CH1 – Accounting in Business

Accounting – An information and measurement system that identifies, records and

communicates information about an organization’s business activities.

Accounting is called the language of business because all organizations set up an accounting
system to communicate data that helps people make better decisions. These people are
divided into two groups: Internal and External users.
 Internal Users – executives, sales staff, managers, budget analysts, internal
auditors, controllers.
 External Users – shareholders, lenders, government, consumer groups, external
users, customers.

Recordkeeping / Bookkeeping – recording of transactions and events.

Fraud Triangle – These 3 factors must exist for a person to commit fraud:
 Opportunity – a person must be able to commit fraud with a low risk of getting
caught.
 Pressure/Incentive
 Rationalization or attitude – person justifies the fraud and fails to see the criminal
nature.

Generally Accepted Accounting Principles (GAAP) – concepts and rules that governs
financial accounting
Securities and Exchange Commission (SEC) – a government agency that has legal authority
to set the GAAP
Financial Accounting Standards Board (FASB) – private-sector group that sets broad and
specific principles.
International Accounting Standards Board (IASB) issues International Financial Reporting
Standards (IFRS)

Accounting Principles:
1. The Measurement Principle / Cost Principle – Accounting information
is based on actual cost, measured in cash.
2. The Revenue Recognition Principle – revenue is recognized when
goods or services are provided and at the amount expected to be
received from the customer.
3. The Expense Recognition Principle – company records the expenses it
incurred to generate the revenue reported.
4. The full disclosure principle – company reports the details behind
financial statements that would impact user’s decisions.

Accounting Assumptions:
1. The going-concern assumption – accounting information reflects a
presumption that the business will continue operating instead of being
closed or sold.
 2. The monetary unit assumption – we can express transactions and events
in monetary, or money, units.
3. The time period assumption – life of the company can be divided into
time periods.
4. The business entity assumption – a business is accounted for separately
from other entities. Business entity can take one of three legal forms: a
solo proprietorship, partnership or corporation.

Accounting Constraints:
1. The Materiality Constraint – only information that influences decisions
need to be disclosed.
2. The Benefit Exceeds Cost Constraint – only information with benefits
of disclosure greater than the costs of providing it need to be disclosed.

Two basic aspects of the company – what it owns and what it owes.

Assets – resources a company owns or controls, that have expected future benefit. For ex:
cash, land, supplies, equipment, building…

Liability – what company owes to non-owners.

Equity – claims of the owner(s).

ACCOUNTING EQUATION:
Assets = Liabilities + Equity

Financial Statements:
o Income Statement – includes revenues and expenses and shows net income/loss
o Statement of Owner’s equity – changes in equity from net income/loss, investments
and withdrawals.
o Balance Sheets – describes company’s financial position (Assets, Liabilities, Equity)
o Statement of Cash Flows – cash inflows and outflows.

ROA ( Return on assets) = net income / average total assets.

 CH2 – Analyzing and Recording Transactions

The process to get from transactions and events to financial statements include the
following:

Source Documents – identify and describe transactions and events entering the accounting
system. For ex: check, sales ticket, purchase orders, bills from suppliers, invoices, bank
statements…

Account – is a record of increases and decreases in specific asset, liability, equity, revenue or
expense.

General Ledger – is a record of all accounts used by a company.

An unclassified balance sheet broadly groups accounts into assets, liabilities and equity.

Asset Accounts – assets are resources owned or controlled by the company, and they have
expected future benefit.

Supplies Account – Supplies are assets until they are used, then their cost is recorded as
expenses. (same for equipment). If company owns several buildings, different account is kept for
each of them sometimes.
Normal Balance Side:

General Journal:
Balance Column Account:
 Has better structure than T-Accounts but similar format
 Has the column with the Balance of the account after each entry.
 An account is assumed to have a normal balance.

Abnormal Balance – refers to a balance on the side where decreases are recorded.

