Accounting in Action

Overview of the Accounting Process

Financial accounting involves the identification, measurement, and communication of financial information about economic entities to interested parties. The process ensures that users such as creditors, managers, tax preparers, regulatory agencies, and investors can make informed decisions based on reliable financial data.

• Economic Entities: Includes corporations, partnerships, proprietorships, and not-for-profit organizations.

• Transactions: Business events that are measurable and involve an exchange (e.g., acquiring supplies, paying debts, receiving cash from customers).

• Financial Statements: The main reports are the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows.

• Users: Internal (management) and external (creditors, government, investors).

• Decisions: Focus on profitability, solvency, and cash flows.

Additional info: The accounting process is governed by Generally Accepted Accounting Principles (GAAP), ensuring consistency and comparability across entities and time.

The Recording Process

Steps in the Recording Process

The recording process is the systematic method by which business transactions are captured and summarized for reporting.

• Step 1: Journalize Transactions – Record each transaction in the journal as a debit and credit.

• Step 2: Post to Ledger – Transfer journal entries to the general ledger (T-accounts).

• Step 3: Prepare Trial Balance – Summarize balances in each account to ensure debits equal credits.

• Step 4: Prepare Financial Statements – Use the trial balance to prepare the Income Statement, Statement of Stockholders’ Equity, Balance Sheet, and Statement of Cash Flows.

Key Questions:

• Which accounts are involved?

• Are they assets, liabilities, equity, revenue, or expenses?

• Are the accounts increasing or decreasing?

• Should each account be debited or credited?

Debit and Credit Rules

The double-entry system ensures that the accounting equation remains balanced:

• Assets: Increase with debits, decrease with credits.

• Liabilities and Equity: Increase with credits, decrease with debits.

• Contra-accounts: Have opposite rules to their related accounts.

Expanded Accounting Equation:

Adjusting the Accounts

Types of Adjusting Entries

Adjusting entries are made at the end of the period to update account balances before preparing financial statements. They ensure that revenues and expenses are recognized in the correct period (accrual accounting).

• Prepayments: Recognize expense for assets used up (e.g., prepaid insurance) or revenue for liabilities earned (e.g., unearned revenue).

• Accruals: Record expenses incurred but not yet paid (e.g., salaries payable) or revenues earned but not yet received (e.g., interest receivable).

Examples of Adjusting Entries:

• Expense for used supplies:

• Depreciation:

• Unearned revenue earned:

• Accrued salaries:

Reversing Entries

Reversing entries are optional and made at the beginning of the next period to simplify the recording of subsequent cash transactions related to prior period accruals.

Completing the Accounting Cycle

Closing Entries

At the end of the period, temporary accounts (revenues, expenses, dividends) are closed to Retained Earnings to reset their balances for the next period.

• Step 1: Close revenues and gains to Income Summary.

• Step 2: Close expenses and losses to Income Summary.

• Step 3: Close Income Summary to Retained Earnings.

• Step 4: Close dividends (or withdrawals) to Retained Earnings (or Capital for proprietorships).

Assumption: The periodicity assumption requires closing entries to ensure that each period’s results are reported separately.

Financial Statements and Their Organization

Multi-Step Income Statement

The multi-step income statement provides detailed information about a company’s profitability by separating operating and non-operating activities.

• Sections: Sales, Cost of Goods Sold, Gross Margin, Operating Expenses, Operating Income, Other Items (interest, gains/losses), Income Before Taxes, Income from Continuing Operations, Discontinued Operations, Net Income, Other Comprehensive Income, Comprehensive Income.

• Earnings per Share (EPS):

Balance Sheet

The balance sheet presents a snapshot of a company’s financial position at a specific point in time.

• Assets: Current Assets, Investments, Property, Plant & Equipment, Intangible Assets, Other Assets.

• Liabilities: Current Liabilities, Long-Term Liabilities.

• Stockholders’ Equity: Contributed Capital, Retained Earnings, Accumulated Other Comprehensive Income, Treasury Stock.

Statement of Cash Flows

The statement of cash flows reports the sources and uses of cash, classified into operating, investing, and financing activities.

• Operating Activities: Cash flows from core business operations.

• Investing Activities: Cash flows from buying/selling long-term assets.

• Financing Activities: Cash flows from borrowing, repaying debt, issuing stock, and paying dividends.

Indirect Method: Adjusts net income for non-cash items and changes in working capital to arrive at cash from operations.

GAAP and Standard Setting

Evolution and Structure of GAAP

Generally Accepted Accounting Principles (GAAP) are the rules and standards that govern financial accounting in the U.S. They have evolved through the efforts of several organizations:

• Committee on Accounting Procedure (CAP): 1939-1959, issued Accounting Research Bulletins.

• Accounting Principles Board (APB): 1959-1973, issued APB Opinions.

• Financial Accounting Standards Board (FASB): 1973-present, issues Statements of Financial Accounting Standards (SFAS), Interpretations, and Technical Bulletins.

