Chapter 1: Accounting in action
Accounting: identifies, records and communicates the economic events of an
organization.
Bookkeeping: only the recording part.
Users of accounting data:
1. Internal: managers, CEO’s, Marketing, HR etc
2. External: investors, creditors, regulators, taxing authorities etc.
Generally Accepted Accounting Principles (GAAP): the standards of recording
economic events.
Within GAAP there are two measurement principles. The selection of which principle to
use depends on relevance (Could it change a decision?) and faithful representation
(numbers reflect what happened - factual).
1. Historic cost principle: Companies record assets at their cost. Even if the land
appreciates, the value does not change in the books.
2. Fair value principle: assets and liabilities should be recorded at their actual
value. This is mostly used in actively traded investment assets.
Two important assumptions in accounting:
1. Monetary unit assumption: only include data in accounting that can be expressed
in money terms.
2. Economic entity assumption: activities of the entity should be kept separate
from the activities of its owner. Bill Gates should keep his living costs separate
from the expenses of Microsoft.
Legal types of businesses:
1. Proprietorship: owned by one person. Personally liable. Not a lot of money is
needed to start this.
2. Partnership: owned by multiple persons. Personally liable.
3. Corporation: Separate legal entity, ownership is divided into stocks/shares.
Assets: the resources a business owns. Provides future benefits or service.
Liabilities: claims against company resources
Owners equity: claim of owner to assets. If a business liquidates, the law requires
creditors to be paid first, then owners. → owner’s equity = residual equity.
Increases with investments by owner
Decreases with drawings by owner.
ASSETS = LIABILITIES + OWNER’S EQUITY.
,Creditors: people to whom a business owes money.
Revenue: gross increase in owner’s equity resulting from activities with the goal of
earning income.
Expenses: cost of assets consumed or services used in the process of earning revenue.
Assets = liabilities + (owner’s capital - owner’s drawings + revenues - expenses)
(Owner’s equity)
Purchases of assets are NOT an expense, they are an increase in an asset account and a
decrease in cash.
The Four Financial Statements
1. Income Statement: Revenues and Expenses → net income/loss.
Investments/drawings are NOT included in this as it is not a business expense.
2. Owner’s equity statement: changes in owner’s equity. (net income is used in this
one)
3. Balance sheet: assets, liabilities, owner’s equity, expenses.
4. Statement of cash flows: inflow and outflow of cash over a period of time.
Chapter 2: the recording process
(T-)Account: record of increases and decreases in a specific asset/liability.
Debit (Dr.): left side of account. Incr assets, decr liabilities.
Credit (Cr.): right side of account. Decr assets, incr liabilities.
double entry system: each transaction is recorded with equal debits and credits.
Normal balance: the side of an account where an increase in the account is recorded.
(Debit for Assets, Credit for Liabilities)
Journal: where all transactions are recorded in chronological order. It helps:
1. Discloses the complete effects of a transaction
2. Provides a chronological record of transactions
3. Prevents or helps locate errors
Journalizing, a complete entry:
1. Date of transaction
2. Accounts, amounts credited/debited
3. Brief explanation of the transaction
simple entry: only two accounts are involved, one credit and one debit.
compound entry: entry that requires more than two accounts. For example: an asset
purchase partly paid on credit, partly with cash.
Ledger: the entire group of accounts maintained by a company. All A, L, OE.
,Three column form of account: 3 columns:
1. Debit
2. Credit
3. Balance
posting: transferring journal entries to the ledger.
chart of accounts: a chart with the accounts and account numbers that identifies their
location on the ledger.
Trial balance: A list of accounts and their balances at a given time. Debit MUST equal
credit. So it is possible to uncover errors. However, a trial balance does not prove the
company recorded all transactions / the ledger is correct.
Chapter 3: Adjusting the accounts
Time period assumption: dividing the economic life of a business in artificial time
periods.
Interim periods: monthly / quarterly time periods.
fiscal year: accounting time period of one year in length. Companies each choose their
own fiscal year-end.
calendar year: jan 1 - dec 31.
Accrual-basis accounting: companies record transactions in the periods of which the
events occur. Recognize revenue when the task is performed, even though money has
not been received yet for example.
Cash-basis accounting: recording transactions when they receive cash/pay cash. It is
simpler, but not as good as accrual-basis accounting.
Revenue recognition principle: requires companies to recognize revenue in the
accounting period in which the performance obligation is satisfied.
Expense recognition principle: expenses follow revenue. Expenses should be recognized
in the same accounting period as the revenues they help generate. Efforts should be
matched with results.
Adjusting entries: entries made at the end of an accounting period to ensure the rev
and exp recognition principles are followed. These should be made every time a financial
statement is prepared.
Accruals: service performed/expense but cash not paid/received
, Deferrals: prepaid expenses / unearned service revenue
Prepaid expenses are costs that expire over time/use: insurance / supplies for
example.
Depreciation: the process of allocating the cost of an asset to expense over its useful
life. It is ALLOCATION, not valuation. Depreciation does not try to accurately value an
asset.
contra asset account: an account to offset an asset account on the balance sheet. The
normal balance is credit. Using a CAA is good because it tracks both the purchase price
and the cost of the asset. (Accumulated Depreciation)
book value = asset - contra asset. =/= fair value
Alternative treatment of Deferrals: if the company expects to consume for example
supplies before the next financial statement date, it may expense the supplies right
away instead of debiting an asset account.
Same thing for unearned service revenue: if the company expects to perform the
obligation before the next financial statement date, it may book the revenue
immediately.
Chapter 4: Completing the
Accounting Cycle
Worksheet: multiple column tool used in the adjustment process. It is NOT an
accounting record or replacement for fin. statements. It includes:
- Trial Balance
- Adjustments
- Adjusted Trial Balance
- Income Statement
- Balance Sheet
After the worksheet is done, financial statements can be prepared with data from the
worksheet.
Closing Entries
Two types of accounts:
- Temporary Accounts: relate to only one accounting period and are closed at the
end. (Sales, expenses).
