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VYC1 Principles of Accounting Study Guide
● Accounting ○ Takes data from source documents and turns data into meaningful info ○ Categorizes HOW and WHY money flows in/flows out of a business by using accounts in a journal entry that classifies a transaction ○ Transactions are approached from the perspective of the company’s accountant ○ There are 6 major account categories: ■ Assets - items a company owns to help produce future revenue ■ Liabilities - represent a company’s debt ■ Equity (capital) - the level of ownership in a business ■ Revenue - what a company earns when it sells a product or service ■ Expenses - costs incurred to help produce revenue ■ Drawings - refers to money taken out of a business by its sole owner ○ A Chart of Accounts lists all accounts that a business uses and assigns them a unique number ○ Each account category can be split into individual accounts and depicted in a “T” format called a T-account ● Account Characteristics ○ Each category of account has a “normal balance” that indicates how the balance of that account category increases ○ The left side of a T-account is called the DEBIT (DR) side ○ The right side of a T-account is called the CREDIT (CR) side ○ Some account categories increase by noting the transaction amount on the DEBIT side, while others increase by noting the amount on the CREDIT side
● Debits and Credits ○ The account categories on the left page (Assets, Expenses, and Drawings) increase with a DEBIT ○ The account categories on the right page (Liabilities, Revenue, and Capital) increase with a CREDIT ● Journal Entries ○ Financial data from source documents is categorized through journal entries ○ A journal entry must contain a DEBIT and a CREDIT amount - the total DEBIT and CREDIT amounts must equal ○ Three things to analyze when making a journal entry ■ Which accounts will be affected ■ What are the transaction amounts involved ■ Whether to DEBIT or CREDIT each account ○ Each journal entry should contain an entry date and explanation ● Journals and Ledgers ○ Journal entries are written into a book called the General Journal ○ Account transactions are transferred (“posted”) to an individual account’s record called a Ledger ○ An account’s ledger is another form of its T-account ○ A book containing all of the account ledgers together is called the General Ledger ● Trial Balance ○ Lists the names and balances of all of the accounts in the order they appear in the ledger ○ Prepared on a specific date ○ Proves only the equality of debits and credits ○ Will not prove that transactions were correctly analyzed and recorded in proper accounts ○ Will not show whether proper amounts were noted in journal entries ○ Will not disclose omitted journal entries
○ Relate to the Income Statement: Net Income increases the Retained Earnings account balance, while a net loss decreases it ○ Beginning Retained Earnings + Net Income - Dividend Payments to Stockholders = Ending Retained Earnings ● The Balance Sheet ○ Lists balances of accounts in Asset, Liability and Equity account categories as of a certain date. Permanent or Real Accounts ○ Balances are transferred from the Adjusted Trial Balance on Worksheet ○ Assets = Liabilities + Equity (too much ALE makes you lose your balance) ○ A Classified Balance Sheet splits Assets into 3 groups: Current Assets, Property Plant and Equipment, and Long-term Assets ○ A Classified Balance Sheet splits Liabilities into 2 groups: Current Liabilities and Long-term Liabilities ● The Statement of Cash Flows ○ Summarized the company’s cash receipts and cash payments over an accounting period ○ Essentially an analysis of a business’ checking account ○ Separates cash inflows/outflows into 3 categories: Operating, Investing & Financing ○ Measures a company’s ability to operate profitably and remain solvent ● Closing Journal Entries ○ “Reset” Revenue and Expense accounts (temporary accounts) to zero so the Income Statement is ready to use in next accounting period ○ Revenue and Expense accounts are CLOSED via journal entry to an account called Income Summary, which in turn is CLOSED into Retained Earnings ○ An After-closing Trial Balance is prepared to check that Total Debts = Total Credits, after recording closing entries ● Revenue ○ Means essentially the same thing as “sales” or “fees” - all are REVENUE accounts on the income statement ○ Is recognized when it is EARNED (when product is shipped or services performed) in accrual accounting ○ Is the price of goods sold or services rendered ○ Revenue-type accounts are CLOSED (reset at zero) at end of each accounting period ● Accounts Receivable (A/R) ○ Generated by sales to customers who have established a credit account with a company ○ NOT the same as sales to customers who use a credit card for a purchase ○ Appear in the Current Assets section of the Balance Sheet ○ A/R Balance is usually slit into 30/60/90 day subtotals so a company can see how long it is taking customers to pay amounts owed; this process is called Aging the accounts
