Chapter 1-3 Study Guide
Chapter 1-3 Study Guide Acct 2010
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Chapter 1: Business Decisions and Financial Accounting Learning Objective 1.1: Describe various organizational forms and business decision makers. Organizational Forms o Sole Proprietorship A form of business owned (and usually operated) by one individual Is the easiest form of business to start because it does not require any special legal maneuvers Considered a part of an owner’s life. All profits/losses are part of the taxable income of the owner and the owner is personally liable for all business debts o Partnership Similar to a sole proprietorship, except that profits, taxes, and legal liability are the responsibility of two or more owners instead of just one Slightly more expensive than a sole proprietorship because a lawyer is needed to draw up the partnership agreement, which describes how profits are shared between partners and how that would change if partners are added Key advantage: by having more owners, it typically has more resources available to it, which help’s with business growth o Corporation A separate entity from both legal and accounting perspectives. The corporation (not the individuals) are legally responsible for its taxes and debts, which means that individuals cannot lose more than their investment into the company Disadvantages: 1) legal fees for creating corporation can be high and 2) income taxes must be paid by both the corporation and its owners Large potential to raise money Can raise lots of money for growth because they divide ownership into shares that can be sold to new owners, which is indicated on a stock certificate Owners of a company’s stock can buy and sell stock privately or publicly. Most corporations start out as private companies, but will “go public” if they need financing o Private: Apple o Public: Chickfila o Other Limited Liability Company (LLC) Combines characteristics of a partnership and a corporation Accounting for Business Decisions o Accounting – an information system designed by an organization to capture, analyze, record, and summarize the activities affecting its financial condition and performance and then report the results to decision makers, both inside and outside the organization o Every organization needs an accountant to help in reporting financial information and help owners understand the effects of business decisions Private accountant: hire to work as an employee of a business Public accountant: can contract someone who provides advice to a variety of businesses o Purpose of an accounting system To capture information about the operating, investing, and financing activities of a company so that it can be reported to decision makers, both inside and outside the business o Managerial accounting reports Detailed financial plans and continually updated reports about the operating performance of the company These reports are made available only to the company’s employees so they can have increased knowledge in making future business decisions o Financial accounting reports (financial statements) Are prepared periodically to provide information to people not employed by the business. Those outside of the business are not given access to detailed internal records of the company, so they rely on the financial statements 4 main groups of external users (who receive financial statements) Creditors o Include suppliers, banks, and anyone to whom money is owed o Suppliers want to be sure they will be paid for the goods and services they deliver. Banks look to evaluate credit on the risk they take in loaning money. Investors o Include existing and potential stockholders o Stockholders look to assess the financial strength of the company and its value Directors o Member of a company’s Board of Directors o Use financial statements to ensure that the company’s managers make decisions that are in the best financial interests of the stock holders Government o Securities and Exchange Commission (SEC) is responsible for the functioning of stock markets, so it keeps a close watch on public corporations financial statements o Internal Revenue Service (IRS), along with state/local governments use financial statements to ensure taxes are done correctly Learning Objective 1.2: Describe the purpose, structure, and content of the four basic financial statements. The Basic Accounting Equation o Resources Owned = Resources Owed o (By the Company) = (To creditors) + (To stockholders) o **(Assets) = (Liabilities) + (Stockholder’s Equity) o Separate Entity Assumption A business’s financial reports include only the activities of the business and not the personal dealings of its stockholders o Assets An economic resource presently controlled by the company; it has measurable value and is expected to benefit the company by producing cash inflows or reducing cashout flows in the future Cash, supplies, equipment, software, inventory o Liabilities Measurable amounts that the company owes to creditors Note payable A liability that occurs when money is