ACCN 2010 -Study Guide
ACCN 2010 -Study Guide ACCN 2010
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This 19 page Study Guide was uploaded by Tala Rafii on Monday September 26, 2016. The Study Guide belongs to ACCN 2010 at Tulane University taught by Christine Smith in Summer 2015. Since its upload, it has received 79 views. For similar materials see Financial Accounting in Business at Tulane University.
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Bold: key word Green: definition Yellow: important Red: very important è: Therefore, in consequence Chapter 1 Introducing the Basics of Accounting à What is Accounting? It is a “special language” used to communicate financial information about economic entities to interested parties. Accounting is the precise, unbiased, realistic language that captures financial information about an entity (and communicates it) to interested users. à Who are the interested parties? Ø Internal users: people in the entity: the CEO, CFO, CIO, employees, executive management, accountants, shareholders. Ø External users: competitors, creditors (want to see if the economic entity is credit worthy), customers, regulatory authorities (the Internal Revenue Service (IRS) and the Securities and Exchange Commission (SEC)), and potential investors. The results of these financial transactions are reported in a set of periodic financial statements. à Why do accountants go through this exercise? They share that story because the users (internal and external) share the information and make decisions. à Why are people forced to make decisions? Because resources are scarce and we have to make decisions on how to allocate them. For instance, time is scarce and we have to allocate it wisely. Success in business requires making many decisions, and decisions require financial information. à We need to be able to compare stories è they need to have been prepared by a set of rules/standards that everybody shares. In the United States, these rules are referred to as the US GAAP: Generally Accepted Accounting Principles. à Countries started adopting the same rules about two decades ago because of the rise of globalization and the multiplication of multinational corporations è there has been a convergence. Nowadays, 2 different standards exist: Ø US GAAP Ø IFRS: International Financial Reporting Standards (most economies use it) à Many of their standards overlap. However there are some key differences. In this class, we will focus on US GAAP. As storytellers, we make assumptions: • The economic entity assumption: Accountants record and communicate the information as if the economic entity is separate from the financial of its owners. The business is treated as a person by itself. à As an accountant, if I open a business, I will not report to my users everything I own, because these expenses won’t be withdrawn form the economic entity. I will only tell the story of the economic entity. • Monetary unit assumption: We capture and record the entity’s information in terms of a monetary unit. • Time period assumption: The business profit or losses are measured on a timely basis. • Going concern assumption: The business is going to be operated for a non-predefined period, in other words, there is no ending date for business life. • Unnamed assumption: Profit is not bad. It must follow Corporate Social Responsibility but it is vital. 3 Forms of Business Organizations: § Sole Proprietorship: business owned by one person. Simple to set up and gives control over the business. § Partnership: business owned by two or more persons associated as partners. Formed because one individual does not have enough economic resources to pen or expand the business. Sometimes partners bring unique skills or resources to the partnership. § Corporation: business organized as a separate legal entity owned by stockholders. Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is more attractive because shares of stock are easy to sell (it is easier to transfer ownership). It is easier for corporations to raise funds. Legal liability: a sole proprietorship and a partnership are personally liable for all debts and legal obligations of the business. Stockholders have no personal legal liability. Foundation of Accountingà the Accounting Equation ASSETS= EQUITIES Assets= a future economic benefit. Something that the company has (sometimes intangible) that represents a future economic benefit è an unused cost. Example: - Accounts receivable: we are one of Tulane’s customers and we owe them money. - Physical assets: automobiles, real estate à they help us generate revenue. Also called Property, Plant and Equipment. - Cash: the ultimate asset, gives the most flexibility. à Those assets had a source which gave claims to those assets: EQUITIES= Non-ownersà Liabilities + Ownersà Owner’s equity/Shareholder’s equity = contributed capital+ earned capital ASSETS = EQUITIES Assets - Liabilities = Equities – Liabilities Which can also be written as: Assets – Liabilities = (Liabilities + Owner’s Equity) - Liabilities è Net Assets = Owner’s Equity Owners are entitled to the claims of increased assets because they took the financial risk. If Assets>Liabilities, the owner’s claims are the residual obtained. The basic accounting equation à it is the prism through which we will analyze every recorded event. à We know a transaction has occurred if it has an impact on the accounting equation. Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services. Expenses are the cost of assets consumed or services used in the process of generating revenues. à The company compares the Revenue of a period with the Expenses of that period to determine whether it earned a profit or not. If Revenues > Expenses è Net income results If Revenues < Expenses è Net loss results 4 Financial Statements: • Income Statement: to show how successfully the business performed during a period of time. We report its revenues and expenses. Investors are interested in a company’s past Net Income because it provides useful information for predicting future Net Income. • Retained Earnings Statement/ Statement of Owner’s Equity/ Statement of Capital/ Statement of Stockholders’ Equity: to indicate how much of previous income was distributed to owners in the forms of dividends, and how much was retained in the business to allow for future growth. If a company is profitable at the end of each period, it must decide what portion of profits to pay to shareholders in dividends. Retained earnings = Net Income retained in the corporation. • Balance Sheet: to present a picture at a point in time of what the business owns (Assets), and owes (Liabilities). It reports assets and claims to assets at a specific point in time. It helps users determine if the company relies on debit or stockholders’ equity to finance its assets. • Statement of Cash Flows: to show where the business obtained cash during a period of time and how it was used. It reports the cash effects of a company’s operating, investing, and financing activities. It helps users determine if the company generates enough cash from operations to fund its investing activities. The results on some financial statements become inputs to other statements è the statements are interrelated. Exercise: Beau’s Bodacious Baseball Business We are going into the Business of buying and selling baseballs. The business goes into existence on January 1 , 2016. We are forming our Business as a sole proprietorship. The economic entity assumption: We tell the story of a discrete economic entity as if it were separate from its owners even if it’s legally not the case è we are not going to look at Beau’s property. o Beau opens up a checking account for BBBB with $1,000 of personal funds. Transaction 1: There has been a transaction because the equation was affected. ASSETS = LIABILITIES + OWNER'S EQ Cash BP, Capital 1,000 1,000 o BBBB purchases 1,000 baseballs from Spalding Sports at $10 each, for a total purchase of $10,000. Paid $600 cash as down payment and will pay balance of $9,400 in 60 days. Transaction 2: 1,000 x 10 = 10,000 à total transaction This is a transaction on credit. We need to pay $10,000 but we only pay a down payment of $600. à We still need to pay $9,400 è we have an account payable of $9,400. ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Payable BP, Capital 1,000 10,000 9,400 1,000 <600> o BBBB sells 300 baseballs for $14 each, for a total sale of $4,200. Customers pay $200 cash as down payment, with balance of $4,000 due in 30 days. (Breakdown into 2 transactions – 3A and 3B). Transaction 3: ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> Accounts Receivable is an asset of future economic benefit because it represents a claim to cash that we have because a customer purchased a service or good from us and has not paid yet. There are 2 different types of Beau’s increase in revenue: - Contributed capital - Earned capital= caused by Beau taking a risk and generating revenue or sales. Revenue will take different names but it is always earned capital. The decrease in Beau Parent, Capital caused by operating business is called expenses (specifically here: cost of goods sold). o Customer sends BBBB a check for $2,500. Transaction 4: ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> 2,500 <2,500> o BBBB writes a check to Spalding sports for $2,700. Transaction 5: ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> 2,500 <2,500> <2,700> <2,700> o Beau’s wife calls and says she needs $250. Beau looks in his wallet to find no money. Therefore, BBBB writes a check to Beau for $250. Transaction 6: Beau’s claims against assets have increased because there are fewer assets. We call this situation capital withdrawn/ drawing/ dividends (in a corporation). ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> 2,500 <2,500> <2,700> <2,700> <250> <250> o When BBBB purchased the baseballs from Spalding Sports, they had to rent a storage space to store the inventory for $50 a month. The baseballs were stored there for the entire month, however, the landlord had not yet been paid. Transaction 7: -We don’t record transactions only when cash is involved because according to the GAAP, we record stories according to the accrual method of accounting. à better representation of the true situation of the economic entity. ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> 2,500 <2,500> <2,700> <2,700> <250> <250> 50 <50> At the end of the month, we have to prepare the reports. The first thing to do: add up the totals in each account. ASSETS = LIABILITIES + OWNER'S EQ Cash Inventory Acc. Receivable Acc. Payable BP, Capital 1,000 9,400 1,000 <600> 10,000 200 4,000 4,200 <3,000> <3,000> 2,500 <2,500> <2,700> <2,700> <250> <250> 50 <50> 150 + 7,000 + 1,500 = 6,750 + 1,900 We will prepare our story now. First of all, important: each financial statement requires a 3-line header: Company’s name (no abbreviation) Financial Statement’s name The period of time § First financial statement: the Income Statement. We tell the story for a period of time. The Income Statement tells the users how successful or not the business was during that period of time in what it decided to do. We will begin our Income Statement by listing Revenues. Beau’s Bodacious Baseball Business Income Statement For the month ended January 31 , 2016 REVENUES: Sales $ 4,200 EXPENSES: Cost Of Goods Sold $ 3,000 Rent 50 Total expenses 3,050 NET INCOME: $ 1,150 We have a rule in GAAP called the Matching Principle: to get more accurate results, we include only the expenses incurred caused by operating the business during the period. Net Income= the best measurement of success for that specific period. à The Net Income is NOT money. The business can’t spend its earnings (net income). It does not exist. The business only has $150 cash. § The second financial statement: the Statement of Owner’s Equity/ Stockholder’s Equity (if it’s a corporation) We will take the entire account in Beau Parent, capital. Beau’s Bodacious Baseball Business Statement of Owner’s Equity For the month ended January 31 , 2016 st Beau Parent, capital at January 1 , 2016 $ 0 Contributed Capital 1,000 $ 1,000 Net Income 1,150 $ 2,150 Drawing (250) Beau Parent, capital at January 31, 2009 $ 1,900 § Third financial statement: the Balance Sheet. It is not a moving image, it is a snapshot/ picture. It simply takes the accounting equation and lays it out. Beau’s Bodacious Baseball Business Balance Sheet As at January 31 , 2016 ASSETS: Cash $ 150 Inventory $ 7,000 Accounts Receivable $ 1,500 TOTAL ASSETS: $ 8,650 LIABILITIES: Accounts Payable $ 4,750 OWNER’S EQUITY: Beau Parent, capital $ 1,900 TOTAL LIABILITIES AND OWNER’S EQUITY: $ 8,650 Chapter 2 The Accounting Information System Accounting Information System= the system of collecting and processing transaction data and communicating financial information to decision-makers. Accounting Cycle: Analyze Business Transactions à Journalize à Post à Trial Balance à Adjusting Entries à Adjusted Trial Balance à Financial Statements à Closing Entries à Post-Closing Trial Balance Accounting transactions= economic events that require recording in the financial statements. Transaction analysis= process of identifying the specific effects of economic events on the accounting equation. 1492: An Italian priest documented and wrote a tome on Accounting. In that book, he documented the “double-entry bookkeeping system of Accounting”. He did not invent it, the Phoenicians did. à The method/system with which we capture economic events has not changed since 1492.à The rules and guidance have changed. We keep track of every individual account separately. General Ledger= the sum of all the accounts of a company we are keeping score of. à Every business will have ONLY ONE General Ledger in its history. The story simply continues. Account Left Right = = Debit Credit è We call them T-accounts. Ø Debit means Left. Ø Credit means Right. ASSETS = LIABILITIES + OWNER’S EQUITY Any Asset Any Liability Any OE Left Right Left Right Left Right Debit Credit Debit Credit Debit Credit Expenses Revenues * There is a duality: every time we debit an account, let’s credit an equal corresponding account. è ΣDebits = ΣCredits To increase an Asset account, we will always debit, so we affect the left side of the T- account. • If I increase an asset account by debiting it, then I will decrease an asset account by crediting it. • If I increase a liability account by crediting it, I decrease it by debiting it. Stockholders’ Equity Relationships: Companies report the subdivisions of Stockholders’ equity in various places in the Financial Statements. Any change of dividends, revenues and expenses affect Stockholders’ Equity (notably in the Balance Sheet). Example: Beau’s Bodacious Baseball Business 1- General Journal: Record in chronological order (not by account) the activity. 