● Sales Discounts ○ Discount that companies offer credit customers to entice early payment of amounts due ○ Usually stated on sales invoice in terms such as, for example, “2/10, n/30” meaning customer can take a 2% discount off total amount due if paid within 10 days, otherwise the total (net) amount is due within 30 days ○ Sales Discounts (DR balance) is a contra-revenue account as it offsets the Sales account (CR balance) ● Sales Returns and Allowances ○ Contra-revenue account (DR balance) used instead of debiting the Sales account so companies can track amount of returned goods ○ Sales Returns is when a customer returns a product to a business ○ Sales Allowance is when a business reduces a product’s initial sale price (for damaged goods, clearance item, etc) ● Bad Debts - Direct Write-off Method ○ Used by companies that do not have many credit sales ○ Does not adhere to Matching Principle ○ Bad Debts are recorded when they are deemed to be uncontrollable ○ Allowance for Uncollectable Accounts is NOT used: instead, the amount is journalized directly to the customer’s A/R account ● A/R Aging Report ○ List of customers who owe money to the business ○ Shows total amount due from customers as well as how many days payment is past-due ○ The A/R Aging report can be created anytime so companies can can monitor past-due amounts ○ The term “bad debts” means the same thing as “uncollectable accounts” or “doubtful accounts” ○ An amount that is deemed to be collectable is 1.No longer an asset in the form of A/R
- Becomes an expense called Bad Debts Expense ○ Expenses incurred must match the revenue they help to earn in the same period ○ Since a company does not know when customers will actually pay amounts owed, Bad Debts Expense must be estimated in the month the revenue is earned; remember, a company may earn revenue but not collect amounts due ● Estimating Bad Debts - Balance Sheet Method ○ A business estimates the % of losses likely to occur in each age column; this %, when applied to the total dollar amount in age column, shows the estimated uncollectable (bad debt) portion ○ The sum of all of the uncollectable columns equals the company’s total uncollectable amount ○ Estimated Bad Debts is recognized through a journal entry so that it appears in the Expense section of the Income Statement
Describe the purpose of the cash budget ● Details a company’s cash inflow and outflow during a specified period, such as a month, quarter or year ● Primary purpose is to provide the status of the company’s cash position at any point in time ● Helps in prioritizing payments in the budget period Describe the bank reconciliation process ● The process of checking this statement against personal records to determine if there are differences between the cash balance on the bank statement and the cash balance in the individual records Describe financial accounting ● The process of recording, summarizing and reporting the myriad of a company’s transactions resulting from business operations over a period of time Identify the three major steps in the Accounting Process ● Observe, identify, and measure events ● Record, classify, and summarize measurements ● Report economic events and interpret financial statements Who are the various users of financial statements and for what purpose ● Owners and prospective owners - has the company earned satisfactory income on its total investments? Should an investment be made in this company? Should the present investment be increased, decreased, or retained at the same level? ● Creditors, lenders, and suppliers - should a loan be granted to the company? Will the company be able to pay its debts as they become due? ● Employees and their unions - does the company have the ability to pay increased wages? Is the company financially able to provide long-term employment for its workforce? ● Customers - does the company offer useful products at fair prices? Will the company survive long enough to honor its product warranties? ● Governmental units - is the company, such as a local public utility, charging a fair rate for its services? ● General public - is the company providing useful products and gainful employment for citizens without causing serious environmental problems? What are the four basic assumptions of GAAP? ● Business/Economic Entity Assumption - the enterprise is separate from its owners and other entities ● Going Concern Assumption - the entity will continue indefinitely
