Accounting Fundamentals

Accounting FundamentalsAccounting Fundamentals

Dr. Yan XiongDr. Yan XiongDepartment of AccountancyDepartment of Accountancy

CSU SacramentoCSU SacramentoThe lecture notes are primarily based on Reimers The lecture notes are primarily based on Reimers

(2003).(2003). 7/11/037/11/03

Chapter 2: Quality of Accounting InfoChapter 2: Quality of Accounting Info

AgendaAgenda Objectives of accounting informationObjectives of accounting information Elements of financial statementsElements of financial statements Recognition and measurement in Recognition and measurement in

financial statementsfinancial statements

AgendaAgenda Objectives of Accounting InformationObjectives of Accounting Information

Securities and Exchange Commission has Securities and Exchange Commission has the legal authority to set the accounting the legal authority to set the accounting rules for companies that are publicly rules for companies that are publicly traded.traded.

The SEC has delegated that responsibility The SEC has delegated that responsibility to the accounting profession.to the accounting profession.

Currently, the Financial Accounting Currently, the Financial Accounting Standards Board is the standards-setting Standards Board is the standards-setting body.body.

Who Sets the Rules?Who Sets the Rules?

GAAP (not a clothes store)GAAP (not a clothes store) Generally Accepted Accounting Generally Accepted Accounting

Principles (GAAP) are the rules Principles (GAAP) are the rules that most companies follow in that most companies follow in preparing their financial reports.preparing their financial reports.

GAAP are not exact rules: GAAP are not exact rules: professional judgment is needed.professional judgment is needed.

Statements of Financial Statements of Financial Accounting Concepts provide the Accounting Concepts provide the basis and guidance for basis and guidance for establishing accounting standards.establishing accounting standards.

GAAPGAAP

Objectives Objectives QualitiesQualities To provide useful information for decision-To provide useful information for decision-

making.making. Relevant:Relevant:

specific to a business entityspecific to a business entity,, timelytimely, , simplified and condensedsimplified and condensed,, focus on earningsfocus on earnings, , all within a cost-benefit all within a cost-benefit

framework.framework.

Objectives Objectives Qualities Qualities

To provide useful information for To provide useful information for decision-making.decision-making. ReliableReliable::

representational faithfulnessrepresentational faithfulnessverifiableverifiableunbiasedunbiased

Objectives Objectives Qualities Qualities

To provide useful information for decision-To provide useful information for decision-making.making. ComparableComparable: :

from year to year for one from year to year for one companycompany,,

across companies for a single across companies for a single yearyear, ,

to industry averages,to industry averages,estimates.estimates.

Objectives Objectives Qualities Qualities

To provide useful information for decision-To provide useful information for decision-making.making. ConsistentConsistent::

same rules used each timesame rules used each time

Additional Concepts/ConstraintsAdditional Concepts/Constraints

Cost/benefitCost/benefit MaterialityMateriality Full disclosureFull disclosure

AgendaAgenda Elements of Financial StatementsElements of Financial Statements

Elements of Financial StatementsElements of Financial Statements

AssetsAssets LiabilitiesLiabilities EquityEquity RevenueRevenue ExpensesExpenses

Elements of Financial StatementsElements of Financial Statements

Next to each item, indicate whether it is an AAsset, LLiability, EEquity, RRevenue or EExpense.

_____ Cash

_____ Common Stock ($1 par)

_____ Depreciation Expense

_____ Insurance Expense

_____ Interest Receivable

_____ Interest Earned

_____ Investment in U.S. Bonds

Elements of Financial StatementsElements of Financial Statements

_____ Cash Asset

_____ Common Stock ($1 par) Equity

_____ Depreciation Expense Expense

_____ Insurance Expense Expense

_____ Interest Receivable Asset

_____ Interest Earned Revenue

_____ Investment in U.S. Bonds Asset

More elements of financial statementsMore elements of financial statements_____ Miscellaneous Expense

_____ Prepaid Insurance

_____ Rent Revenue

_____ Retained Earnings

_____ Salaries Expense

_____ Salaries Payable

_____ Service Revenue

_____ Supplies Used

_____ Unearned Rent

More elements of financial statementsMore elements of financial statements_____ Miscellaneous Expense Expense

_____ Prepaid Insurance Asset

_____ Rent Revenue Revenue

_____ Retained Earnings Equity

_____ Salaries Expense Expense

_____ Salaries Payable Liability

_____ Service Revenue Revenue

_____ Supplies Used Expense

_____ Unearned Rent Liability

AgendaAgenda Recognition and measurement in Recognition and measurement in

financial statementsfinancial statements

Transactions are measured and recorded Transactions are measured and recorded at COST.at COST.

Revenue is recognized--included on the Revenue is recognized--included on the income statement--when it is EARNED.income statement--when it is EARNED.

Expenses are recognized in the period in Expenses are recognized in the period in which the related revenue is recognized: which the related revenue is recognized: MATCHING CONCEPT.MATCHING CONCEPT.

This is ACCRUAL ACCOUNTING.This is ACCRUAL ACCOUNTING.

Recognition and Measurement in Recognition and Measurement in Financial StatementsFinancial Statements

Accruals and DeferralsAccruals and Deferrals ACCRUALS:ACCRUALS:

Action first, dollars Action first, dollars laterlater

E.g., services are E.g., services are performed, payment performed, payment to be received laterto be received later

DEFERRALS:DEFERRALS: Dollars first, action Dollars first, action

laterlater E.g., payment is E.g., payment is

made in advance for made in advance for insurance or rent, insurance or rent, the action of using it the action of using it comes latercomes later

Both types of transactions and adjustments Both types of transactions and adjustments are part of ACCRUAL ACCOUNTING.are part of ACCRUAL ACCOUNTING.