borrowed from a bank Owe suppliers for paper, pens, business cards, etc. Account Payable When a company buys goods from another company, it usually does so on credit by promising to pay them at a later date Salaries, wages to employees, taxes to governments **From a legal perspective, creditors have priority over stockholders. This means that if a company goes out of business, liabilities must be paid before any amounts are paid to stockholders** o Stockholder’s Equity Represents the owners’ claims on the business. These claims arise for two reasons: 1) The owners have a claim on amounts the contributed directly to the company in exchange for its stock (Common Stock: equity paid in by stockholders) 2) The owners have a claim on amounts the company has earned through profitable business operations (Retained Earnings: equity earned by the company) o This is particularly important because a business can survive only if it is profitable. It will be profitable if the total amount earned from selling goods and services is greater than the costs incurred to generate those sales. These profits belong to the company’s owners, so they increase the stockholder’s equity. Revenues Are earned by selling goods and services to customers Expenses Are all costs of doing business that are necessary to earn revenues Include advertising, utilities, rent, salaries, wages, insurance, supplies Are said to be incurred to generate revenues Net Income “profit” in casual conversation, accounting term is “net income” Calculated as (Revenues) – (Expenses) By generating a net income, a company increases its stockholders’ equity Net income can be 1) left in the company to accumulate or 2) can be paid out to the company’s stockholders for their own personal use in the form of dividends Dividends An optional distribution of earnings to stockholders, approved by the company’s board of directors Dividends are reported as a reduction in Retained Earnings ** Dividends are not an expense incurred to generate earnings** The Four Financial Statements o Income Statement Reports the amount of (Revenues) – (Expenses) for a given period of time Heading identifies who, what, and when Name of the business, title of the report, and the time period covered Unit measure of assumption Results of business activities should be reported in an appropriate monetary unit, which in the United States is the U.S. dollar Body of an Income Statement Contains the detailed breakdown of revenues, expenses, and net income Revenues come first, with the largest, most relevant revenue first. Expenses are subtracted, again from largest to smallest, except that “Income Tax Expense” is the last expense listed. Net income is the difference between total revenues and total expenses. o Net income does not equal cash made in that time period, but rather how much better off your business is. Revenues and expenses may have to be paid/received during a later time period. o Statement of Retained Earnings Reports the way that Net Income and the distribution of dividends affected the financial position of the company during the given time period Most changes in stockholder’s equity is attributed to generating and distributing earnings Set Up Statement starts with the Retained Earnings balance at the beginning of the period o Retained earnings are the profits that have accumulated in the company over time, which means that a new business will have $0 in retained earnings Next, statement adds Net Income and subtracts any Dividends for the current period to arrive at Retained earnings at the end of the time period o Balance Sheet Reports the amount of assets, liabilities, and stockholders’ equity of a business at a point in time Think of the balance sheet as a picture or screen capture of the resources and claims to resources at the end of a particular day Unlike the other financial reports, the balance sheet is presented for a point in time Set Up First lists the assets of the business. Assets are listed in order of how soon they are used or turned into cash o Cash should always be the first asset listed in the balance sheet. Represents the total amount of cash on hand and in the corporation’s bank account o Accounts receivable represents a company’s right to collect from customers for sales and services provided on credit o Supplies indicates the cost of office supplies on hand at the balance sheet date Cost principle: assets are initially reported on the balance sheet based on their original cost to the company Second section lists the business’s liabilities and stockholders’ equity balances o Accounts Payable represents the amount a business owes suppliers for equipment, supplies, and other items purchased on credit o Note Payable is the written promise to repay a loan from the bank. As with all liabilities, these are financial obligations of the business arising from past business activities Within stockholders equity… o Common stock reflects the dollar amount of the company’s stock given o Retained Earnings reports the earnings expected to be retained in the company as of a