Chapter 1: Accounting: The Language of Business Including Balance Sheet Transactions
1.Accounting is an information and measurement system designed to meet the needs of a diverse set of users managers, owners, customers and lenders in this competitive business environment. The goal of the accounting system is to provide relevant, reliable and comparable information about various business entities and opportunities and to improve decisions.
2.Accounting reports include specific tables or statements comparing the current period to past periods and explanatory text such as footnotes (notes) and other commentary.
3.Prospective users of accounting reports include investors, potential investors, creditors, suppliers, employees, regulators and other groups.
4.Accounting reports follow generally accepted accounting procedures (GAAP), an accepted set of rules designed to describe companies.
5.GAAP is an amalgam of rules determined by the Securities and Exchange Commission (SEC), the Financial Accounting Standards Board (FASB), and the American Institute of Certified Accountants (AICPA).
A.The SEC administers laws governing the securities markets and can determine the information available to public constituencies. Although the SEC retains oversight, the authority to develop specific standards has been delegated to the private sector.
B.The FASB is a private body that holds public hearings before determining accepted accounting procedures. Many of the board's pronouncements reflect controversial and new issues and may undergo revision in future. The board has accepted many AICPA procedures as part of generally accepted accounting procedures.
6.Accounting reports include:
A.A management discussion includes a commentary describing the company's recent performance and major issues affecting that performance.
B.Required tables or statements include a balance sheet (describing the company's current financial position), an income statement and a cash flow statement (each describing the company's recent performance (in different ways)), and a statement of shareholders' equity (describing the ownership of the company).
C.Notes to the financial statement clarify some items reported in the financial statements, adding details, and report on some items not included in the financial statements.
D.Reports by management asserting that company data are reliable and conforming to GAAP, and the independent auditors, indicating that the accounting audit has followed generally accepted procedures are also included in the report.
7.Basic Accounting Information
A.Companies report using consolidated financial statements. These statements combine the activities and position of the parent company and those of the subsidiaries the company owns or controls.
B.Cash basis accounting focuses on the cash flows as they affect the company. Events that may affect cash flows in the future are ignored.
C.Fair value accounting focuses on the market values of items the company owns or can use (assets) and on the market values of the obligations that the company must cover (liabilities).
D.Accrual accounting assumes that assets will generate future flows even if they do not generate cash flows today. Events that are expected to generate future cash flows are included in the company's statements.
E.Statements may report on the past for periods of a quarter or a year, but they provide inputs for decision making about the firm's future.
a.The Balance Sheet (Statement of Financial Position) provides a summary report of the firm's assets and liabilities. The leftover represents the residual or ownership position.
Assets Liabilities = Owners' Equity or A L = OE
This can be restated as A = L + OE or
Assets = liabilities + Owners' Equity
b.The Income Statement summarizes one period's activities generating inflows (revenues) and outflows (expenses) associated with the sale of the company's products or services. The excess of revenues over expenses is the company's net income for the period. The focus is on accrual accounting.
Revenues Expenses = Net income or R E = NI
Net income during a period is an addition to owners' equity. If there are no other changes, then OE0 + NI1 = OE1 or owners' equity at time 0 plus net income during time 1 = owners' equity at time 1.
c.The Statement of Cash Flows summarizes one period's activities as they affect the company's cash inflows and outflows.
8.The Balance Sheet: Fundamental Concepts
A.Balance sheets report the entity’s accounting-recognizedassets, liabilities and owners’ equity as of a specific point in time. Balance sheets are for fiscal years, not calendar years.
B.Assets = Liabilities + Owners’ Equity - (A = L + OE).
C.Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. (Concept Statement 6 (Con6), para 25). Economic assets may differ from accounting-recognized assets.
D.The common characteristic possessed by all assets is a “future economic benefit” defined as an eventual cash inflow or benefit to the entity.
E.To recognize an accounting asset, two conditions must be met.
a.A: An exchange must take place. This means that there must be a formal commitment. This precludes all promises and future contracts as being assets. A signed contract doesn’t generate an asset, but the purchase of supplies does.
b.B: The future benefit must be quantifiable. This establish the value of the asset to be reported on the balance sheet. This precludes, for example, most R&D expenses and patent-related within the firm since the amount of the future benefit is sufficiently uncertain.
F.If the entity is no longer able to receive the benefit, then the asset ceases to be.
G.Liabilities are probable future sacrifices of economic benefits arising from the present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. (Con6, para 35). The amounts and timing of the economic resources are known and estimable.
H.To recognize a liability, two conditions must be met.
A: A past transaction must take place. This creates a commitment to complete an agreement. This precludes all promises and future contracts as liabilities unless the firm has received some service or asset in the past.
B: The amount to be sacrificed must be quantifiable and probable. This provides precision to the amount of the obligation. This precludes unsettled lawsuits since the firm does not know if it will win or lose the suit.
I.There are four types of liabilities, relating past benefits and future sacrifices.
