Financial Accounting: Exam 1 Study Guide (Chapters 1–4)

Chapter 1: Fundamental Accounting Concepts

Qualitative Characteristics of Accounting Information

Accounting information must possess certain qualities to be useful for decision-making. These qualities are classified as fundamental and enhancing characteristics.

• Fundamental Qualities: Relevance (including materiality) and faithful representation are essential for information to be useful.

• Enhancing Qualities: Comparability, verifiability, timeliness, and understandability improve the usefulness of information but are not fundamental.

• Example: Comparability is an enhancing quality, not a fundamental one.

The Fundamental Accounting Equation

The accounting equation forms the basis of double-entry accounting and represents the relationship among assets, liabilities, and owner's equity.

• Equation: $\text{Assets} = \text{Liabilities} + \text{Owner's Equity}$

• Alternative Forms: $\text{Assets} - \text{Liabilities} = \text{Owner's Equity}$

• Application: Used to ensure the balance sheet remains balanced after every transaction.

Classification of Transactions

Transactions are classified based on their impact on accounts and financial statements.

• Expenses: Outflows or using up of assets as part of operations (e.g., payment of salaries).

• Dividends: Distributions to shareholders, not classified as expenses.

• Repayment of Bank Loan: Reduces liabilities, not an expense.

• Purchase of Land: Increases assets, not an expense.

Impact on Stockholders' Equity

Some transactions affect stockholders' equity, while others do not.

• No Impact: Purchase of land from bank loan proceeds (increases asset and liability, no effect on equity).

• Reduces Equity: Dividends to stockholders, net loss.

• Increases Equity: Investments of cash by stockholders.

Financial Statements and Reporting Periods

Financial statements are prepared for specific periods or as of a specific date.

• Balance Sheet: Prepared as of a specific date, showing assets, liabilities, and equity.

• Income Statement, Retained Earnings Statement, Statement of Cash Flows: Prepared for a period of time.

Balance Sheet Example

Given a balance sheet, liabilities can be calculated as the sum of accounts payable and bank loans.

Account	Amount ($)
Cash	100
Accounts Receivable	500
Stockholders' Equity	700
Accounts Payable	200
Bank Loans	1,000

• Total Liabilities: $1,000 + 200 = $1,200$

Dividends Calculation Example

To find dividends paid during the year:

• Formula: $\text{Ending Equity} = \text{Beginning Equity} + \text{Net Income} - \text{Dividends}$

• Example: If beginning equity is $160,000, ending equity is $120,000, and net income is $180,000, then:

$120,000 = 160,000 + 180,000 - \text{Dividends}$ $\text{Dividends} = 160,000 + 180,000 - 120,000 = 220,000$

Chapter 2: The Accounting Cycle and Journal Entries

Normal Balances and Debits/Credits

Each account type has a normal balance, which determines whether it is increased by a debit or a credit.

• Debit (D): Dividends, Expenses, Assets

• Credit (C): Liabilities, Equity, Revenues

• Acronym: DEA (Debit: Dividends, Expenses, Assets), LER (Credit: Liabilities, Equity, Revenues)

Journal Entry Rules

Journal entries must always balance, with total debits equaling total credits.

• Debits on the left, credits on the right.

• Example: Billing a client for services rendered:

Account	Debit	Credit
Accounts Receivable	500
Service Revenue		500

Recording Investments and Transactions

• Owner invests land: Debit Land, Credit Capital Stock.

• Example: $5,000 land investment:

Account	Debit	Credit
Land	5,000
Capital Stock		5,000

Accounting Process Sequence

The accounting process follows a logical sequence:

1. Transaction

2. Source Document

3. Journal Entry

4. Post to Ledger Account

5. Trial Balance

Chapter 3: Accruals, Adjustments, and Internal Controls

Accrued Expenses and Payroll

Accrued expenses are recorded when incurred, not when paid.

• Example: If payroll is $10,000 per week and the period ends midweek, accrue for days worked but not yet paid.

• Journal Entry: Debit Salary Expense, Credit Salary Payable for the accrued amount.

Adjusting Entries and Their Effects

Failure to record adjusting entries can overstate or understate assets, liabilities, expenses, and income.

• Example: Not recording utilities expense will overstate assets and net income, and understate expenses and liabilities.

Prepaid Expenses and Unearned Revenue

• Prepaid Insurance: When insurance is paid in advance, debit Prepaid Insurance (asset), credit Cash. As time passes, debit Insurance Expense, credit Prepaid Insurance.

• Unearned Revenue: When cash is received before earning revenue, debit Cash, credit Unearned Revenue (liability). When revenue is earned, debit Unearned Revenue, credit Revenue.

Closing Accounts

• Temporary Accounts: Revenues, expenses, and dividends are closed at period end.

• Permanent Accounts: Assets, liabilities, and capital stock are not closed.

Current Assets

• Definition: Assets expected to be converted to cash or used up within one year or the operating cycle, whichever is longer.

Chapter 4: Cash, Bank Reconciliation, and Internal Controls

Cash Account and Inclusions

• Cash Account: Includes currency, coins, checks, and money orders. May also include certain travel advances to employees if they are expected to be repaid or used for business expenses.

Bank Reconciliation

Bank reconciliation ensures the cash balance per books matches the cash balance per bank statement by accounting for timing differences and errors.

• Adjustments: Add deposits in transit, subtract outstanding checks, adjust for bank errors.

• Purpose: To identify discrepancies and ensure accurate cash reporting.

Bank Reconciliation Example

Item	Amount ($)
Ending cash per bank statement	1,567
Ending cash per company records	7,283
Deposits in transit at month-end	3,245
Outstanding checks at month-end	2,399
Customer check returned NSF	45

• Adjusted ending cash balance: $7,283$

Journal Entries for Bank Errors

• Example: If a check for $70 is returned and a $25 fee is charged, the entry is:

Account	Debit	Credit
Accounts Receivable	70
Miscellaneous Expense	25
Cash		95

Internal Controls

• Objectives: Reliability of financial reporting, efficiency and effectiveness of operations, compliance with laws and regulations.

• Not an Objective: Assurance of elimination of business risk.