certain date *This number matches the ending amount of Retained Earnings in the Statement of Retained Earnings **Balance sheet should always come out equal due to The Basic Accounting Equation** o Statement of Cash Flows Reports the operating, investing, and financing activities that caused increases and decreases in cash during a certain period of time This report is of interest to external users and includes only those activities that result in cash changing hands Divided into 3 types of activities Operating o Directly related to running the business to earn a profit o Includes selling products and services, paying employee wages, buying advertising, renting a building, obtaining insurance coverage, etc. Investing o Involve buying and selling productive resources with long lives, purchasing investments, and lending to others o Includes buildings, land, equipment, software, etc. o *For early businesses, a negative number for investing cash flows occurs because the company needs to buy a significant amount of equipment and software Financing o Any borrowing from banks, repaying bank loans, receiving cash from stockholders for company stock, or paying dividends to stockholders o Relationships among the Financial Statements Net Income (from the income statement) is a component in determining ending Retained Earnings (from Statement of Retained Earnings). Ending Retained Earnings (from the Statement of Retained Earnings) is then reported on the Balance Sheet. Cash (on the Balance Sheet) is equal to the ending cash (on the Statement of Cash Flows). Learning Objective 1.3: Explain how financial statements are used by decision makers. Using Financial Statements o Creditors are mainly interested in assessing: Is the company generating enough cash to make payments on its loan? Answer comes from the Statement of Cash Flows In particular, are interested in seeing whether operating activities are producing positive cash flows Does the company have enough assets to cover its liabilities? Answer comes from the Balance Sheet In particular, comparing assets to liabilities o Investors expect a return on their contributions to a company Return may be immediate (through dividends) or longterm (through selling stock certificates at a price higher that their original cost) Dividends and higher stock prices are more likely if a company is profitable Looking to analyze their ability to make a profit Learning Objective 1.4: Describe factors that contribute to useful financial information. Useful Financial Information o Arises when businesses apply generally accepted accounting principles in an ethical business environment Generally Accepted Accounting Principles o Currently, Financial Accounting Standards Board (FASB) has the primary responsibility for setting the underlying rules of accounting in the USA. As a group, these rules are called Generally Accepted Accounting Principles. o Accounting rules in the US are similar to those used elsewhere in the world, but some important differences exist International Accounting Standards Board (IASB) runs the rest of the world o **Main goal of GAAP and IFRS is to ensure companies produce financial information that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the companies. For Financial Statements to be judged as useful, it must possess two fundamental characteristics: o Relevance Information is relevant if it makes a difference in decision making o Faithful Representation Information is faithful if it fully depicts the economic substance of business activities o Usefulness of Financial Information is enhanced when it is: Timely Available in time to affect decision makers Verifiable Others reach similar values using similar methods Comparable The same accounting principles are used over time and across companies Understandable Reasonably informed users can comprehend and interpret it Ethical Conduct o Ethics Refers to the standards of conduct for judging right from wrong, honest from dishonest, and fair from unfair Intentional financial misreporting is both unethical and illegal Code of Professional Conduct All “American Institute of Certified Public Accountants” (AICPA) must adhere to this, helping to eliminate fraud In response to frauds, the government introduced new laws, like the Sarbanes Oxley Act Requires top managers of public companies to sign a report certifying their responsibilities for the financial statements, maintain an audited system of internal controls to ensure accuracy in their accounting reports, and maintain an independent committee to oversee top management and ensure that they cooperate with auditors When faced with an ethical dilemma, you should follow this 3 step process: Identify who will be affected by the situation Identify and evaluate the alternative courses of action Choose the alternative that is the most ethical Chapter 2: The Balance Sheet Learning Objective 2.1: Identify financial effects of common business activities that affect the balance sheet. Building a Balance Sheet from Business Activities o Balance Sheet is structured like the