● Periodicity Assumption - related to timeliness, the life of an enterprise can be divided into artificial time periods ● Monetary Unit Assumption - a common denominator is the dollar, measurement scale used in financial statements is nominal units of money, without any adjustment for changes in purchasing power What are the four basic GAAP principles? ● Historical Cost Principle - refers to the notion that all values listed and reported are the costs to obtain and acquire the asset, not the fair market value ● Revenue Recognition Principle - states that all revenue must be reported when it is realized and earned, not necessarily when the actual cash is received, also known as accrual accounting. A company should establish an allowance for bad debts accounts ● Matching Principle - holds that the expenses in the financial statement must be matched with the revenue. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or product actually makes its contribution to revenue ● Full Disclosure Principle- holds that information pertinent to make a reasonable judgment on the company’s finances must be included, so long as the costs to obtain that information is reasonable What are the five basic constraints of GAAP ● Objectivity Principle - the company financial statements provided by the accountants should be based on objective evidence ● Materiality Principle - the significance of an item should be considered when it is reported ● Consistency Principle - the company uses the same accounting principles and methods from year to year ● Conservatism Principle - when choosing between two solutions, the one that will be least likely to overstate assets and net income, or understate liabilities and net losses ● Cost-Benefit Relationship - the company considers the costs necessary to prepare the information and what benefit users will get from it in making decisions, for example, about voluntary financial statement disclosures What are the key differences and similarities between GAAP and IFRS? ● GAAP is rules-based and IFRS is principles-based ● IFRS guidelines provide much less overall detail than GAAP ● Under GAAP, how to record a transaction is focused on a review of the rules-based literature ● Under IFRS, a review of the facts surrounding the transaction and how they relate to the accounting principle drives how the transaction is recorded ● IFRS rules ban the use of last-in, first-out (LIFO) inventory accounting methods. GAAP rules allow for LIFO ● GAAP does not allow for inventory reversals, while IFRS permits them under certain conditions
Differentiate between Accounts and T-accounts ● Accounts are a part of the accounting system used to classify, record, and to summarize the increases, decreases, and balances of each asset, liability, stockholders’ equity item, dividend, revenue, and expense ● T-accounts are used to record increases and decreases in an account Recording Assets, Liabilities, and Stockholders’ Equity ● Assets are on the left side of the equals sign in the accounting equation. Increases to assets are on the left side of the T-accounts ● Liabilities and stockholders’ equity are on the right-hand side of the accounting equation ● Increases for both of these types of accounts are on the right-hand side of the T-account ● Assets increase by debits (left side) to the T-account and decrease by credits (right side) to the T-account ● Liabilities and stockholders’ equity decrease by debits (left side) to the T-account and increase by credits (right side) to the T-account Recording Rules for Revenues and Expenses ● Record increases in revenues on the right (credit) side of the T-account and decreases on the left (debit) side. The reasoning behind this rule is that revenues increase retained earnings and increases in retained earnings are recorded on the right side ● Record increases in expenses in the left (debit) side of the T-account and decreases on the right (credit) side. The reasoning behind this rule is that expenses decrease retained earnings and decreases in retained earnings are recorded on the left side Rules of Debit and Credit ● Increases in asset accounts are debits; decreases are credits ● Decreases in liability accounts are debits; increase are credits ● Decrease in stockholders’ equity accounts are debits; increases are credits ● Decreases in revenue accounts are debits; increases are credits ● Increases in expense accounts are debits; decreases are credits ● Increase in dividend accounts are debits; decreases are credits Describe the five types of general ledger accounts ● Balance sheet accounts (assets, liabilities, and stockholders’ equity
○ Real accounts because they are not sub classifications or subdivisions of any other account ○ Permanent accounts because their balances are not transferred (or closed) to any other account at the end of the accounting period ● Income statements (revenues and expenses) ○ Nominal accounts because they are merely sub classifications of the stockholders’ equity accounts ○ Temporary accounts because they temporarily contain revenue, expense, and dividend information that is transferred (or closed) to the Retained Earnings account at the end of the accounting period How are transactions for the five types of accounts recorded in the ledger (debits and credits) ● Asset = debit ● Dividends = debit ● Expenses = debit ● Liability = credit ● Equity = credit ● Revenue = credit What are the steps in the Accounting Cycle?