Posting Journal entries:

TRIAL BALANCE:
Trial balance is a list of ledger accounts and their balances at a point in time.
Financial Statements:

Links between financial statements over time:

 Income Statement - expenses, revenues ---> net income/loss
 Statement of owner’s equity – Starting Capital balance, investments, net
income/loss, withdrawals, --> Ending Capital Balance
 Balance Sheet – Assets, Liabilities, Equity
 CH 3 – Adjusting Accounts for Financial Statements
 The Time Period Assumption – life of the company can be divided into time periods.
 Annual Financial Statements – Reports covering a one-year time period
 Interim Financial Statements – Covering one, three- or six-month time periods.
 Annual reporting period does not always match a calendar year ending on December
31st. An organization can adopt a fiscal year consisting of any 12 months or 52 weeks.
 Companies that have seasonal variations often choose a natural business year, which is
when sales activities are at their lowest.

 After external transactions and events are recorded, several accounts require adjustments
before their balances appear on the financial statements.
o Accrual Basis Accounting – applies adjustments so revenue are recognized when
services or goods are delivered, and expenses are recognized when they incurred.
o Cash Basis Accounting – recognized revenue when cash is received and
recognizes expenses when cash is paid.
 Most Agree that Accrual accounting better reflects business performance
rather than cash receipts and payments.

 An adjusting entry is made at the end of the accounting period to reflect a transaction or
event that is not yet recorded. Each adjusting entry affects one or more income statement
accounts and one or more balance sheet accounts.(never the Cash account)
 Prepaid expenses are assets paid for in advance of receiving future benefits. When these
assets are used, they become expenses.

 Plant assets – long term tangible assets used to produce and sell services and products.
Plant assets are expected to provide benefits for more than just one period. For example,
building, land, machines, vehicles and fixtures.
 Depreciation – a process of allocating costs of plant assets over their expected useful
lives. Depreciation expense is recorded with an adjusting entry similar to other prepaid
expense.
o Straight-Line Depreciation – allocated equal amounts of the assets’ net cost to
depreciate during its useful life.
o Accumulated Depreciation is kept in a separate contra account.
 Contra account is an account linked with another account, it has an
opposite normal balance, and it is reported as subtraction from that other
account’s balance. Shows both – full costs of assets and total depreciation.
o Book value – or net amount, equals assets’ cost less its accumulated depreciation.
o Land account does not require deprecation.

 Unearned revenue – refers to cash received in advance of providing products and

services, also called deferred revenues, are liabilities. When cash is expected, an
obligation to provide products and services is accepted.

 Accrued Expenses – refer to costs that are incurred in a period but are both unpaid and
unrecorded. Must be recorded on the Income statement in the period when it incurred.
 Ch 4 – Completing the Accounting Cycle
 Work Sheet – a document that is used internally by companies to help adjusting and
closing accounts and with preparing financial statements.
 Benefits: Aids for preparation of financial statements; Reduces the risk of
errors when working with many accounts and adjustments; Links accounts
and adjustments to their impacts on financial statements; Helps in
preparing interim financial statements when journalizing adjusting entries
is postponed until year-end; Shows the effects of proposed or “what-if”
transactions.
 It is an accounting aid and is not a substitute for journals, ledgers, or
financial statements.
 It is constructed at the end of the period before adjustments.

 Preparing a Work sheet:

1. Enter unadjusted trial balance;
2. Enter Adjustments (after entering them, adjustments must still be journalized and
posted).
3. Prepare adjusted trial balance.
4. Sort Adjusted trial balance accounts to financial statements.
5. Total statement columns, calculate loss or income, balance columns.