basic accounting equation of (Assets) = (Liabilities) + (Expenses) o Key activity for any startup company is to obtain financing Two sources of financing are available to businesses Equity o Refers to financing through owners’ contributions and reinvestments of profit Debt o Refers to financing the business through loans o Promissory note Terms for repaying a loan described in detail in this legal document *Note: a business is obligated to repay debt financing, but it is not obligated to repay its equity financing o After obtaining initial financing, a company will start investing in assets that will be used after the business opens Ex: logo, equipment, supplies, etc. Three features that will be important for understanding how accounting works o The company always documents its activities Promissory notes, electronic stock certificates, checks, invoices, and other documents indicate the nature of the underlying business area o The company always receives something and gives something Any exchange that affects the company’s assets, liabilities, or stockholders’ equity must be captured in and reported by the accounting system. o Cost Principle Assets and liabilities should be initially recorded at their original cost to the company Each exchange is analyzed to determine the dollar amount that represents the value of items given and received Process for Accounting Business Activities 1) Picture the documented activity a. Picture what is described in words. This step is easily overlooked but is vital to succeeding. 2) Name what’s exchanged a. Building on the previous step, assign names to what your business has received and given 3) Analyze the financial affects a. Show how the costs cause elements of the accounting equation to increase and/or decrease Transactions and Other Activities o Transaction An event or activity that has a direct and measurable financial effect on the assets, liabilities, or stockholder’s equity of a business Are of special importance because they are the only activities that enter the financial accounting system Include two types of events: External exchanges o Exchanges involving assets, liabilities, and/or stockholders’ equity between the company and someone else. o Ex: selling merchandise Internal events o Do not involve exchanges with others outside the business, but rather occur within the company itself. o Ex: Creation of a product. Turing supplies into a product o Some important activities that occur will not be captured by the accounting system because they do not involve transactions An exchange of only promises is not an accounting transaction. Ex: rent, placing orders, etc. Documents are created for these activities, but are excluded until payment and material are exchanged Learning Objective 2.2: Apply transaction analysis to accounting transactions. Accounting Cycle o Analyze Record Summarize Prepare the Trial Balance Report Financial Statements Step 1: Analyze Transactions o Two simple ideas are used when analyzing transactions Duality of Effects Every transaction has at least two effects on the basic accounting equation. “Give and receive”, “Push and Pull”, “Newton’s 3 Law” A = L + SE Must always be true o Chart of Accounts As part of transaction analysis, a name is given to each item exchanged, which are referred to as account titles Definition: A summary of all account names (and corresponding account numbers) used to record financial results in the accounting system Tailored to each company’s business. Although “Account Payable” exists within all companies, names may differ based on specificity o Ex: Issue Stock to Owners “Scott incorporates SonicGateway Inc. on August 1. The company issues common stock to the owners (Scott and Angus) as evidence of their contribution of $10,000 cash, which is deposited in the company’s bank account.” Picture o Receives $10,000 o Gives Stock certificate Name o SonicGateway has received $10,000 cash. o SonicGateway gave $10,000 of common stock Analyze o (Assets) = (Liabilities) + (Stockholder’s Equity) o a) Cash +10,000 = (Liabilities) + Common Stock + 10,000 **A reference is included “a)” so that we can refer back to the original transaction if needed** Goal of transaction analysis is to identify the specific amounts affected, the dollar amount of the change in the accounts, and the direction of this change on the accounting equation o Ex: Invest in Logo/Trademarks “SonicGateway pays $300 cash to create the company’s logo.” Picture o Receives Logo o Gives $300 cash Name o SonicGateway has received a logo costing $300. o SonicGateway gave $300 cash. Analyze o (Assets) = (Liabilities) + (Stockholders’ Equity) o b) Cash 300 = (No change) + (No change) Logo +300 o *Notice that even though the transaction did not affect liabilities or stockholders’ equity, the accounting equation remained in balance because the decrease in one asset was offset by the increase in another (decrease in cash, increase in branding)* o Ex: Obtain a Logo from the Bank “SonicGateway borrows $20,000 from a bank, depositing those funds in its bank account