- Analyze transactions by examining source documents
- Journalize transactions in the general journal
- Post entries to the respective accounts in the general ledger
- Prepare a trial balance of the unadjusted accounts and begin the trial balance worksheet
- Journalize and post adjusting journal entries, prepare adjusted trial balance, and complete worksheet
- Prepare the financial statements
- Journalize and post closing entries
- Prepare the post-closing trial balance Differentiate between source documents, journals, general ledger, and financial statements ● Source documents - provides detailed evidence of a financial event ● Journals - captures details in date order as debits/credits ● General ledger - sorts and summarizes details by account type ● Financial statements - summarizes GL account balances for decision makers What are Special Journals and Subsidiary Ledgers and why are they used? ● Special Journals - group together similar transactions ○ Used for frequent and recurring transactions such as sales, purchases, cash receipts, and cash disbursements ○ Use one-line transactions that are not required to be posted to the ledger independently. At the end of the period, the total of the items in the special journal can be used in posting to the general ledger
Identify the Debit and Credit entries for adjustments - including deferrals and accruals ● Brings the amounts in the general ledger accounts to their proper balances before the company prepares its financial statements ● Deferred items - consist of two types of adjusting entries: asset/expense adjustments and liability/revenue adjustments ○ Asset/expense group - prepare adjusting entries for prepaid expenses and depreciation expense ○ Liability/revenue group - prepare adjusting entries for unearned revenues ○ Prepaid insurance - advance payment of insurance is an asset because the company will receive insurance coverage in the future ○ Prepaid rent - the company debits the prepayment of rent in advance to the prepaid rent account ○ Supplies on hand - office supplies, selling supplies, or training supplies, are purchased in bulk and recorded as an asset until the company uses them ● Deferred depreciation ○ Depreciation asset - a long-lived asset such as a building, machine, vehicle, or piece of equipment that provides a service or a benefit to a business over a long period of time ○ Depreciation expense - the amount of asset cost assigned as an expense to a particular accounting period ○ Depreciation accounting - the process of recording depreciation expense ■ Asset cost - the asset cost is the amount that a company paid to purchase the depreciable asset ■ Estimated residual value - the estimated residual value (scrap/salvage value) is the amount that the company expects to sell the asset for at the end of its estimated useful life ■ Estimated useful life - the estimated useful life of an asset is the estimated time that a company expects to use the asset. Useful life is an estimate, not an exact measurement ○ Straight line depreciation - assigns the same amount of depreciation expense to each accounting period over the life of an asset ● Accumulated depreciation account ○ A contra asset account that shows the total of all depreciation recorded on the asset from the date of acquisition up through the balance sheet date ○ Contra asset account - a deduction from the asset to which it relates in the balance sheet. Purpose is to reduce the original cost of the asset down to its remaining undepreciated cost or book value ● Accrued assets ○ Assets such as interest receivable or accounts receivable, that have not been recorded by the end of an accounting period. Also called accrued revenue ○ asset/revenue and liability expense Other key items ● Each adjusting journal entry has a dual purpose
- To make the income statement report the proper revenue or expense