Other influential bodies include the SEC, IASB (for IFRS), GASB (governmental), AICPA, PCAOB, IMA, IRS, and AAA.

Qualitative Characteristics of Useful Information

For accounting information to be useful, it must possess certain fundamental and enhancing characteristics:

• Fundamental: Relevance (predictive value, confirmatory value, materiality), Faithful Representation (completeness, neutrality, free from error).

• Enhancing: Comparability, Verifiability, Timeliness, Understandability.

Key Assumptions in GAAP

• Separate Entity: Business is distinct from its owners.

• Monetary Unit: Financial information is measured in stable currency.

• Going Concern: Entity will continue to operate in the foreseeable future.

• Periodicity: Economic activity can be divided into time periods for reporting.

Measurement and Reporting Issues

Measurement Bases

GAAP allows a mixed-attribute system, primarily using historical cost and fair value:

• Historical Cost: Objective and verifiable.

• Fair Value: Reflects current market value; more relevant for certain assets/liabilities.

Fair Value Hierarchy:

• Level 1: Quoted prices in active markets.

• Level 2: Observable inputs other than quoted prices.

• Level 3: Unobservable inputs (company estimates).

Revenue and Expense Recognition

Revenue Recognition (ASU 2014-09): Recognize revenue when performance obligations are satisfied. Five steps:

1. Identify contract with customers.

2. Identify separate performance obligations.

3. Determine transaction price.

4. Allocate price to obligations.

5. Recognize revenue as obligations are satisfied.

Expense Recognition: Match expenses to revenues in the period incurred (matching principle), allocate systematically (e.g., depreciation), or recognize immediately if no future benefit is expected.

Inventories

Inventory Valuation and Cost Flow Assumptions

Inventory is valued at the lower of cost or market/net realizable value. Cost flow assumptions include:

• Specific Identification: Tracks actual cost of each item.

• FIFO (First-In, First-Out): Oldest costs assigned to cost of goods sold; ending inventory reflects recent costs.

• LIFO (Last-In, First-Out): Newest costs assigned to cost of goods sold; ending inventory reflects older costs. Not allowed under IFRS.

• Average Cost: Uses weighted or moving average.

Inventory Errors: Can affect both the balance sheet and income statement, but some errors are counterbalancing and correct themselves over two periods.

Retail Inventory Methods

Used by merchandisers to estimate ending inventory and cost of goods sold:

• Conventional Retail Method: Uses cost-to-retail ratio, excludes markdowns from ratio.

• LIFO Retail Method: Applies LIFO to retail inventory; separates layers by period.

• Dollar-Value LIFO Retail: Adjusts for changes in price levels using indexes.

Cash, Receivables, and Securities

Cash and Cash Equivalents

• Cash: Includes currency, checking/savings accounts, undeposited checks.

• Cash Equivalents: Short-term, highly liquid investments (e.g., T-bills, commercial paper) with maturities of 90 days or less.

• Bank Reconciliation: Adjusts book and bank balances for timing differences and errors.

Accounts Receivable

• Valuation: Reported at net realizable value (gross receivables less allowance for doubtful accounts).

• Allowance Method: Estimates uncollectible accounts using percentage of sales or aging of receivables.

• Write-offs: Remove uncollectible accounts from the books; recoveries are reinstated.

• Factoring and Assigning: Receivables can be sold (factored) or used as collateral (assigned) for loans.

Notes Receivable

• Interest-bearing vs. Non-interest-bearing: Non-interest-bearing notes are recorded at present value, with the difference as a discount.

• Impairment: Receivables are tested for impairment; losses are recognized if collection is unlikely.

Securities

• Debt Securities: Classified as Held-to-Maturity (amortized cost), Trading (fair value through income), or Available-for-Sale (fair value through OCI).

• Equity Securities: Reported at fair value; unrealized gains/losses recognized in income.

Time Value of Money

Present and Future Value Concepts

The time value of money recognizes that a dollar today is worth more than a dollar in the future. Key calculations include:

• Future Value of a Single Sum:

• Present Value of a Single Sum:

• Future Value of an Ordinary Annuity:

• Present Value of an Ordinary Annuity:

Applications include notes receivable/payable, bonds, leases, and investment funds.

Practice Problems and Applications

Sample Journal Entries and T-Accounts

Students should be able to analyze transactions, determine accounts affected, and apply debit/credit rules. Practice includes:

• Recording purchases, sales, collections, and payments.

• Adjusting entries for accruals and prepayments.

• Closing entries for revenues, expenses, and dividends.

• Preparing trial balances, income statements, retained earnings statements, and balance sheets.

HTML Table: Example of Account Classification

Summary

This study guide covers the foundational concepts, processes, and reporting requirements of financial accounting, including the accounting cycle, GAAP, financial statements, measurement issues, and practical applications. Mastery of these topics is essential for success in college-level financial accounting courses and professional practice.