and signing a formal agreement to repay the loan in two years.” Picture o Receives $20,000 o Gives Promissory Note Name o SonicGateway has received $20,000 in cash. o SonicGateway gave a note, payable to the bank for $20,000. Analyze o (Assets) = (Liabilities) + (Stockholders’ Equity) o c) Cash + 20,000 = (Note Payable +20,000) + (SE) o Ex: Invest in Equipment “SonicGateway purchases and receives $9,600 in computer, printers, and desks, in exchange for its promise to pay $9,600 at the end of the month.” Picture o Receives Equipment o Gives Promise Name o SonicGateway has received $9,600 of equipment. o SonicGateway gave a promise to pay $9,600 at the end of the month. Analyze o (Assets) = (Liabilities) + (SE) o d) Equipment +9,600 = (Accounts Payable +9,600) + (SE) o Ex: Pay Supplier “SonicGateway pays $5,000 to the equipment supplier listed above in transaction d).” Picture o Receives Paid notification o Gives $5,000 Name o SonicGateway has received a release from $5,000 of its promise to pay on account. o SonicGateway gave $5,000 cash. Analyze o (Assets) = (Liabilities) + (SE) o e) Cash 5,000 = Accounts Payable – 5,000 + (SE) o Ex: Order Software for App “SonicGateway signed a contract with a programmer for program code for a game app for $9,000. No code has been received yet.” Picture o Receives Promise of Future Delivery o Gives Promise to Pay for Purchase Name o An exchange of only promises is not a transaction. Analyze o This does not affect the accounting equation. o Ex: Receive Software “SonicGateway receives the $9,000 of app game code listed above, pays $4,000 cash and promises to pay the remaining $5,000 next month.” Picture o Receives Software o Gives $4,000 and promise of future payment Name o SonicGateway has received software costing $9,000. o SonicGateway gave $4,000 cash and a promise to pay $5,000 on account. Analyze o (Assets) = (Liabilities) + (SE) o g) Cash 4,000 = (Accounts Payable +5,000) + (SE) Software +9,000 o Ex: Receive Supplies “SonicGateway receives supplies costing $600 on account.” Picture o Receives Supplies o Gives Promise of future payment Name o SonicGateway has received supplies costing $600. o SonicGateway gave a promise to pay $600 on account. Analyze o (Assets) = (Liabilities) + (SE) o h) Supplies + 600 = (Accounts Payable +600) + (SE) Step 2 & 3: Record and Summarize o One way to record and summarize the financial effects of transactions would be to enter your understanding of their effects into a spreadsheet By summing each spreadsheet column, you could compute new balances at the end of each month and report them on the balance sheet. Makes it easy to see the individual impact of each transaction and how transactions combine with beginning balances to yield ending balances, but it is impractical to use for most large organizations. o Computerized Accounting Systems Handle a large number of transactions. Systems follow the accounting cycle, which is repeated day after day, month after month, year after year. o Transactions are analyzed and their financial effects are entered into journals each day they occur, which are later summarized into ledger accounts that keep track of the financial effects on each account. Journals Used to record the effects of each days’ transactions; organized by date Ledgers Used to summarize the effects of journal entries on each account; organized by account Learning Objective 2.3: Use journal entries and Taccounts to show how transactions affect the balance sheet. Luca Pacioli o “The Accountant Who Changed the World” o According to Pacioli, “Doubleentry accounting is based on a simple concept: each party in a business transaction will receive something and give something in return. In accounting terms, what is received is a debit and what is given is a credit. The T account is a representation of a scale or balance.” The Debit/Credit Framework o Framework for journals and ledger accounts were created more than 500 years ago. Although computers now perform many routine accounting tasks involving journals and ledger accounts most computerized systems still require you to know how these accounting records work. **To understand this framework, think of the accounting equation (A = L + SE) as an old fashioned weight scale that tips at the equals sign. Assets (cash, equipment, etc.) are put on the left side and liabilities and stockholders’ equity accounts are put on the right. Likewise, each individual account has two sides, with one side used for increases and the other for decreases. ** o Accounts increase on the same side as they appear in A = L + SE Accounts on the left side of the accounting equation increase on the left side of the account and accounts on the right side of the equation increase on the right. Assets increase on the left side of the account. Liabilities increase on the right side of the account. Stockholders’ equity accounts increase on the right side of the account. Left is debit (dr), right is credit (cr) Use debits for increases in assets (and for decreases in liabilities and stockholders’ equity