Financial accounting – test

Accounting is the process of identifying, recording, summarizing, and reporting economic

information to decision makers.

Financial: outsiders (owners, creditors, suppliers, regulators, unions, others), managing public
information.

Sequence of events leading to financial statements found in those reports

1- Measurable economic event occurs
2- Private (work for the reporting entity) bookkeepers/accountants analyze event to
determine what elements/accounts are affected, then record the event into records.
3- Records are summarized into financial statements.
4- Financial reports that include the statements are provided to users who make decisions

Comparative ownership features

- Sole proprietorship: single owner
- Partnership: two or more co-owners
- Corporation:
. Publicly owned – owned by the public through the sale of shares; potentially thousands of
owners.
. Privately owned – owned by families or a small group of shareholders; shares are not sold or
traded in an open market.

How are companies supervised?

- Shareholders: elect a board of directors to look out for their interests
- Board directors:
Often include outsiders such as CEOs and presidents of other corporations, academics,
attorneys, and community representatives
Can also include insiders – company CEO, CFO, etc.
Part must be independent if stock is regulated
Set strategic direction of the company
- Senior Managers: run day to day operations

Regulation of financial reporting

Federal government: legislative, judicial, executive.
SEC: has statutory authority to:
- Regulate investment management activities
- Regulate stock market activities
- Investigate violations of security laws
- Control financial reports and their preparers
Financial accounting standards board (FASB), institutes of chartered accountants (AECA)

Audit – examination of a company’s transactions and the resulting financial statement.

Ethics – doing what is right for all stakeholders.

The balance sheet (also called the statement of financial position)

Shows the financial status of a company at a particular instant in time
Reflects the basic accounting equation, which is:
Resources = Claims against those resources
Or
Assets = Liabilities + Owners’ equity

Assets - economic resources that the company owns or controls from past transactions/events
that it expects to help generate future benefits (in short: Goods or rights on others’ goods)
- Accounts: subdivision of the element Assets
Current assets:
- Cash and cash equivalents
- Accounts Receivable (customer bought it on credit)
- Inventories (Merchandise, Supplies, Parts)
Long-term assets:
- Prepaid expenses (taxes, utilities, insurance)
- Property
- Plant
- Equipment

Liabilities – economic obligations of the organization to outsiders from past transactions/events

that it expects to pay in the future
- Accounts – subdivision of the element liabilities
. Accounts Payable (we bought it on credit)
. Notes payable
. Long-term dept

Owners’ equity – owners’ claim on the organization’s assets, i.e., assets minus liabilities
Accounts – subdivision of the element equity
- Paid in capital
- Paid in capital in excess of par/stated value
- Retained earnings

Balance sheet transactions

Every transaction of a company or entity affects the balance sheet equation
- An entity is an organization that stands apart from other organizations and individuals
as a separate economic unit for which the balance sheet is being prepared
- A transaction is any event that affects the financial position of that entity and that can
be reliably recorded in money terms
At least two accounts will be affected for every entry recorded (compound entry => 2 accounts)
Differences in reporting owners’ equity
- Proprietorships and partnerships
. Owners’ equities = “capital”
. Owners’ equities are recorded in the capital account
- Corporations
. Owners’ equities (residual interests in the company) also called stockholders’/shareholders’
equity
. Total capital investment = paid-in capital

Income – increase in wealth over time

From the very first day of the year, to the last (the day in which you close the report)
All companies have to report every single year
The company starts with an investment in cash with which they will buy merchandise/inventory
used to produce the product they are going to sell. When the merchandise is sold, the customer
pays the company with a profit included. Then we repeat the cycle.

Income = 60 000. The company has increased retained earnings by 60 000.

Revenues – net assets received from customers in exchange for delivery of goods or services.
Expenses – net assets given up or consumed when delivering goods or services to customers.
Income (profit, earnings) – revenues less expenses during some reporting period:
- Revenues/Expenses – usual and frequent
- Gains/Losses (later) – unusual and/or infrequent
Retained earnings – income less dividends since the inception of the business.

Two different ways to calculate income:

- Cash-only in and out flows
- Accrual

Accrual accounting example:

Accounts receivable – amounts owed by customers to the business ad a result of a usual and
frequent transaction not involving cash.
Cost of goods sold (an expense) – the cost of the products the business sold to the customer
that generated the revenue.