A:Cash inleads toCash out
B:Goods or service inleads toCash out
C:Cash inleads to Goods or service out
D.Goods or service inleads to Goods or service out
J.(Owners’) Equity is the residual interest in the assets that remains after deducting its liabilities (Con6, para 49). Owners’ Equity (Also known as shareholders’ equity and stockholders’ equity) is divided into contributed capital (the amount invested directly by shareholders to the entity) and retained earnings. Contributed capital is divided into Par Value and Additional Paid-In Capital (also known as paid-in-capital in excess of par value).
Example of Par Value and Additional Paid-in-Capital (APIC)
Assume a firm sells 100 shares of stock for $10 apiece. Its par value is $1 per share. The accounting would show:
Cash +1,000 (Asset) 100 times $10
Par Value + 100 (SE)100 times $ 1
Additional Paid-in Capital +900 (SE)100 times $ 9
Note that Par Value + APIC = Market Value on Transaction date
Some Balance Sheet Facts
A.Current Assets are assets that are expected to be turned into cash within one year. Cash and Inventory are examples.
B.Noncurrent (Long-term) Assets are assets that are expected to be turned into cash after one year or over a period of several years. Property and machinery are examples.
C.Current Liabilities are liabilities that are expected to be settled within one year. Wage and tax obligations are examples.
D.Noncurrent (Long-term) Liabilities are liabilities that are expected to be settled after one year. Borrowings due to be repaid after several years are examples.
E.Retained Earnings is the amount earned by the entity and not yet distributed to shareholders.
F.Valuation (Adjunct, adjustment or contra) accounts can be used to ‘adjust’ the value of an asset, liability or equity. Accumulated depreciation is an example.
G.Every transaction affects the balance sheet in two ways, via debits and credits.
H.Transactions may affect two (or more) asset accounts, two (or more) liability accounts, two (or more) owners’ equity accounts or some combination of these accounts.
I.The balance sheet reported each year is a ‘cumulative’ document reflecting the net impact of all past activities.
J.Many entities also provide quarterly balance sheets which are abbreviated versions of the fiscal year-end balance sheet.
K.(Among other things) the balance sheet can be used to help assess current (short-term) and long-term risk.
L.Ratios such as the current ratio are used to estimate short-term risk.
M.Ratios such as the debt-to-asset ratio are used to estimate long-term financial risk.
N.Balance sheet fiscal years can differ from calendar years. Most go from a given month-end to the same month-end in the following year. They may also have 52 week (periodically 53 week) fiscal years.
O.Companies can change their fiscal years.
P.The Securities and Exchanges Commission (SEC) requires the issuance of a 10-K form which includes the entity’s financial statement plus additional information. Some entities use the 10-K form as the annual report.
Chapter 2: Measuring Income to Assess Performance
The Income Statement: Fundamental Concepts
1.Operating Cycle – The pattern of events to move an asset through the company’s accounts as part of the company’s normal day-to-day business. On example is the ‘cash cycle’ whereby a company’s cash is followed through the firm. The cash is converted into inventory. The inventory is then sold thereby creating a receivable. The receivable is paid and the company again has cash.
2.Net Income = Revenues – Expenses
3.Net Income = Revenues – Expenses + Gains – Losses (More comprehensive)
4.Revenues represent actual or expected cash inflows that have occurred or will occur as a result of the entity’s ongoing major operations. (Con6 par. 79)
Expenses are outflows from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major operations. (Con6 par. 80)
Gains are increases in equity from peripheral or incidental transactions of an entity. (Con6 par. 82)
Losses are decreases in equity from peripheral or incidental transactions of an entity. (Con6 par. 83)
5.Revenue Recognition has three parts. All three must happen for revenues to be recognized.
A.Earned: The company must have completed (pretty much) its obligations to the customer.
B.Realization: Cash collection must be reasonably certain.
C.Legal Transfer of Risk: Seller retains only ordinary business risks that can be estimated with reasonable accuracy
6.Revenues can come before cash (Accounts Receivable) (credit card sales), be contemporaneous with cash (Cash) (cash sales), or can follow cash (Advances from Customers) (insurance, subscriptions).
7.Expenses are divided into several categories:
A.Product Costs are linked to revenues. Cost of goods sold is the major type of product cost. These expenses are matched to the sale of goods.
B.Period Costs are expensed over time. Examples of period costs are interest expense, depreciation, rent, income taxes, and salary expense. These expenses are matched to the time period in which the resources are deemed to be used.
C.Some costs do not fit either category perfectly. Examples are advertising and research expenses. They may be linked to revenues in the long-term, but may not be in the short-term and may vary substantially without regard to a specific time frame.
8.Expenses can be divided into direct and indirect expenses.
A.Direct expenses have a clear and immediate association with the revenue earning outputs of the entity. An example is the material required to produce a salable good.
B.Indirect expenses do not have a clear and direct association with the revenue earning outputs of the entity. examples include plant maintenance, security and general systems support.
9.Expenses can come before cash (for example, Salaries Payable), be contemporaneous with cash (Cash) or can follow cash (for example, Prepaid Rent).