Tom’s Wear: February 2001Tom’s Wear: February 2001 Let’s look at each of the transactions Let’s look at each of the transactions

that took place during February, that took place during February, Tom’s second month of business.Tom’s second month of business.

We’ll show how each affects the We’ll show how each affects the accounting equations, and then we’ll accounting equations, and then we’ll prepare the four basic financial prepare the four basic financial statements.statements.

Acquisition of Inventory Acquisition of Inventory DateDate

February February 11

TransactionsTransactions Tom’s Wear purchases 200 Tom’s Wear purchases 200

T-shirts at $4 each on T-shirts at $4 each on account. account. Assets = Liabilities + CC + RE

$800 inventory $800 A/P

Acquisition of a ServiceAcquisition of a ServiceDateDate

FebruaryFebruary55

TransactionsTransactions Tom’s Wear hires a Tom’s Wear hires a

company to advertise his company to advertise his business for $150--$100 business for $150--$100 cash and $50 on account. cash and $50 on account.

Assets = Liabilities + CC + RE

(100) cash 50 other payables (150) expenses

Sales and Collection CycleSales and Collection CycleDateDate

February 14February 14TransactionsTransactions

Tom’s Wear pays for 3 Tom’s Wear pays for 3 month’s worth of insurance month’s worth of insurance for $150. for $150.

Assets = Liabilities + CC + RE

+ 150 prepaid insurance (150) cash

Sales and Collection CycleSales and Collection CycleDateDate

February 20February 20TransactionsTransactions

Tom’s Wear sells 185 T-Tom’s Wear sells 185 T-shirts for $10 each. 170 shirts for $10 each. 170 shirts were cash sales and shirts were cash sales and the other sales were on the other sales were on account.account. Assets = Liabilities + CC + RE

+1,700 cash

+1,850 sales

+ 150 A/R

Sales and Collection CycleSales and Collection CycleDateDate

February 20February 20

TransactionsTransactions Tom’s Wear sells 185 T-shirts Tom’s Wear sells 185 T-shirts

for $10 each. 170 shirts were for $10 each. 170 shirts were cash sales and the other sales cash sales and the other sales were on account.were on account. Assets = Liabilities + CC + RE

+1,700 cash

+1,850 sales

+ 150 A/R

(740) inventory (740) cost of goods sold

Note: Recall that the cost of shirts was $4 each.

Acquisition/Payment CycleAcquisition/Payment CycleDateDate

February 28February 28TransactionsTransactions

Tom’s Wear pays dividends Tom’s Wear pays dividends of $100.of $100.

Assets = Liabilities + CC + RE

(100) cash (100) dividends

Adjustment for Year-end Adjustment for Year-end Financial Statements Financial Statements

DateDate February 28February 28

Prepaid insurance that has Prepaid insurance that has been used needs to be been used needs to be recorded as an expense. recorded as an expense. Only the unused portion Only the unused portion remains on the balance remains on the balance sheet as an asset. sheet as an asset. Assets = Liabilities + CC + RE

(25) prepaid insurance (25) insurance expense

Tom’s Wear, Inc.Tom’s Wear, Inc.Income StatementIncome Statement

For the month ended February 28, 2001For the month ended February 28, 2001RevenueRevenue

SalesSales $1,850$1,850ExpensesExpenses

Cost of salesCost of sales $ 740 $ 740Other expensesOther expenses 175 175 915915

Net incomeNet income $ 935$ 935

Tom’s Wear, Inc.Tom’s Wear, Inc.Statement of Changes in Statement of Changes in

Shareholder’s EquityShareholder’s EquityFor the month ending 2/28/01For the month ending 2/28/01

Beginning contributed capitalBeginning contributed capital $5,000$5,000

Contributions during the yearContributions during the year -0- -0-Ending contributed capitalEnding contributed capital 5,0005,000Beginning retained earning $ 385Beginning retained earning $ 385Net Income for the yearNet Income for the year 935 935 Dividends Dividends (100)(100)Ending Retained earningEnding Retained earning

$1,220$1,220Total shareholder’s equityTotal shareholder’s equity $6,220$6,220

Tom’s WearTom’s WearBalance SheetBalance SheetAs of 2/28/01As of 2/28/01

AssetsAssets Liabilities + Shareholder’s EquityLiabilities + Shareholder’s Equity

CashCash $6,695$6,695 Accounts payableAccounts payable 800800

A/R 150A/R 150 Other Payables Other Payables 5050

InventoryInventory $ 100$ 100 Common stock, Common stock, T. PhillipsT. Phillips $5,000 $5,000 Prepaid Ins 125Prepaid Ins 125 Retained earningsRetained earnings

12201220

Total assetsTotal assets $ 7,070 Total liabilities + SH’s Equity$ 7,070 Total liabilities + SH’s Equity $ $ 7,0707,070

Tom’s Wear, Inc.Tom’s Wear, Inc.Statement of Cash FlowsStatement of Cash Flows

For the month ended 2/28/01For the month ended 2/28/01Cash from operating activitiesCash from operating activities

Cash from customersCash from customers $ 1700$ 1700Cash paid for advertisingCash paid for advertising (100) (100)Cash paid for insuranceCash paid for insurance (150) (150)

Total cash from operationsTotal cash from operations $1450$1450

Cash from investing activitiesCash from investing activities -0- -0-Cash from financing activitiesCash from financing activities

DividendsDividends (100) (100)

Total Cash from FinancingTotal Cash from Financing (100)(100)

Net Increase in CashNet Increase in Cash $ 1350 $ 1350Cash, Beginning Balance Cash, Beginning Balance 53455345Cash, ending BalanceCash, ending Balance 6,6956,695