Note: not Income Summary since Dividends are not an expense) for the balance in the Dividends account, and credit Dividends for the same amount. * * The Income Summary account is used only in closing. The post-closing trial balance could be used to prove the equality of the permanent account balances carried forward into the next accounting period since the post-closing trial balance will contain only permanent accounts.
Summary of the Accounting Cycle * Accounting cycle (short version) 1. Identify and journalize accounting events. 2. Adjusting entries. 3. Prepare financial statements. 4. Closing entries. The Classified Balance Sheet * The balance sheet presents a snapshot of a company’s financial position at a point in time. To improve users’ understanding of a company’s financial position, companies often group similar assets and similar liabilities together. * A classified balance sheet generally contains the standard classification as follows. Assets Liabilities and Equity Current assets Current liabilities Long-term investments Long-term liabilities Property, plant, and equipment Stockholders’ equity Intangible assets * current assets (short-term: one year or operating cycle) in order (according to liquidity): Cash and cash equivalents Short-term investment Accounts receivable Inventories Prepaid expenses * Property, plant, and equipment: depreciation and accumulated depreciation * Within the current liabilities section, companies usually list notes payable first, followed by accounts payable, and the other liabilities in order of magnitude.
It will important to read
out following chapters:
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