Transaction Analysis Cash vs Accrual Accounting Accrual accounting based on GAAP Realization principle o Record revenue when 1 The earnings process is complete or virtually when goods are sold services performed complete 2 There is reasonable certainty as to the collectability of the asset o It is not necessary to receive cash in order to record revenue o The receipt of cash doesn t always indicate that a revenue has been received earned o Record revenue independent of exchange of cash o It is required that the receipt of cash be relatively assured in order to record revenue Problem 1 The Matching Principle o Record expenses when in 1 The same accounting period that the related revenue is earned The determining factor in the timing of recording expenses is the generation of revenue not the payment of cash For most expenses it is difficult to trace to a specific revenue so they recorded when they are incurred Problem 2 Cash accounting does not follow GAAP o Record revenues when cash is received o Record expenses when cash is paid Problem 3 Accrual accounting must be used by all companies who sell stock to the public Cash accounting can be used by any company who doesn t sell stock to the public Cash accounting is also used by individuals to account for their personal finances If a company who does not sell stock to the public attempts to a get a bank loan they are typically required to present their financial statements using accrual accounting This is usually required because cash accounting can be easily manipulated and thus could lead to misleading financial statements Account recorded place where all increases and decreases in financial statement are Analyze accounts using a T account o 1 Top heading place account name o 2 Left side debit o 3 Right side credit Example 4 Accounting transactions financial statements economic events that require recording in the o Transactions are recorded in the financial statements because they result in a change to assets liabilities and or equity accounts o Not all activities represent transactions all the accounts of the company taken together think of the ledger as Ledger all the T accounts of the company Journal Journal entry Notice debts always credits Double entry accounting the place where all accounting transactions are initially recorded the means used to record transactions in the journal every transaction must be recorded with at least one credit and one debit with the total dollar debits total dollar credits Posting ledger process of transferring credit and debit accounts from the journal o Posting the T accounts allows us to determine the ending balance in each account Double entry system Example 5 Gains than it cost effects two or more accounts a gain is recorded when you sell an asset other than inventory for more o You are not in the business of selling these assets they are not part of your inventory o The gain selling price cost o A gain is classified as a revenue account Losses than it cost a loss is recorded when you sell an asset other than inventory for less o You are not in the business of selling these assets they are not part of your inventory o The loss cost selling price o A loss is classified as an expense account New account dividends o Payments by corporation to stockholders o Not an expense account o Dividends are classified as a contra equity account since it reduces equity Accounting Cycle Basic Steps 1 Record transactions in the journal use journal entries 2 Post debit and credit amounts from the journal to the ledger 3 Prepare a trial balance o Trial balance a list of accounts and their balances at a given time The primary purpose of a trial balance is to prove debits credits after posting If debits and credits do not agree the trial balance can be used to uncover errors in journalizing a post o The total debits must equal the total credits Errors can occur and trial balance agrees o Incorrect accounts or amounts used in journalizing or posting o A journal entry is not recorded 4 From trial balance prepare financial statements Financial statement analysis among financial statement numbers and the trends in those numbers over time involves the examination of both the relationships o Purposes o 1 Use the past performance of a company to predict how it will do in the o 2 Evaluate the performance of a company with an eye toward identifying future problem areas Financial ratios relationships between financial statements amounts o Ratios are used by creditors and investors to help them make decisions o Specifically these ratios aid users in deciding whether or not to invest in or loan money to a company a single ratio by itself is not very meaningful they provide meaningful Note information when they can be compared with same bench mark needs to be a comparison o Typical benchmarks or Comparison Points 1 Other companies that operate in the same industry 2 Industry averages 3 Past years trend analysis Two ratios to be discussed o 1 Working capital current assets current liabilities o 2 Current ratio currents assets current liabilities Both of these are referred to as liquidity ratios measure the short term ability of the company to its debts as Liquidity ratios they come due o Who cares Short term creditors such as bankers and suppliers Both ratios give a user a feel for the company s ability to pay their debts when their due one ratio is in the form of a dollar and the other in form of of times Effects of transactions on the liquidity ratios o Assume working capital is positive and the current ratio is greater than 1 Transaction purchased supplies costing 200 on account o We are increasing assets and current liabilities by 200