accounts). Use credits for increases in liabilities and stockholders’ equity accounts (and for decreases in assets). The normal balance for an account is the side on which it increases. Assets normally have debit balances, whereas liabilities and stockholders’ equity accounts normally have credit balances. o Accountants didn’t dream up this debit/credit framework to confuse. Purpose of the double entry system is to introduce another check on the accuracy of accounting numbers. Also requires that debits = credits Step 1: Analyzing Transactions o Debit/credit framework does not change the first step of the accounting process. Step 2: Recording Journal Entries o Financial effects of transactions are entered into a journal using a “debitsequalcredits” format o When looking at journal entries, notice the following: A date is included for each transaction Debits appear first (on top). Credits are shown below the debits and are indented to the right (both the words and the amounts). If more than one account is credited, their order doesn’t matter as long as for each journal entry debits are on top and credits are on the bottom and indented. Total debits equal total credits for each transaction Dollar signs are not used because the journal is understood to be record of financial effects. The reference column will be used later to indicate when the journal entry has been summarized in the ledger accounts. A brief explanation of the transaction is shown below the debits and credits. The line after the explanation is left blank before showing the next journal entry. o Simplified example of a Journal Entry Debit Credit d) Software (+A) 9,000 Cash (A) 4,000 Accounts Payable (+L) 5,000 o Main Differences between Simplified Format and a Formal Journal entry are… When a date is not given, use some form of reference for each transaction, such as “d)” to identify the event Omit the reference column and transaction explanation to simplify the entry Include the appropriate account type (A, L, SE) along with the direction of the effect (+ or ) next to each account title to clarify the effects of the transaction on each account. This parenthetical note will reinforce the debit/credit framework and help you ensure the accounting equation remains in balance. Step 3: Summarizing in Ledger Accounts o By themselves, journal entries show the effects of transactions, but they do not provide account balances. That’s why Ledge Accounts are needed. After journal entries have been recorded (in step 2), their dollar amounts are copied (“posted”) to each ledger account affected by the transaction, so that account balances can be computed. In most computerized accounting systems, this happens automatically. o TAccount A simplified version of a ledger account used for summarizing the effects of journal entries Each TAccount represents the debit and credit columns of a ledger account **Notice** (examples on p. 5964) Every account starts with a beginning balance, normally on the side where increases are summarized. For balance sheet accounts, the ending balance is the beginning balance for the current period. Dollar signs are not needed in journal entries and Taccounts. Each amount is accompanied by a reference to the related journal entry, which makes it easy to trace back to the original transaction should errors occur. To find ending account balances, express the Taccounts as equations. The ending balance is double underlined to distinguish it from transactions and symbolize the final result of a computation. The ending balance is shown on the side that has the greatest dollar amount. Learning Objective 2.4: Prepare a trial balance and a classified balance sheet. Preparing a Trial Balance and Balance Sheet o Next step in the accounting cycle to prepare an internal accounting report: trial balance An internal report that lists all accounts and their balances to check on the equality of total recorded debits and total recorded credits If total debits do not equal total credits, the balance sheet will not be in balance Lists the ending balance in every Taccount and then computes total debits and total credits and because the column totals come out equal, a balance sheet can be prepared from the Taccount o Classified Balance Sheet A balance sheet that shows a subtotal for current assets and current liabilities Contains subcategories for assets and liabilities labeled as current Current Assets: assets the business will use up or turn into cash within 12 months of the balance sheet date Current Liabilities: debts and other obligations that will be paid or fulfilled within 12 months of the balance sheet date o Companies list assets in order of liquidity, how soon they will be used up or turned into cash. o Companies list assets in order of maturity, how soon they will be paid in cash or fulfilled by providing a service. *Equipment and Note Payable Accounts are understood to be long term* Learning Objective 2.5: Interpret the balance sheet using current ratio and an understanding of related concepts. Assessing the Ability to Pay o Classified balance