Chapter 1: Introduction to Accounting

The Accounting Equation

The accounting equation forms the foundation of financial accounting and represents the relationship among a company's assets, liabilities, and stockholders' equity.

• Equation:

• Assets: Resources owned by the company (e.g., cash, inventory, equipment).

• Liabilities: Obligations owed to outsiders (e.g., loans, accounts payable).

• Stockholders' Equity: Owners' claims on the assets after liabilities are settled (e.g., common stock, retained earnings).

Financial Statements

Financial statements summarize a company's financial performance and position. The main statements are:

• Income Statement: Reports revenues and expenses to determine net income.

• Statement of Retained Earnings: Shows changes in retained earnings over a period.

• Balance Sheet: Presents the company's assets, liabilities, and equity at a specific point in time.

Income Statement Formula:

Statement of Retained Earnings Structure:

• Beginning Retained Earnings

• + Net Income (or - Net Loss)

• - Dividends

• = Ending Retained Earnings

Balance Sheet: Presents the accounting equation at a point in time.

Relationship Among Financial Statements

• Net income from the income statement is added to the statement of retained earnings.

• Ending retained earnings from the statement of retained earnings appears in the equity section of the balance sheet.

Example: If a company earns $10,000 in net income and pays $2,000 in dividends, retained earnings increase by $8,000.

Chapter 2: Financial Statements

Transactions Impacting the Balance Sheet

Business transactions affect the balance sheet by changing assets, liabilities, or equity. Each transaction must keep the accounting equation in balance.

• Examples: Purchasing inventory (increases assets and liabilities), paying off debt (decreases assets and liabilities).

Classified Balance Sheet

A classified balance sheet organizes assets and liabilities into current and noncurrent categories:

• Current Assets: Expected to be converted to cash or used within one year (e.g., cash, accounts receivable).

• Noncurrent Assets: Long-term resources (e.g., property, plant, equipment).

• Current Liabilities: Obligations due within one year (e.g., accounts payable).

• Noncurrent Liabilities: Long-term obligations (e.g., bonds payable).

Financial Ratios

Ratios help assess a company's performance in profitability, liquidity, and solvency.

Chapter 3: Accounting Records

Transaction Analysis

Not all events are transactions. Only those that affect the accounting equation are recorded.

• Transaction: An economic event that changes assets, liabilities, or equity.

• Examples: Sale of goods, payment of expenses, borrowing money.

Debits and Credits

Accounting uses a double-entry system. Each transaction affects at least two accounts, with debits and credits recorded according to specific rules.

• Debits (Dr): Increase assets, expenses, and dividends; decrease liabilities, revenues, and equity.

• Credits (Cr): Increase liabilities, revenues, and equity; decrease assets, expenses, and dividends.

• DEA/LOR: Mnemonic for normal balances:

  • DEA: Dividends, Expenses, Assets (normal Debit balances)

  • LOR: Liabilities, Owner's Equity, Revenues (normal Credit balances)

Steps in Recording Transactions

1. Identify accounts affected and their classification (asset, liability, equity, revenue, expense).

2. Determine dollar amounts and the effect on the accounting equation.

3. Book the journal entry (record debits and credits).

4. Update T-accounts for each affected account.

5. Calculate final balances after all entries are posted.

Example: If a company pays $500 cash for supplies, debit Supplies (asset) $500, credit Cash (asset) $500.

Chapter 4: Adjusting Records

Revenue Recognition and Deferred Revenue

Revenue is recognized when earned, not necessarily when cash is received. If cash is received before revenue is earned, it is recorded as deferred (unearned) revenue, a liability.

• Revenue is credited only when earned.

• Deferred revenue is reduced and revenue is recognized when the service or product is delivered.

Expense Recognition and Deferred Expenses

Expenses are recognized when incurred, following the matching principle: match expenses with related revenues in the same period.

• If payment is made before use, record as a deferred expense (asset, e.g., prepaid insurance).

• When used, transfer from asset to expense.

Adjusting Entries: Deferrals and Accruals

Adjusting entries ensure that revenues and expenses are recorded in the correct period.

• Deferrals: Adjust previously recorded assets or liabilities (e.g., supplies used, unearned revenue earned).

• Accruals: Record revenues earned or expenses incurred but not yet recorded (e.g., interest earned, wages payable).

Contra Asset Accounts

A contra asset account offsets a related asset account. The most common is Accumulated Depreciation, which reduces the book value of fixed assets.

• Increased with credits, decreased with debits (opposite of regular assets).

Adjusting Journal Entries (AJE)

At the end of the period, adjusting entries are made to update account balances before preparing financial statements.

• Examples: Recording depreciation, accruing interest, adjusting prepaid expenses.

Additional info:

• Preparation of adjusted trial balances and closing entries (zeroing out temporary accounts and updating retained earnings) are important but not required for Exam 1.

• Temporary accounts include all income statement accounts and dividends.