Closing Process:
 Closing process is an important step at the end of the accounting period after the financial
statements are completed.
 It prepares accounts for recording the transactions and events of the next period.
 In the closing process:
1. We must identify accounts for closing
2. Record and post closing entries.
3. Prepare a post-closing trial balance.
  Temporary accounts – relate to one accounting period. They include all income
statement accounts, the owner withdrawal account, and the income summary account.
They are temporary because the accounts are opened at the beginning of a period, used to
record transactions and events for that period, and then closed at the end of the period.
The closing process applies to temporary accounts only.
 Permanent accounts- repost on activities related to one or more future accounting
period. They include asset, liability and owner capital accounts. Permanent accounts are
not closed each period and carry their ending balance into future periods.

Recording Closing entries:

 They transfer the end-of-period balances in revenue, expense and withdrawals accounts
to the permanent capital account.
 Closing is necessary, because:
o Revenue, Expense and withdrawals accounts should begin each period with zero-
balance.
o Owner’s capital should reflect on past period’s revenues, expenses and
withdrawals.


 Post-Closing Trial Balance – list of permanent accounts and their balances from the
ledger after all closing entries have been journalized and posted. The aim of it is to verify
that total debits equal total credits for permanent account and all temporary accounts have
zero balances.
 Accounting Cycle – steps in preparing financial statements. It’s called a cycle because
the steps are repeated each reporting period.
 Steps: 1. Analyze transactions 2. Journalize 3. Post 4. Prepare
unadjusted trial balance 5. Adjust and post accounts 6.Prepare
adjusted trial balance 7.Prepare Financial Statements 8. Close
Accounts 9. Prepare post-closing trial balance 10.Reverse and
post(optional)

A Classified Balance Sheet:

 An unclassified balance sheet broadly groups accounts into assets, liabilities and
equity.
 A classified balance sheet organizes assets and liabilities intro subgroups that provide
more information to decision makers.
 Does not have required layout, but usually contains following categories: Current
assets, Noncurrent assets, Long-term investments, plant assets, intangible assets,
current liabilities, noncurrent liabilities, equity.
 Current assets are expected to come due within one year or the company’s operating
cycle (whichever is longer).
 The Operating cycle is the time span from when cash is used to acquire goods and
services until cash is received from the sale of goods and services. Mostly operating
cycles are less than a year.
 Intangible Assets – long-term resources that help benefit business operations but lack
physical form, such as copyrights, franchises and etc.

 Current Ratio is one measure of the company’s ability to pay its short-term
obligations.


 Ch 5 – Accounting for Merchandising Operations

 Accounting activities differ for service and merchandising companies.

 Merchandise consists of products, also called goods, that a company buys to
resell to the costumers. A merchandiser earns income by buying and selling
merchandise. A wholesaler buys products from the manufacturer and sells them
to the retailers, a retailer buys products from manufacturers or wholesalers and
sells them to the costumers.
 Net income = revenues from selling merchandise – (cost of merchandise
sold + other expenses).
 Usual Accounting term for revenues from selling is sale, and for expenses for
buying and preparing products – cost of goods sold. (Sometimes service
companies may use the same terms).


 Gross profit or Gross Margin = net sales – cost of goods sold.

 Merchandise Inventory, or simply, inventory, refers to products that a company
owns and intends to sell. The cost of this asset includes the cost that incurred to
buy a product, plus shipping and preparation cost.
 A merchandising company’s operating cycle starts with purchasing merchandise
and ends by collecting cash from selling the merchandise. The length of the cycle
can be different for different kinds of businesses. Companies try to keep their
operating cycles short, assets tied up to inventory or accounts receivable are not
productive. Cash sales shorten accounting cycles.

