Chapter 2 Detailed Notes
Chapter 2 Detailed Notes ACCT 2110
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This 8 page Class Notes was uploaded by Autumn Notetaker on Friday January 8, 2016. The Class Notes belongs to ACCT 2110 at Auburn University taught by Jennifer Cornett in Fall 2015. Since its upload, it has received 51 views. For similar materials see Principles of financial accounting in Accounting at Auburn University.
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Date Created: 01/08/16
Chapter 2: The Accounting Information System Fundamental Accounting Concepts o To effectively use financial statements, you must understand the procedures used to record information about business activities and how this information ultimately is transformed into financial statements o Reviewing financial statements means you are assessing a company’s performance, cash flows, and financial position o To make the assessments, you need to infer the actions of a company from what you see in the financial statements o That inference depends on your understanding of how companies transform the results of their activities into financial statements o Accounting cycle: a simple and orderly process, based on a series of steps and conventions o The Conceptual Framework GAAP (generally accepted accounting principles) rest on a conceptual framework of accounting Qualitative characteristics, assumptions, principles Framework flows from the fundamental objective of financial reporting: to provide information that is useful in making investment and credit decisions. Designed to support the development of a consistent set of standards and provide a consistent body of thought for financial reporting o Qualitative Characteristics of Useful Information 2 fundamental characteristics that useful information should possess: relevance and faithful representation Relevance: Information that is relevant is capable of making a difference in a business decision by helping users predict future events (predictive value) or providing feedback about prior expectations (confirmatory value). Material information is the omission or misstatement of information that could influence a decision (it is also relevance). Faithful representation: information should be a faithful representation of the realworld economic event that it is portraying. Information should be complete, neutral (unbiased), and free from error (accurate). It is reliability. 4 enhancing characteristics that are complementary to the fundamental characteristics: They should be maximized fully: Comparability: Comparable information allows external users to identify similarities and differences between 2 or more items. Useful when it can be compared with similar information about other companies or with similar information about the same company at a different time period. Comparability information also has consistency. Consistency can be achieved when a company applies the same accounting principles for the same items over time. Also, achieved when multiple companies use the same information in a single time period. Comparability is the goal while consistency helps achieve it. Verifiability: Information is verifiable when independent parties can agree on the measurement of the activity. General consensus Timeliness: Information is timely if it is available to users before it loses its ability to influence decisions. Understandability: If users who have reasonable knowledge of accounting and business can comprehend the meaning of the information, it is considered understandable. Cost constraint: bounds the qualitative characteristics because the benefit received from accounting information should be greater than the cost providing that information. Cost should not exceed benefit. Tradeoffs are necessary in the criteria. The accountant has to exercise judgment in determining the accounting principles that would produce the most useful information. Full disclosure policy: any information that would make a difference in the financial statements should be revealed by accountants o Accounting Assumptions Economic entity assumption: each company is accounted for separately from its owners (no personal transactions) Continuity (or GoingConcern) Assumption: A company will continue to operate long enough to carry out its existing commitments Time period assumption: The life of a company to be divided onto artificial time periods so net income can be measured for a specific period of time (monthly, quarterly, annually) Monetary unit assumption: A company accounts for and reports its financial results in monetary terms ($) o Accounting Principles General approaches that are used in the measurement and recording of business activities Historical cost principle: requires that the activities of a company are initially measured at their cost, the exchange price at the time the activity occurs o Provides an objective and verifiable measure of activity Revenue recognition principle: determines when revenue is recorded and reported; revenue is to be recognized or recorded in the period in which it was earned and the collection of cash is reasonably assured o Usually occurs when services are performed or goods are delivered Expense recognition (or matching) principle: an expense be recorded and reported in the same period as the revenue that it helped generate (may or may not be in the same period as when cash is paid); expenses incurred to help us; should match revenue Revenue and Expense recognition help determine net income Conservatism principle: accountants should take care to avoid overstating assets or income when they prepare financial statement Measuring Business Activities: The Accounting Cycle o 7 steps o Steps 1 4 are performed regularly each period o Steps 57 are performed at the end of the period o Economic Events