sheet makes it easy to see whether current assets are sufficient to pay current liabilities o Current Ratio Since looking at total numbers (assets, liabilities, etc.) differs so much from company to company, it is far easier to express the relationship to pay as a ratio, found by dividing current assets by current liabilities. The Current Ratio is used to evaluate liquidity (the ability to pay liabilities as they come due in the short run). Generally speaking, a higher ratio means higher liquidity and better ability to pay. Balance Sheet Concepts and Values o The purpose of a balance sheet is to report what a company owns and owes, but not necessarily what the company is worth. Some people mistakenly believe that the balance sheet reports a company’s current value. o Net Worth is a term that many accountants and analysts use when referring to stockholders’ equity o **Why is it wrong to think that the balance sheet reports a company’s current value??** Accounting is based on recording and reporting transactions, which affects 1) what is and is not recorded and 2) the amounts assigned to recorded items “What is and is not recorded?” o Measurable exchanges (such as purchases and payments) are recorded, while creativity and insight are not “What amounts are assigned to recorded items?” o Following the cost principle, assets and liabilities are first recorded at cost, which is their cashequivalent vale on the date of the transaction. If an asset becomes worth more, it is not normally recorded as a higher value (with some minor exceptions by the GAAP). But if an asset loses value, it is generally reported on the balance sheet at the lower value. This means that the numbers reported on a balance sheet many not be the asset’s current value. Chapter 3: The Income Statement Section 3.1 Describe common operating transactions and select appropriate income statement account titles. Operating Activities o Are the daytoday functions involved in running a business o Unlike investing and financing activities, operating activities occur regularly and often have a shorter duration of effect o Include buying goods and services from suppliers and employees and selling goods and services to customers and collecting cash from them o Operation Cycle The period from buying goods and services through to collecting cash from customers Length of time for each step in the operation cycle varies from company to company o Operating activities are the primary source of revenues and expenses, and therefore, can determine whether a company earns a profit or incurs a loss o Reliable management approach is to evaluate the revenues and expenses reported on the income statement Income Statement Accounts o Income Statement summarizes the financial impact of operating activities undertaken by the company during the accounting period and includes three main sections: revenues, expenses, and net income o Revenues The amounts a business charges its customers when it provides goods or services Revenue is reported when the company is paid by the customer. The amount of revenue earned during the period is reported first in the income statement o Expenses The costs of operating business, incurred to generate revenues in the period covered by the income statement Expenses are reported when the company uses something (like space in a building, supplies for providing services, or the efforts of employees) Essentially whenever a business uses up its resources to generate revenues during the period, it reports an expense, regardless of when the company pays for the resources o Net Income Calculated by subtracting expenses from revenues It is a total (not an account) and summarizes the overall impact of revenues and expenses in a single number Net loss – Expenses > revenues ; Net Income – Revenues > Expenses *Net Income indicates the amount by which stockholders’ equity increases as a result of a company’s profitable operations. For this reason, net income is a closely watched measure of a company’s success o Time Period Assumption The long life of a company is divided into shorter periods, such as months, quarters, and years Income statement reports the financial effects of business activities that occurred during just the current period. They relate only to the current period and do not have a lingering financial impact beyond the end of the current period. Distinction between Balance Sheet and Income Statement o The revenues and expenses on an income statement report the financial impact of activities in just the current period, whereas items on the balance sheet will continue to have financial impact beyond the end of the current period. o Balance sheet accounts are considered permanent, whereas income statement accounts are considered temporary. o Balance sheet takes stock of what exists at a point in time whereas the income statement depicts a flow of what happened over a period of time. Cash Basis Accounting o Reports revenues when cash is received and expenses when cash is paid; not allowed under GAAP o If fine for managing personal