Revenues are recognized when they are

- Earned – all of the goods or services the customer wants have been delivered to and
accepted by the customer
- Realized – cash has been received from the customer for those goods or services
- Realizable – if anything else besides cash (e.g., accounts receivable) are received, it
(they) should be readily convertible into cash

Revenues increase retained earnings and stockholders’ equity.

Expenses:
- Usual and frequent assets sacrificed or liabilities assumed for goods or services that
contributed to revenue earned in this reporting period
- Deductions from stockholders’ equity

Matching:
List as expenses only those things that directly or indirectly contributed to this period’s revenue
• Product costs – more closely tied to product
• Period costs – more closely tied to the period ex: rent, salary, energy
Depreciation is the systematic allocation of the acquisition cost of long-lived assets to the
periods that benefit from the use of the assets
Land is not subject to depreciation because it does not deteriorate over time

Income statement (AKA: Statement of Earnings, Operations, Profit and Loss) – changes that
took place between those points in time attributable to operating the business
Revenues
Expenses
Gains/Losses (later)
Net income (loss)

+ BASIC CONCEPTS AT THE END OF THE PRESENTATION (SESSION5)

Net income = revenues – expenses

Analyze transactions, events, circumstances – looking for three things

- Which accounts are affected?
- What amounts are involved?
- In which direction did the accounts change? - Increase? - Decrease?

T-account = visualization of every account.

At least two entries are required to keep the accounting equation in balance.
Total debit amount has to be equal to the amount that you have credited.

The steps of the financial accounting process – Recording process

Transaction Documentation – original records underlying transactions, events, circumstances

are analyzed to determine the amounts, accounts, and direction (up/down) each caused

Journal – chronological listing of events (diary)

Ledger – grouping like events into one record, e.g. cash in minus cash out = cash balance

Trial Balance – ledger acts. collectively balance

We have to analyze each transaction to find which accounts are affected in the process.

Chart of accounts – list of all the accounts.

Posting = copying amounts from the journal to the ledger

- At least two postings per transactions
- For complex events, could involve many accounts (called compound journal entries)

Cross refencing – using numbering, dating, and/or some other identification in the ledger to
trace it back to the appropriate journal entry or vice versa.

Purchase an asset and depreciate it

- “Matching” suggests expenses include only those costs that contribute to the
production of revenue
- To deduct total cost of multi-year asset in first year is poor matching
- Alternative approach – deduct some each year

+ READ THE REST OF THE PRESENTATION (SESSION7)

Adjustments to the Accounts
Explicit transactions are
- Observable events that trigger nearly all day-to-day routine entries
- Supported by source documents
Implicit transactions
- Do not generate source documents or any visible evidence that the event actually
occurred
- Are recorded in end-of-period entries called adjustments

Adjustments – help assign the financial effects of implicit transactions to the appropriate time
periods
Adjustments arise from four basic types of implicit transactions:
- Accrual of unrecorded expenses
- Expiration of unexpired (deferred) costs
- Accrual of unrecorded revenues
- Earning of revenues received in advance

Accrue – means to accumulate a receivable (asset) or payable (liability) during a given period
even though no explicit transaction occurs. For example, interest receivable or payable builds
with the passage of time.

Expiration of unexpired costs

 Earning of revenues received in advance

Accrual of unrecorded expenses

Other examples where expenses liabilities arise but are unrecorded include:
- Wages
- Income taxes
- Utilities
- Interest

Adjustments are necessary to accurately

- Match expense to the period in the books of the entity that will have to pay
- Record revenue in the books of the provider or recipient of those services when earned

Interest is the “rent” paid for the use of money. Interests accumulates (accrues) as the time
passes regardless of when a company actually pays cash for interest.

When uncertainty prevails, conservatism suggests selecting measurement methods that

- Understate assets
- Overstate liabilities
 - Understate Equity (and net income) by: Understating revenue and gains; Overstating
expenses and losses
It is unethical to knowingly overstate assets or equity (net income)

Each adjusting entry affects at least

- One income statement account
- One balance sheet account
The Cash account is not adjusted
The end-of-period adjustment process is reserved for implicit transactions, which anchor the
accrual basis of accounting