Each business activity (financing, investing, operating) consists of events that affect the company Some events are external (company and another entity) and some are internal (company’s own actions) Accountants measure effects of events and incorporates the events into the accounting system, then into financial statements If involving exchange of assets, liabilities, stockholder’s equity, revenue, or expenses they are transactions and must be recorded If results in financial impact and can measure with reasonable accuracy, then it is a transaction—if not, it is not recorded o Accounting Transaction: any economic event that affects a company’s assets, liabilities, or equity at the time of the event (external or internal) and is recognized on financial statements o The Expanded Accounting Equation Assets = Liabilities + Stockholder’s Equity (Contributed Capital and Retained Earnings) (Common Stock) Assets=Liabilities+ Contributed Capital+ Beginning Retained Earnings+ (Revenues Expenses Dividends) STEP 1: Analyze Transactions: Transaction Analysis: the process of determining the economic effects of a transaction on the elements of the expanded accounting equation Must always remain in balance, therefore two things happen to the equation at a time 1. Analyze transaction and the accounts that are affected (transaction analysis) applying debit and credit rules a. Source documents i. Ex. Sales slip, check, bill, cash register tape 2. Journalize transaction (journal entry) 3. Transfer journal information to accounts in the ledger (book of accounts) post in accounts 4. This makes a trail balance Transaction 1: Issuing Common Stock (Financing) o On March 1, HiTech sold 1000 shares of common stock to several investors for cash of $12000. The effect of this transaction on the accounting equation is: Assets (+$12000) = Liabilities + Stockholder’s Equity (Contributed Capital +$12000; Retained Earnings) Journal Entry 3/1: Cash is debited $12000; Contributed Capital is credited $12000 Transaction 2: Borrowing Cash (Financing) o On March 2, HiTech raised additional funds by borrowing $3000 from First Third Bank of Cincinnati. HiTech promised to pay the amount borrowed plus 8% interest. Assets (+$3000) = Liabilities (Note Payable +$3000) + Stockholder’s Equity Journal Entry 3/2: Cash is debited $3000; Note payable credited $3000 Transaction 3: Purchase of Equipment for Cash (Investing) o On March 3, HiTech purchased office equipment from MicroCenter for $4500 in cash. The effect of its transaction on the accounting equation is: Assets (+4500 Equipment; $4500 Cash) = Liabilities + Stockholder’s Equity Journal Entry 3/3: Equipment is debited $4500 (increase); Cash is credited $4500 (decrease) Transaction 4: Purchasing Insurance (Operating) o On March 4, HiTech purchased a 6month insurance policy for $1200 cash. The effect of this transaction on the accounting equation: Assets (+$1200 prepaid insurance, $1200 cash) = Liabilities + Stockholder’s Equity Journal Entry 3/4: Debit $1200 of prepaid insurance (increase); credit $1200 cash (decrease) Transaction 5: Purchase of Supplies on Credit (Operating) o On March 6, HiTech bought office supplies from Hamilton Office for $6500. Hamilton Office agreed to accept full payment in 30 days. Assets (+$6500 supplies) = Liabilities (+6500 account payable) + Stockholder’s Equity Journal Entry 3/6: Debit office supplies $6500; Credit accounts payable $6500 Transaction 6: Sale of Services for Cash (Operating) o On March 10, HiTech sold advertisement services to Miami Valley Products in exchange for $8800 in cash. Assets (+$8800 advertisement cash) = Liabilities + Stockholder’s Equity (Contributed Capital; Retained Earnings (+8800 revenue) Journal Entry 3/10: Debit advertisement cash $8800; Credit revenue $8800 Transaction 7: Sale of Services for Credit (Operating) o On March 15, HiTech sold advertising services to the Cincinnati Enquirer for $3300. HiTech agreed to accept full payment in 30 days. Assets (+$3300 account receivable) = Liabilities + Stockholder’s Equity (Contributed Capital; Retained Earnings +$3300 revenue) Journal Entry 3/15: Debit the accounts receivable $3300; Credit revenue $3300 Transaction 8: Receipt of Cash in Advance (Operating) o On March 19, HiTech received $9000 from the OA News for advertising services to be completed in the next 3 months. Assets (+$9000 cash) = Liabilities (+$9000 unearned revenue) + Stockholder’s Equity Journal Entry 3/19: Debit cash $9000; Credit unearned revenue $9000 Transaction 9: Payment of Liability (Operating) o On March 23, HiTech pays $6000 cash for the supplies previously purchased from Hamilton Office Supply on credit in Transaction 5. Assets ($6000 cash) = Liabilities ($6000 accounts payable) + Stockholder’s Equity Journal Entry 3/23: Debit $6000 accounts payable; Credit $6000 of cash Transaction 10: Collection of a Receivable (Operating) o On March 29, HiTech collected $3000 cash from the Cincinnati Enquirer fro services sold earlier on credit in Transaction 7. Assets (+$3000 collection of cash; $3000 reduces accounts receivable) = Liabilities + Stockholder’s Equity Journal Entry 3/29: Debit $3000 for cash; Credit $3000 for the account receivable Eliminating accounts receivable is like giving up our option of making money in the future because we were just paid so obligation over (paying off what they owe us so receivable no longer exists) Transaction 11: Payment of Salaries (Operating) o On March 26, HiTech paid weekly employee salaries of $1800. Assets ($1800 cash) = Liabilities + Stockholder’s Equity (Contributed Capital; Retained Earnings ($1800 salaries expense)) Journal Entry 3/26: Debit salaries expense $1800; Credit cash $1800 Pay cash (minus) it is your credit; receive cash (positive) it is a debit Retained earnings is decreasing because the salaries expense is