finances, but not for running a business o **Doesn’t measure financial performance very well when transactions are conducted using credit rather than cash. Credit often introduces a significant delay between the time an activity occurs and the time it impacts a bank account balance. Since most companies use credit for their transactions, cash basis accounting is not likely to correspond to the business activities that actually occur during a given period. ** Section 3.2: Explain and apply the revenue and expense recognition principles. Accrual Basis Accounting o Reports revenues when they are earned and expenses when they are incurred, regardless of the timing of cash receipts or payments; required under GAAP; produces a better measure of profits arising from the company’s activities o For any external reporting of financial information, accrual system must be used o “Rule of Accrual” Financial effects of business activities are measured and reported when the activities occur, not when the cash related to them is received or paid Revenues are recognized when they are earned and expenses when they are incurred Revenue Recognition Principle o The requirement under accrual basis accounting to record revenues when they are earned, not necessarily when cash is received for them Revenues should be recognized when they are earned Recognized – revenues are measured and recorded in the accounting system Earned – the company has fulfilled its performance obligations to the customer by doing what it promised to do. As a result, the customer is able to direct the use of and obtain the benefits from the good or service. For most businesses, these conditions are met at the point of delivery o All companies expect to receive cash in exchange for providing goods and services, but the timing of cash receipts does not dictate when revenues are recognized. Instead, the key factor in determining when to recognize revenue is whether the company has provided goods or services to customers during the accounting period. Cash before Sale/Service Some companies (airlines, magazine publishers, insurance companies, retail stores) receive cash before delivering goods or services. o Ex: Gift Card. Will record the cash received when the gift card is issued, but since no goods or services have been delivered yet to customers, no revenue is recorded. Rather, there is an obligation to accept the gift card as payment in the future. Unearned Revenue – a liability representing a company’s obligation to provide goods or services to customers in the future Revenues will be reported later, when goods or services are provided in exchange for the gift card Cash with Sale/Service Common for companies that are selling to consumers. Customers pay for goods/services at the same time that cash/credit is exchanged, so cash/credit and revenue are reported at the same time. Sale/Service before, cash after Typically arises when a company sells on account, meaning that the company provides goods or services to a customer not for cash, but instead for the right to collect cash in the future. This right is an asset called Accounts Receivable. Sales Revenue is recorded on the income statement, while Accounts Receivable is recorded on the balance sheet. Later, when payment is received, the business will increase its Cash Account and decrease its Accounts Receivable account. No additional revenue is reported when the payment is received because the revenue was already recorded when the app was downloaded. Expense Recognition Principle (“Matching”) o Under accrual business accounting, expenses are recognized in the same period as the revenues to which they relate, not necessarily the period in which cash is paid to them. o Definition: The practice under accrual basis accounting to record expenses in the same period as the revenues they generate, not necessarily the period in which cash is paid to them. o Record expenses in the same period as the revenues with which they can be reasonably associated. If an expense cannot be directly associated with revenues, it is recorded in the period that the underlying business activity occurs. Ex: It is not clear when advertising yields revenue, advertising expense is simply reported in the period that ads are run. o Notice that it is the timing of the underlying business activities, not the cash payments, that dictates when expenses are recognized o Cash Before Expense It is common for businesses to pay for something that provides benefits only in future periods. Ex: A business might buy office supplies now but not use them until next month. Under the expense recognition principle, the expense from using these supplies is reported next month, when the supplies are used to earn revenue, not in the current month, when the supplies were purchased. This month, the supplies represent as asset. o Cash With Expense Ex: A company has arranged to make automatic monthly payments to its utility company for electricity at the end of each month. Because the electricity is used?
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