2- Post the general journal entries into the General Ledger. v The first step: journalization. GENERAL JOURNAL Transaction# Accounts Debit Credit 1 Cash $1,000 Beau Parent, capital $1,000 2 Inventory $10,000 Cash $600 Accounts Payable $9,400 3A Cash $200 Accounts Receivable $4,000 Sales Revenue $4,200 3B Inventory $3,000 COGS $3,000 4 Cash $2,500 Accounts Receivable $2,500 5 Accounts Payable $2,700 Cash $2,700 Beau Parent, 6 drawing $250 Cash $250 7 Rent Expense $50 Accounts Payable $50 v The second step: we post the journal entry into the General Ledger. View page 39 in “Keeping Score”: This table represents our General Ledger (the book of accounts). § All the Accounts North are our Balance Sheet accounts à Real/Permanent accounts, because these accounts never go away, they continue to grow infinitum. § South of the double horizontal lines, we put the income statement accounts à they are temporary/nominal accounts, because once we measured the success for a given period, we’re going to close them out and start capturing again. § All accounts to the left –i.e. Assets and Expenses- are increased by a Debit, decreased by a Credit and have a normal Debit balance. § All accounts to the right –i.e. Liabilities, Owner’s Equity and Revenues- are increased by a Credit, decreased by a Debit and have a normal Credit balance. Normal (positive) Credit balance= Credits will exceed Debits. à We have to summarize the General Ledger and put it in a communication medium that makes sense. o Step 1: We will sum up the Debit and the Credit in every T-account. We subtract the smaller from the larger (ex: For an asset: Debit-Credit). à We have calculated the current existing balances in every one of our T-accounts that form our General Ledger. o Step 2: We will now form a Trial Balance to make sure we followed the laws of Credit and Debit. This is our intermediary step between posting and preparing our financials. It is not a formal financial statement; only people from the company see it. Beau’s Bodacious Baseball Business Trial Bastnce January 31 , 2016 Account Debit Credit Cash $ 150 Inventory 7,000 Acc. Receivable 1,500 Acc. Payable $ 6,750 Beau Parent, capital 1,000 Beau Parent, drawing 250 Sales 4,200 Cost of Goods Sold 3,000 Rent 50 TOTAL $ 11,950 $ 11,950 à The fact that SUM DEBITS= SUM CREDITS only means that we followed the laws of Debit and Credit. Limitations of a Trial Balance: It does not prove that all transactions have been recorded or that the ledger is correct. The Trial Balance may balance even if: - A transaction is not journalized - A correct journal entry is not posted - A journal entry is posted twice - Incorrect accounts are used in journalizing or posting - Offsetting errors are made in recording the amount of a transaction An error= unintentional mistake An irregularity= intentional misstatement, unethical o Step 3: Prepare Financial Statements. 1. Income Statement Beau’s Bodacious Baseball Business Income Statement For the month ended January 31 , 2016 REVENUES: Sales $ 4,200 EXPENSES: Cost Of Goods Sold $ 3,000 Rent 50 Total expenses 3,050 NET INCOME: $ 1,150 The Net Income is the net increase of owner’s claims against the assets generated during the period, due to successfully operating the business. We are using an accrual basis of accounting. The Net Income is not how much the business is worth, but it helps valuating the business. 2. Statement of Owner’s Equity/Statement of Capital Beau’s Bodacious Baseball Business Statement of Owner’s Equitst For the month ended January 31 , 2016 Beau Parent, capital at January 1 , 2016 $ 0 Contributed Capital 1,000 $ 1,000 Net Income 1,150 $ 2,150 Drawing (250) Beau Parent, capital at January 31, 2009 $ 1,900 3. Balance Sheet Beau’s Bodacious Baseball Business Balance Sheet st As at January 31 , 2016 ASSETS: Cash $ 150 Inventory $ 7,000 Accounts Receivable $ 1,500 TOTAL ASSETS: $ 8,650 LIABILITIES: Accounts Payable $ 4,750 OWNER’S EQUITY: Beau Parent, capital $ 1,900 TOTAL LIABILITIES AND OWNER’S EQUITY: $ 8,650 If we had a corporation, we would have 2 equity accounts: a common stock account and a retained earnings (dividends) account. à Their total would be the same, so in this case it would be equal to $1,900. Here, common stock = $1,000 and retained Earnings= $900. Chapter 3 By using the example of a sole proprietorship business, we have seen the basic accounting equation and we are starting to see the accounting cycle. Accounting cycle= the collective process of recording and analyzing the accounting transactions of the economic entity. Hand out: Accounting Cycle in-class problem Remember: according to the economic entity assumption, we are keeping score of the business as if it were separate from its owner, even if it is legally not the case. General Journal Trans.date Transaction# Account Debit Credit 7/2/14 1 Cash 10,000 Csmith, capital 10,000 7/2/14 2 Delivery van 4,200 Equipment 2,400 Supplies/Inventory 1,000 Cash 7,600 7/2/14 3 Prepaid Insurance 1,200 Cash 1,200 7/2/14 4 Cash 5,400 Unearned catering fees 5,400 Comments: Transaction 2: - GAAP says we have to make an account for each separate category of assets, because we will use and consume these different types of assets in different ways and at different times. - The difference between supplies and supplies expense is the difference between used and unused cost. à Supplies become expenses once you use the goods to generate revenue. - After transaction 2, we have become less liquid. But this is not necessarily a bad thing, because we bought necessary things to do business. Transaction 3: - This insurance is an unused cost. We are going to derive benefit from it over a period of time, which is 12 months. It is an asset called prepaid insurance. (Side note: at the end of July, 1/12 of the cost of prepaid insurance has been used, and therefore we will have to make an adjusting entryà we credit prepaid insurance for $100 and we debit expenses for $100.) Transaction 4: - Before, we talked about non-owner’s claims against the assets being to creditors or vendors. Here, we have received an asset (Cash) without doing anything to get those assets. à We would be tempted to credit Revenue but careful: GAAP says we can’t record Revenue until we have earned it. As a caterer, I cannot credit Revenue until I’ve catered. è This is called the Revenue Recognition Principle. - We do get that an owner has a claim against the asset, and here it is the customer. We will credit a liability account but it is not an accounts payable. à We have a sort of customer deposit. We will call the account Unearned Catering Fees. -The assumption is that during the month, I will have catered/performed, therefore Unearned Catering Fees will change. At the end of the month, we will debit (decrease) Unearned Catering Fees and credit Revenues. Trans.date Transaction# Account Debit Credit 7/3/14 5 Prepaid Rent 4,000 Cash 4,000 7/12/14 6 Wage Expense 2,500 Cash 2,500 7/15/14 7 Accounts Receivable 4,500 Catering fees earned 4,500 7/16/14 8 Supplies/Inventory 2,300 Accounts Payable 2,300 Comments: Transaction 5: - These $4,000 represent an unused cost. Therefore, in our Assets, we have a new account called Prepaid Rent. - At the end of the month, we will move $1,000 (=1/4 x 4,000) from being an asset to becoming an expense of the period. Transaction 6: - The business has incurred a cost. It is a used cost, because as of July 12 , those people have worked and helped generate revenue. - We will calththis cost Wage Expense. -Until July 11 , we had no revenue and no expense, because the business is a startup. Transaction 7: - We did the work. There is no cash, but it does not matter because we use the accrual method. Why? Because the accrual method best reflects the economic reality of the entity. - We will create a Revenue account called Catering fees earned. - We debit Accounts Receivable. (Side note: this is separate from the agreement in transaction 4.) Transaction 8: Assets have increased è claims to those assets have increased à non-owner’s claims. Trans.date Transaction# Account Debit Credit 7/17/14 9 Cash 3,900 Accounts Receivable 3,900 7/26/14 10 Wage Expense 2,600 Cash 2,600 7/31/14 11 Delivery van expense 450 Accounts Payable 450 Comments: Transaction 9: We do not credit Revenues again because we have already done it. à We record the Revenue when we earn it, with no regard of the receipt of cash. Transaction 10: Wage Expense is clearly a used cost, therefore it is an expense. Transaction 11: Accounts Payable has been affected. We debit an expense because the $450 represent a used cost of the period: the van has helped us generate revenue. Accrual Accounting Concepts Making adjustments is necessary to avoid misstatement of revenues and expenses. I- The Accrual Basis of Accounting and the Reasons for Adjusting Entries Accounting divides the economic life of a business into artificial time periods. Many business transactions affect more than one of these arbitrary time periods. For example, a new building purchased by Citigroup will be used for many years à it would not make sense to expense the full cost of the building at the time of purchase because it will be used for many subsequent periods è Companies allocate the cost to the periods of use. 2 Principles used as guidelines: • The Revenue Recognition Principle: It requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied. • The Expense Recognition Principle (=matching principle): “Let the expenses follow the revenues”. Expense recognition is tied to revenue recognition. The Need for Adjusting Entries In order for revenues to be recorded in the period in which the performance obligations are satisfied, and for expenses to be recognized in the period in which they are incurred, companies make adjusting entries. Adjusting entries ensure that the revenue recognition and expense recognition principles are followed. Adjusting entries are required every time a company prepares financial statements. The company analyzes each account in the Trial Balance to determine whether it is complete and up-to-date for financial statement purposes. 