Chapter 2 1 The basic model i First objective of any system is to identify the economic events that can be expressed in financial terms by the system ii Economic event any event that directly affects the financial position of the company 1 External events involve an exchange between the company and a separate economic entity 2 Internal events directly affect the financial position of the company but don t involve an exchange transaction with another entity b The accounting equation i Assets liabilities equity 1 Shareholders equity a Paid in capital amounts invested by shareholders b Retained earnings amount earned by the corporation c Account relationships i Double entry system dual effect that each transaction has on the accounting equation 1 Used to process transactions ii General ledger a collection of storage areas called accounts used to keep track of increases and decreases in financial position elements iii T accounts for instructional purposes iv Permanent accounts assets liabilities and shareholders equity at a point in time v Temporary accounts changes in the retained earnings component of shareholders equity for a corporation caused by revenue expense gain and loss transactions 2 The accounting processing cycle 1 4 during act period 5 8 at the end of period 9 10 at end of year a Step 1 obtain information about transactions from source documents b Step 2 analyze the transaction c Step 3 record the transaction in a journal d Step 4 post from the journal to the general ledger accounts i Posting transferring debits and credits recorded in individual journal entries to the specific accounts affected e Step 5 prepare an unadjusted trial balance i Unadjusted trial balance a list of the general ledger accounts listed in the order that they appear in the ledger along with their balances at a particular date ii Allow us to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances f Step 6 record adjusting entries and post to the general ledger accounts i The effect of internal events ii Do not involve an exchange transaction with another entity and are not initiated by a source document iii Recorded at the end of any period when financial statements are prepared iv Required to implement the accrual accounting model v Help ensure all revenues are recognized in the period goods or services are transferred to customers regardless of when cash is received vi Enable a company to recognize all expenses incurred regardless of when cash is paid vii Used for prepayments deferrals accruals estimates 1 Estimates used to comply with the accrual accounting model a Ex calculation of depreciation expense requires an estimate of expected useful life of the asset being depreciated as well as its expected residual value 2 Accruals transactions where the cash outflow or inflow takes place in a period subsequent to expense or revenue recognition a Accrued liabilities expenses incurred but not yet paid i Adjusting entry is debit to an expense and a credit to a liability b Accrued receivables when the revenue is recognized in a period prior to the cash receipt i Adjusting entry is a debit to asset receivable and a credit to revenue 3 Prepayments occur when the cash flow precedes either expense or revenue recognition a Ex company buy supplies and use them next period b Prepaid expenses the costs of assets acquired in one period and expensed in a future period i When cash is paid it is not to satisfy a liability or pay a dividend or return capital to owners ii Benefits provided by these assets expire in future periods and their cost is expensed in future periods as related revenues are recognized iii Debit to an expense iv Credit to an asset c Deferred revenue created when a company receives cash from a customer in one period for goods or services that are to be provided in a future period i Adjusting entry is a debit to a liability and a credit to revenue g Step 7 prepare an adjusted trial balance i Adjusted adjusting entries have now been posted to the accounts h Step 8 prepare financial statements i The income statement a change statement that summarizes the profit generating transactions that caused shareholders equity to change during the period ii The statement of comprehensive income to report the changes in shareholders equity during the period that were not a result of transactions with owners 1 Other comprehensive income or loss items OCI are excluded from the determination of net income and the income statement but are included in the broader concept of comprehensive income 2 Single continuous statement of comprehensive income a Net income is a subtotal within the statement followed by these OCI items 3 Two separate but consecutive statements a Company presents an income statement immediately followed by a statement of comprehensive income iii The balance sheet to present the financial position of the company on a particular date 1 Grouped into common characteristics current or not iv The statement of cash flows change statement that reports the events that caused cash to change during the period 1 Operating activities 2 Investing activities 3 Financing activities v The statement of shareholders equity a change statement that discloses the sources of changes in the permanent shareholders equity accounts i Step 9 close the temporary accounts to retained earnings i Serves a dual purpose 1 The temporary accounts are reduced to zero balances ready to measure activity in the upcoming accounting period 2 These temporary account balances are closed transferred to retained earnings to reflect the changes that have occurred in that account during the period ii Close revenues and expenses to income summary and then income summary is closed to retained earnings iii First closing entry transfers revenues account balances to income summary iv Second closing entry transfers the expense account balances to income summary v Third entry closes the income summary account to retained earnings j Step 10 prepare a post closing trial balance i It verifies that the closing entries were prepared and posted correctly and that the account are now ready for next year s transactions 3 Conversion from cash basis to accrual basis a Most companies must convert from an accrual basis to a cash basis when preparing the statement of cash flows