- To make the balance sheet report the proper asset or liability ● The effect of failing to prepare adjusting entries causing net income and the balance sheet to be in error Identify the four ways companies should control and manage cash assets ● Account for all cash transactions accurately so that correct information is available regarding cash flows and balances ● Make certain that enough cash is available to pay bills as they come due ● Avoid holding too much idle cash because excess cash could be invested to generate income, such as interest ● Prevent loss of cash due to theft or fraud What are the four basic cash control principles ● Prepare a record of all cash receipts as soon as cash is received. Most thefts of cash occur before a record is made of the receipt. Once a record is made, it is easier to trace a theft ● Deposit all cash receipts intact as soon as feasible, preferable on the day they are received or on the next business day. Undeposited cash is more susceptible to misappropriation ● Arrange duties so that the employee who handles cash receipts does not record the receipts in the accounting records. This control feature follows the general principle of segregation of duties, as does the next principle ● Arrange duties so that the employee who receives the cash does not disburse the cash. This control measure is possible in all but the smallest companies Identify some basic control principles for cash disbursements ● Make all disbursements by check or from petty cash. Obtain proper approval for all disbursements and create a permanent record of each disbursement ● Require all checks to be serially numbered and limit access to checks to employees authorized to write checks ● Require 2 signatures on each check over a material amount so that one person cannot withdraw funds from the bank account ● Arrange duties so that the employee who authorizes payment of a bill does not sign checks ● Require approved documents to support all checks issued ● Instruct the employee authorizing cash disbursements to make certain that payment is for a legitimate purpose and is made out for the exact amount and to the proper party ● Stamp the supporting documents paid when liabilities are paid and indicate the date and number of the check issued. These procedures lessen the chance of paying the same debt more than once ● Arrange duties so that those employees who sign checks neither have access to canceled checks nor prepare the bank reconciliation. This policy makes it more difficult for an employee to conceal a theft
○ Represents the accrual basis of accounting and is the accepted method to record uncollectible accounts for financial accounting (GAAP) purposes. ○ Follows the matching principle by recognizing the uncollectible accounts expense in advance of identifying specific accounts as being uncollectible Describe the three methods used to estimate uncollectible accounts receivables under the allowance approach ● Percentage-of-Sales method - estimates uncollectible accounts from the credit sales of a given period ○ Based on a percentage of prior years’ actual uncollectible accounts to the prior years’ credit sales ○ When cash sales are small or make up a fairly constant percentage of total sales, firms base this calculation on total net sales ● Percent-of-Receivables method - estimates uncollectible accounts by determining the desired size of the Allowance for Uncollectible Accounts ○ A company may use either an overall rate or a different rate for each aged category of receivables ● Aging method - the older the receivable, the less likely the company is to collect the receivable ○ An aging schedule classifies accounts receivable according to how long they have been outstanding and uses a different uncollectibility percentage rate for each aging category ○ This gives the company a better basis for estimating the total amount of uncollectible accounts ○ Since the aging schedule approach is an alternative under the percentage-of- receivables method, the balance in the allowance account before adjustment affects the year-end adjusting entry amount recorded for uncollectible accounts List the accounting entries for writing off receivables and recovering uncollectible accounts ● Writing off receivables - as time passes and a firm considers a specific customer’s account to be uncollectible, it writes that account off. It debits the Allowance for Uncollectible Accounts ○ The credit is to the Accounts Receivable control account in the general ledger and to the customer’s account in the accounts receivable subsidiary ledger ● Uncollectible Accounts Recovered - sometimes a company learns that an account has been written off and receives payment. The company reverses the original write-off entry and reinstates the account by debiting Accounts Receivable and crediting Allowance for uncollectible Accounts for the amount received.