2 types of Adjusting Entries: • Deferrals: - Prepaid expenses - Unearned revenues • Accruals: - Accrued revenues - Accrued expenses II- Prepare Adjusting Entries for Deferrals Deferrals= costs or revenues that are recognized at a date later than the point when cash was originally exchanged. - Companies make adjusting entries for deferred expenses to record the portion that was incurred during the period à Prepaid Expenses. - Companies also make adjusting entries for deferred revenues to record services performed during the period à Unearned Revenues. - Prepaid Expenses Prepaid Expenses= Expenses paid in cash before they are used or consumed. Prepaid expenses are costs that expire with the passage of time (rent, insurance) or through use (supplies). Prior to adjustment, assets are overstated and expenses are understated. Depreciation A company typically owns a variety of assets that have long lives. The period of service is referred to as the useful life of the asset. Depreciation= the process of allocating the cost of an asset to expense over its useful life. Depreciation is an allocation concept, not a valuation concept à it does not attempt to report the actual change in the value of the asset. Rather than credit the asset account directly, we credit an account called Accumulated Depreciation è a contra asset account à such an account is offset against an asset account in the Balance Sheet. All contra accounts have increases, decreases, and normal balances opposite to the account to which they relate. - Unearned Revenues Companies record cash received before services are performed, by increasing a liability account called Unearned Revenues à the company has a performance obligation to transfer a service to one of its customers. Unearned Revenues are the opposite of Prepaid Expenses. III- Preparing Adjusting Entries for Accruals - Accrued Revenues They represent revenues for services performed but not yet recorded at the statement date. Accrued Revenues may result from services that have been performed but not yet billed nor collected. An adjusting entry records the receivable that exists at the statement date and the revenue for the services performed during the period. à Without the adjusting entry, assets and stockholders’ equity on the Balance Sheet, and Net Income in the Income Statement are understated. - Accrued Expenses They represent expenses incurred but not yet paid or recorded at the statement date. à Prior to adjustment, both Liabilities and Expenses are understated. Companies pay for some types of expenses after the services have been performed, such as salaries. Therefore, it credits a liability account called Accrued Wages and debits an expense account called Wages Expense. IV- Prepare an Adjusted Trial Balance and Closing Entries After a company has journalized an posted all adjusting entries, it prepares another Trial Balance from the ledger accounts, called the Adjusted Trial Balance à the primary basis for the preparation of financial statements. After doing this Trial Balance, we prepare the financial statements Preparing Closing Entries Closing entries concern temporary stockholders’ accounts. They transfer net income (or net loss) and dividends to Retained Earnings, so the balance in Retained Earnings agrees with the Retained Earnings Statement. In addition to updating the Retained Earnings to its correct ending balance, closing entries produce a zero balance in each temporary account. Companies close the revenue and expense accounts to another temporary account: Income Summary à its balance is the net income (or net loss) of the accounting period. Income Summary is then closed, which transfers the net income (or net loss) from this account to Retained Earnings. Preparing a Post-Closing Trial Balance It is a list of all permanent accounts and their balances after closing entries are journalized and posted. Purpose: 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. Keep in mind: o Something we know for sure: if Assets increase, claims to those Assets have also increased. o Owner’s claims against the assets can increase for 1 or 2 reasons: 1- Contributed capital. It has nothing to do with running the business. 2- Earned capital. It is very important to differentiate contributed capital and earned capital. o <Beau Parent, drawing> and COGS are both a decrease in Owner’s Equity, but the second is caused by operating the business. o Whenever presented by a problem, it is crucial to pay attention to dates. GAAP has rules as when to record transactions and when not to. We want to make sure we are reflecting the reality of the company. Dates are relevant and important. For instance, they help avoid earnings manipulation. o Due to their nature, adjusting entries have no effect on Cash Flows. o Each adjusting entry affects one Balance Sheet account and one Income Statement account.
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