increasing Transaction 12: Payments of Utility (Operating) o On March 30, HiTech paid its utility bill of $5200 for March. Because an asset (cash) is consumed by HiTech as part of the operations of the business, the cost of utilities used during the month is an expense. Assets ($5200 cash utilities) = Liabilities + Stockholder’s Equity (Contributed Capital; Retained Earnings ($5200 utilities expense)) Journal Entry 3/30: Debit $5200 utilities expense; Credit $5200 for cash on utilities Transaction 13: Payment of a Dividend (Financing) o On March 31, HiTech declared and paid a cash dividend of $500 to its stockholders. Assets ($500 cash) = Liabilities + Stockholder’s Equity (Contributed Capital; Retained Earnings ($500 dividend)) Journal Entry 1/31: Debit dividend $500; Credit $500 cash Dividends increasing means a negative impact on retained earnings Double Entry Accounting o Describes the system used by companies to record the effects of transactions on the accounting equation o The effects or transactions are recorded in accounts o Under double entry accounting, each transaction affects at least 2 accounts—two things are happening o Account: an accounting record that accumulates the activity of a specific item and yields the item’s balance; record of increases and decreases in each of the basic elements of financial statements Changes in assets, liabilities, stockholder’s equity, revenues, or expenses on appropriate accounts More sophisticated than the expanded accounting equation 3 parts: Title Left side (Debit side) Right Side (Credit side) Left and right side are a TAccount o Chart of Accounts: the list of accounts that a company uses to capture its business o Transactions can with increase or decrease an account o Balance: the amount in the account at any time o TAccount: 2 column record that consist of an account title and a left (debit)/ right (credit) side o Analyze and determine what is happening in fundamental accounting equation—Assets (resources), Liabilities (obligations), Stockholder’s Equity (Contributed Capital (selling stock), Retained Earnings (net income kept in the business; revenues expenses impact; dividends)) o Debit and Credit Procedures in Transactional Analysis Apply debit and credit rules: Assets should have a normal debit balance (make assets go up, increase debit) (credits make it decrease); Liabilities and Stockholder’s Equity should have normal credit balance (to go up, increase credit) (debit makes it decrease) Used to record business transactions Debit (Dr.) = left Credit (Cr.) = right Double entry system requires debits and credits to be in balance (Dr = Cr) Balance of T account determine by excess Basic Accounting Equations = “Normal Balances” Cash always goes up, and it is always debited You can credit an asset, but it makes the assets decrease STEP 2: Journalize Transactions o Journal: a chronological record showing the debit and credit effects of transactions on a company o Journal entry: shows the entire effect of a transaction in one place o The process of making a journal entry is often referred to as journalizing a transaction. The 3 parts of a journal entry are: The date of the transaction The accounts and amounts to be increased or decreased A brief explanation of the transaction o Each journal entry shows the debit and credit effects of a transaction on specific accounts Transaction 1: Issuing Common Stock o On March 1, HiTech sold 1000 shares of common stock to several investors for $12000 Transaction 2: Borrowing Cash o On March 2, HiTech raised additional funds by borrowing $3000 on a one year, 8% note payable to First Third Bank Transaction 3: Purchase of Equipment for Cash o On March 3, HiTech purchased office equipment from MicroCenter for $4500 in cash. STEP 3: Post to the Ledger o Since the journal lists each transaction in chronological order, it can be difficult to use the journal to determine the balance in any specific account we use a general ledger to keep track of specific accounts o General Ledger: a collection of all the individual financial statement accounts that a company uses o Helps keep track of the balances of specific accounts o Use T accounts to keep track of debits and credits of specific accounts (like cash) to calculate the total balance o Posting: the process of transferring the information from the journalized transaction to the general ledger A posting reference is used to help keep errors from happening and to trace the effects of a transaction through the accounting system STEP 4: Prepare a Trial Balance o To aid in the preparation of financial statements, some companies will prepare a trial balance before they prepare financial statements o Trial Balance: a list of all active accounts and each account’s debit or credit balance o The accounts are listed in order the appear on the ledger—assets first, liabilities, stockholder’s equity, revenues, and expenses o Trail balances help check for equality in debits and credits If debits did not equal credits, the accountant would know that an error had been made A trial balance whose debits equals credits does not mean that all transactions were recorded correctly A trial balance will not detect errors of analysis or amounts It will only prove the equality of debits and credits Which of the following groups of accounts shows only those accounts that are increased with a debit? Assets, expenses, dividends (since expenses and dividends make equity go down, debit makes them go up) DEAD CRLS Debits are in Expenses, Assets, Dividends; Credits are in Revenues, Liabilities, Stockholder’s Equity Which of the following situations cause the trial balance to be out of balance? Recoding a $400 purchase of supplies as a $400 Debit to Supplies and a $4000 Credit to Accounts Payable.
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