10.Retained Earnings are increased by revenues and gains. Retained Earnings are decreased by expenses and losses. Retained Earnings are also decreased by dividends declared. Dividends declared create an obligation to be paid at a later date.
11.Retained Earnings is entirely separate from cash. A company can get cash without earning income or increasing retained earnings. Increases in retained earnings reflect new income, but, there may be no impact on cash (or cash may even decrease).
12.Interest is a period return to debt holders. They are expensed.
13.Common stock dividends are voluntary returns to shareholders distributed by the entity. They are never expensed.
Fundamental Accounting Concepts for the Income Statement
Accounting transactions are events that affect the balance sheet. So, how does income recognition affect the balance sheet?
Answer: Through the retained earnings account.
A.Revenues and gains increase retained earnings (shareholders’ equity). This means that revenues and gains appear as an increase to shareholders’ equity.
B.Expenses and losses decrease retained earnings (shareholders’ equity). This means that expenses and losses appear as a decrease to shareholders’ equity.
C.Remember, double-entry accounting means that every transaction has a left (debit) and a right-(credit) handed side. Therefore, if revenues increase shareholders’ equity, then there must be a corresponding entry to keep the balance sheet equation in balance.
D.For example, suppose the firm sells an item on account (before receiving cash).
Assets = Liabilities + Shareholders’ Equity
+ (A/R) + (Retained Earnings)
E.Suppose the firm sells an item for cash.
Assets = Liabilities + Shareholders’ Equity
+ (Cash) + (Retained Earnings)
F.Suppose the firm delivers an item after receiving cash.
Assets = Liabilities + Shareholders’ Equity
- (Advances) + (Retained Earnings)
G.Similarly, if expenses decrease shareholders’ equity, then there must be a corresponding entry to keep the balance sheet in balance.
H.For example, suppose the firm recognizes a salary expense but has not paid its employees yet.
Assets = Liabilities + Shareholders’ Equity
+ (Salaries/P) - (Retained Earnings)
I.Since revenues and expenses are part of shareholders’ equity (retained earnings), we can use T-accounts for each revenue or expense. Or, we can open up an income account with both revenues and expenses. The key concept is to remember that the revenue, expense, or income account is really just a part of the retained earnings account.
Retained Earnings
Beg. Bal.- / +
Net Income
End. Bal.
Retained Earnings
Beg. Bal.- / +
Expense / Revenue
End. Bal.
J.Many revenues and expenses are taken over time. Basically, revenues shown over time come from advances from customers, also called unearned revenue, deferred revenue or unearned credit. Expenses shown over time are typically expenses based on time (period expenses), such as interest, depreciation, wages, and taxes.
K.Advances from customers arise when the firm receives cash first. However, they cannot show the revenues until the firm provides the product or the service.
Example: The firm receives $1,000 on April 1 for services to be performed on April 8. On April 8, the firm performs the services.
On April 1: Cash + 1,000
Advances from Customers (L) + 1,000
On April 8: Advances from Customers (L) –1,000
Revenues+ 1000
L.As time goes by, firms also show expenses based on the time expired. For example, suppose on January 1 the firm buys an insurance policy covering one year for $1,200. (Recognition of the expense after payment).
On January 1: Prepaid Insurance (A) +1,200
Cash - 1,200
On January 31: Insurance Expense + 100
Prepaid Insurance - 100
M.Another example of a period expense is taxes. Suppose the firm owes $12,000 in taxes at the end of the first quarter (March 31)
March 31: Tax Expense +12,000
Taxes/P + 12,000.
When the firm pays the taxes (let’s assume it’s on April 15) (Recognition of the expense before payment).
April 15: Taxes/P- 12,000
Cash- 12,000.
N.Note that cash flows can (and frequently do) occur at different times from the expense or revenue recognition. It can either come before or after the revenue or expense recognition.
Some Income Statement Facts
O.The gross margin is revenues less cost of goods sold.
P.Operating expenses are day-to-day expenses associated with the business (not financial) end of the firm.
Q.The income statement is a period statement starting anew at zero each year.
R.Income can be negative (a loss). Losses can be due to normal operations or unusual events.
S.Cash and income associated with the same activity can occur in different fiscal years.
T.Some firms do more business in some parts of the year than in other parts of the year so that revenues, expenses and income rise and fall seasonally.
U.Several different income measures can be used as estimates of performance. Some include operating income, income before tax and income after tax.
V.Dividends and income do not have to be related in a given period.
W.Some expenses are sometimes called provisions. These are actually estimates of expenses, such as the provision for taxes and the provision for bad debts.
X.Interest expense is not an operating expense for most firms, but interest expense is an operating expense for firms such as banks.
Y.Financial ratios that are associated with earnings and dividends include the earnings per share ratio (EPS), the dividend yield ratio (dividend/price per share), dividend payout ratio (dividend/earnings per share) and the price-earnings ratio (PE).
Chapter 3: Recording Transactions
1.The recording process has several steps. Some occur immediately. Some take place at the end of the period.
2.Events are recorded immediately in a journal – called journalizing. The journal events are then listed in the ledger, a listing of accounts – called posting.