ACCOUNTING FOR MERCHANDISE PURCHASES
 Perpetual Inventory System – updates accounting record for each purchase
and sale of the inventory;
Periodic Inventory System – updates the accounting records for purchases and
sales of the inventory only at the end of the period. When company sells
merchandise, it only records revenues, not the cost of the goods sold. At the end
of the period, it is computed by cost of merchandise available for sale – ending
inventory amount.
 When we record Purchases without the Cash Discounts, we debit the
Merchandise inventory and credit cash or accounts payable, depending on the
payment method.
 Purchases with Cash discounts – Credit terms for a purchase include the
amounts and timing of payments from a buyer to seller. “n/10 EOM = payment for
net 10 days after the end of the month. n/30 – net 30 days.). Credit Period – the
amount of time allowed before full payment is due before. Sellers can grant cash
discounts to buyers to encourage them to pay earlier, a buyer sees a cash
discount as a purchases discount. A seller views a cash discount as sales
discount. Any Cash discounts are described in the credit terms. “2/10, n/60” –
full payment is due 60-day credit period, but if payment is made within 10 days,
2% can be deducted from the invoice amount. The reduced payment only applies
for the discount period. If discount is used, we credit inventory and cash and
debit acc. payable
 Purchases with Returns and Allowances – purchases returns are a
merchandise a buyer acquires but then returns to the seller. Purchases
 allowances refer to a seller granting a price reduction (allowance) to a buyer of
defective or unacceptable merchandise. Debit Acc. Payable, debit inventory.
 FOB shipping Point / FOB (full on board) factory – buyer accepts ownership
when goods depart the seller’s place of business. The buyer pays for shipping
costs and has the risk of loss in transit. FOB destination – ownership of good
transfer to buyer when the goods arrive at the buyer’s place of business, the
seller is responsible for paying shipping costs and has the risk of loss in transit.
 Supplementary records refer to the information outside the usual general ledger
accounts, such as total allowances and returns and etc.

ACCOUNTING FOR MERCHANDISE SALES

 Each sale of the merchandise has two parts. 1. Revenue received (Asset
increased) from the costumer 2. Cost of goods sold incurred (assets decreased)
to the costumer.
 Sales without Cash Discounts – revenue part: debit acc. Receivable/cash,
credit sales. Expenses part: debit cost of the goods sold, credit inventory.
 Sales with Cash Discounts – New revenue recognition rules require that the
seller report sales net of expected sales discounts. The gross method records
sales at the gross amount and records sales discounts if, and when they are
taken. If costumer uses discount, we debit cash and sales discounts and credit
acc. receivable. Sales Discounts is a revenue contra account.
 Sales with returns and allowances – debit returns and allowances (contra
revenue account) and credit cash. If returned good can be resold, then debit
inventory, credit costs on the goods sold. If the good is defective, we record the
estimated value. Debit inventory with estimated cost and loss from defective
merchandise with remainder amount, credit cost of the goods sold. Allowances
by seller: Dr sales returns and allowances, Cr Cash.

 Shrinkage is the loss of inventory; we compare physical amount of inventory to

recorded amounts.

 MORE ON FINANCIAL STATEMENT FORMATS:
 Multiple-Step Income Statement – shows detailed computations of net sales and
other costs and expenses and reports subtotals for various classes of items. It has
three parts:
1. Gross profit – determined by net sales - cost of the goods sold.
2. Income from operations, determined by gross profit - operating expenses
3. net income – income from operations adjusted for nonoperating items.
Operating expenses are classified into two sections. Selling expenses include the
expenses of advertising merchandise, making sales and delivering goods to the
customers. General and administrative expenses support a company’s overall
operations and include expenses related to accounting, HR management, and
financial management.
Nonoperating Activities consist of other expenses, revenues, losses and gains
that are unrelated to company’s operations. Other revenues and gains commonly
include interest revenue, dividend revenue, rent revenue and gains from asset
disposals. Other expenses and losses often include interest expense, losses from
asset disposals, and casualty losses.

 Single-Step Income Statement – lists cost of goods sold as other expenses and
shows only one subtotal of expenses. Expenses are not or are grouped in very
few categories.

 Acid Test Ratio – measure of merchandiser’s ability to pay its current liabilities. It
differs from current ratio by excluding less liquid current assets such as inventory
and prepaid expenses.

 Gross margin Ratio -