MIDTERM 2 Transaction Analysis Accrual Accounting Based on GAAP 1 Realization Principle we should record revenue when the earning process is complete or virtually complete AND there is reasonable certainty as to the collectability of the asset to be received usually cash This is when goods are sold services are performed RECORDING REVENUE IS INDEPENDENT OF THE CASH EXCHANGE 2 Matching Concept Expenses should be recorded in the same accounting period in which they helped generate revenue Determining factor is the generation of revenue not the cash exchange Some expenses are listed when they are incurred since it can be hard to match some expenses to some revenues Cash accounting does not follow GAAP it records revenues when cash is received and expenses when cash is paid This can be used by companies that do not sell stock to the public If debits credits debit balance Accrual accounting must be used by companies who sell stock to the public because cash accounting can easily manipulate financial statements Must use accrual accounting to get a bank loan Account place where all increase and decreases in financial statement items are recorded T account Account Type 1 Asset 2 Liability 3 Equity 4 Revenue 6 Expense Normal Balance Debit Credit Credit Credit Debit Decrease Credit Debit Debit Debit Credit Increase Debit Credit Credit Credit Debit Accounting Transactions economic events that require recording in Financial Statements that result in a change in assets liabilities and equity Ledger all account of the company take together all T accounts Journal place where all accounting transactions are initially recorded Journal Entry means used to record transactions in the journal Cr Dr Double Entry Accounting every transaction must be recorded with at least one debit and one credit and debits must equal credits Posting process of transferring debit and credit amount from the journal to the ledger journal to T accounts Allows us to determine the ending balance in each account Gain Recorded when you sell an asset OTHER THAN INVENTORY for more than it costs Classified as a revenue selling price cost Bought equipment and am now selling it Loss Sell an asset OTHER THAN INVENTORY for less than it costs Classified as an expense cost selling price Dividends do not effect the income statement They are a contra equity because they reduce equity and reduce retained earnings Accounting Cycle Basic Steps 1 Record transactions in the journal journal entries 2 Post debit and credit amounts from the journal to the ledger to determine ending balance in each account 3 Prepare a trial balance 4 From trial Balance prepare financial statement Trial Balance list of accounts and their balances at a given time Prove debits credits after posting Can be used to discover errors as to why debits don t credits Doesn t always mean there aren t any errors Financial Statement Analysis Examines both relationships amount financial statement numbers and trends in those numbers over time 1 Use past performance to predict future outcomes 2 Evaluate performance and look at problem areas Financial Ratios relationships between financial statement amounts help in decided whether or not to invest in loan money to a company using benchmarks Typical benchmarks include competitors industry averages past year averages Liquidity Ratios measures short term ability of a company to pay debts as they come due bankers suppliers Working Capital current assets current liabilities dollar amount Current Ratio current assets current liabilities number of times Adjusting and Closing Process Accounting Cycle Basic Steps 1 Record Transactions in Journal 2 Post from journal to ledger 3 Prepare unadjusted trial balance 4 Record post year end trial balance 5 Prepare adjusted trial balance 6 From the adjusted trial balance prepare financial statements Accrual Accounting Revenues are recorded when they re earned but expenses are recorded in the same period they help to earn revenues REQ D BY GAAP Adjusting entries are needed to ensure that the realization principle and matching concept are followed Adjusting Entries journal entries made at the end of an accounting period year month to update account balances Required by accrual accounting or GAAP at each preparation of financial statements 2 Main Categories of Adjustments Deferrals transactions for which cash has been received or paid while the related revenues and expenses has not been recorded exchange for cash before action the revenues and expenses have been earned and must be recorded action before exchange of cash transactions in which cash HAS NOT been received or paid but Accrual Deferred Expenses OR Prepaid Expenses a company pays for an expense item in advance and it is recorded as an ASSET because for an item to be an expense it must already be used up Prepaid insurance prepaid rent prepaid supplies Adjusting entries for deferred expenses are required to record the portion of the prepayment representing the expense incurred or the amount of the asset used up Expense Debit Adjusting Entry Beginning Balance Supplies Purchased Ending Balance Supplies When purchased classified as current asset but once they are used up its an expense Supplies Supplies Use Supplies Exp Deferred Revenues or Unearned Revenues company receives cash in advance for goods or services to be delivered later LIABILITY and only becomes a revenues once its earned Adjusting entries for deferred unearned revenues are required to record the portion that represents the revenues earning in a current period Unearned revenue is a liability NOT A REVENUE so it does not affect Net Income Accrued Revenues Revenues earned but no cash is received yet not recorded Revenue Liability Credit Adjusting Entry Unadjusted Balance Debit Adjusting Entry Sale of merchandise on account Debit Assets Credit Revenues Accrued Expenses Expenses incurred but not yet paid in cash and are Depreciation systematic allocation of the cost of a plant asset to be expensed therefore not recorded Salaries Incurred but not yet paid Debit Expenses Credit Liabilities over its useful life Using up of buildings equipment Adjusting entry for each year of useful life DEPRECIATION IS NOT A LOSS OF VALUE Why do we depreciate assets Matching concept because cost allocation each Depreciation Expense Debit Depreciation Expense Credit Accumulated yea not asset valuation Depreciation and is a deferral Depreciation Expense Expense On Income Statement Reduces Net income Shows