○ It posts the debit to both the general ledger account and to the customer’s accounts receivable subsidiary ledger account ○ The firm also records the amount received as a debit to Cash and a credit to Accounts Receivable. And it posts the credit to both the general ledger and to the customer’s accounts receivable subsidiary ledger account Describe the differing accounting treatment for bank vs non-bank credit card sales ● Bank credit card (Visa/MC) sales are treated as cash sales because the receipt of cash is certain ● Non-bank credit card (Amex/Disc) sales are recorded as a service charge and paid at the end of the month Describe the accounting entries for sales returns and allowances ● A sales allowance is a deduction from the original invoiced sales price granted when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit ● A credit memorandum is a document that provides space for the name and address of the concerned parties, followed by a space for the reason for the credit and the amount to be credited ● The amount of sales returns and sales allowances is shown separately in the accounting records in its own account Describe the three groups of current liabilities ● Clearly determinable liabilities - the existence of the liability and its amount are certain ○ Examples are accounts payable, notes payable, interest payable, and wages payable ● Estimated liabilities - the existence of a liability is certain, but its amount only can be estimated ○ An example is estimated product warranties where the company knows that it will have warranty claims from customers. The amount of the claims is not known; therefore, the company uses a formula to calculate the anticipated warranty claims amounts ● Contingent liabilities - the existence of the liability is uncertain and usually the amount is uncertain because contingent liabilities depend (or are contingent) on some future event occurring or not occurring ○ Examples include liabilities arising from lawsuits, discounted notes receivable, income tax disputes, penalties that may be assessed because of some past action, and failure of another party to pay a debt that a company has guaranteed Describe the three classifications for contingent liabilities and the reporting requirements of each ● Remote - if the likelihood of the loss from a contingent liability is highly unlikely, then it is note required to be recorded on the financial statements
○ Behavioral control - the business has the right to direct or control how the person does their work ○ Financial control - worker is reimbursed for expenses ○ Relationship of parties - worker received benefits like insurance, a pension, or paid. Written contract states worker is an employee ○ Issued a W ● Independent Contractors ○ Behavioral control - worker decides how, when, or where to do the work; which tools to use; and where to purchase supplies ○ Financial control - worker has a significant investment in his or her work, are not reimbursed for expenses, and may incur profit or loss. Pays own income tax and unemployment insurance ○ Relationship of parties - worker does not receive benefits. Written contract states worker is an independent contractor ○ Issued a Form 1099 Other key items ● Payroll accounting - includes recording all aspects of employee compensation. This includes mandatory and voluntary deductions ● Mandatory deductions - include state and federal income taxes, social security taxes, and Medicare taxes. These taxes are deducted from worker’s paychecks ● Mandatory employer contributions - are taxes businesses pay in addition to deductions from worker paychecks. These contributions include social security, Medicare, and federal and state unemployment taxes ● Voluntary deductions - deductions authorized by workers that also come out of their paychecks for things like the employee’s portion of healthcare insurance, retirement funds, and health savings accounts. Sometimes these deductions are matched by employers ● Payroll liabilities - include taxes and other amounts withheld from employees’ paychecks and taxes by employers Describe the primary differences between horizontal and vertical analysis ● Horizontal analysis - the calculation of dollar changes or percentage changes in the statement items or totals is ○ This analysis detects changes in a company’s performance and highlights trends including positive and negative trends ● Vertical analysis - analysis of a single financial statement, such as an income statement ○ Percentages of single items to an aggregate total ○ Consists of the study of a single financial statement in which each item is expressed as a percentage of a significant total, such as sales ■ Common-sized statements - financial statements that show only percentages and no absolute dollar amounts
Describe the three main financial ratio categories ● Liquidity ratio - indicates a company’s short-term debt-paying ability ○ Current ratio - indicates the ability of a company to pay its current liabilities from current assets and, thus, shows the strength of the company’s working capital position ■ Also called the working capital ○ Acid test or quick ratio - the ratio of quick assets (cash, marketable securities, and net receivables) to current liabilities ■ These investments earn additional money on cash that the business does not need at present but will probably need within one year ● Profitability ratios - concerned with two areas ○ Relationships on the income statement that indicate a company’s ability to cover operating costs and expenses, and relationships of income to various balance sheet measures that indicate the company’s relative ability to earn income on assets employed ● Leverage ratios - show the relationship between debt and equity financing in a company ○ Equity ratio - index of long-run solvency and safety ○ Debt to Equity ratio - measure of the relative proportion of stockholders’ and of creditors’ equities
