338 terms

Financial Accounting Ch 1-10

Financial Accounting Sixth Edition

Terms in this set (...)

Basic Financial Statement
Basic Financial Statement:
- Income statement (the statement of operations)]
- Statements of retained earnings
- Balance sheet (the statement of financial position)
- Statement of cash flows
Net Income
Net income is profit, the excess of revenues over expenses
Accounting is an information system. It measures business activities, processes data into reports, and communicates data to people.
Financial Statements
Accounting produces financial statments,m which report business information about a business entity. The financial statements measures performance and tell where a business stands in financial terms.
Financial Accounting
Accounting information and analyses prepared for people outside the organization.
Management Accounting
the branch of accounting that focuses on information for internal decision makers of a business
to spread throughout
AICPA Code of Professional Conduct
AICPA Code of Professional Conduct: A certified public accountant assumes an obligation of self discipline above and beyond the requirements of law and regulation...and an unwavering commitment to honorable behavior, even at the sacrifice of personal advantage.
An unincorporated business owned by a single person who is responsible for its liabilities and entitled to its profits.
- But for accounting, a proprietorship is distinct from it's proprietor. Thus, the business records do not include the proprietors personal finances.
A contract between two or more persons who agree to pool talent and money and share profits or losses
- Partner ships are quite risky. Accounting views the partnership as entirely separate from the partners.
a business owned by stockholders who share in its profits but are not personally responsible for its debts
someone who holds shares of stock in a corporation
a certificate documenting the shareholder's ownership in the corporation
Board of Directors
governing body of a corporation that reports to its shareholders and delegates power to run its day-to-day operations while remaining responsible for sustaining its assets
Generally Accepted Accounting Principles (GAAP)
Accounting guidelines, formulated by the Financial Accounting Standards Board, that govern how accountants measure, process, and communicate financial information.
Financial Accounting Standards Board (FASB)
In the US the FASB determines the GAAP.
Conceptual Foundation of Accounting
For information to be useful for investment and credit decisions it must be:
- Relevant (Primary characteristic) - able to influence a decision
- Reliable (Primary) - verifiable and free of error and bias
- Comparable (Secondary) - able to compare different companies
- Consistent (Secondary) - able to compare a company from one period to the next
An organization or a section of an organization that, for accounting purposes, stands apart from other organizations and individuals as a separate economic unit.
Reliability principle
The accounting principle that ensures that accounting records and statements are based on the most reliable data available. Also called the objectivity principle
Cost principle
The principle that states that, when purchased, all assets are recorded at their actual cost regardless of market value.
Going-concern Concept
financial statements are prepared with the expectation that a business will remain in operation indefinitely
Stable-monetary-unit concept
The basis for ignoring the effects of inflation in the accounting records, based on the assumption that the dollar's purchasing power is relatively stable.
Accounting equation
The most basic tool of accounting:
Assets = Liabilities + Owners Equity
An economic resource that is expected to be of benefit in the future (e.g., cash, office supplies, food inventory, furniture, land, buildings, etc.)
An economic obligation (a debt) payable to an individual or an organization outside the business (e.g., loans, goods/ services purchased on credit, etc.)
Owners' equity
The claim of the owners of a business to the assets of the business. Also called capital, stockholders' equity, or net assets
Owners Equity = Assets - Liabilities
Another name for the owners' equity of a business
Money and any medium of exchange that a bank accepts at face value.
Merchandise inventory
The merchandise that a company sells to customers
Property, plant, and equipment
Long-lived assets, such as land, buildings, and equipment, used in the operation of the business. Also called plant assets or fixed assets.
Accounts payable
A liability backed by the general reputation and credit standing of the debtor
Note payable
A liability evidenced by a written promise to make a future payment.
Long-term debt
A liability that falls due beyond one year of the date of the financial statement.
Stockholders' equity
The stockholders' ownership interest in the assets of the corporation
Assets = Liabilities + Stockholders' Equity
Assets = Liabilities + Paid-in Capital + Retained Earnings
Paid-in capital
Total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.
Common stock
stock other than preferred stock
Retained Earnings
the accumulated earnings from a firm's profitable operations that were reinvested in the business and not paid out to stockholders in dividends
Increase in retained earnings from delivering goods or services to customers or clients
Decrease in retained earnings that results from operations; the cost of doing business; opposite of revenues (e.g., wages, building rent, salaries, utility payments, depreciation, etc.)
Net Income
Excess of total revenues over total expenses. Also called net earnings or net profit
Revenues - Expenses = expenses
Ending balance of retained earnings
Ending balance of retained earnings =
Beginning balance of Retained Earnings +/-
Net Income/Loss for the period -
Dividends for the period
Net loss
Excess of total expenses over total revenues
Distributions (usually cash) by a corporation to its stockholders
The flow data flow from one financial statement to the next
The flow data flow from one financial statement to the next:
1. Income statement
2. Statement of retained earnings
3. Balance sheet
4. Statement of cash flows
Income statement
A financial statement that presents the revenues and expenses and resulting net income or net loss of a company for a specific period of time. Also called the statement of operations.
Revenues and expenses measure net income as follows:
Revenues and expenses measure net income as follows:
Net income = total Revenues and Gains - Total Expenses and Losses
In accounting, the word "net" refers to an amount after a subtraction. Net income is the profit left over after subtracting expenses and losses from revenues and gains.
Cost of Goods Sold
the total cost of buying raw materials and paying for all the factors that go into producing finished goods
Net Sales
Total sales less sales discount and sales returns and allowances.
Operating profit
The profit (or surplus) that the firm has made after overheads (indirect costs) have been deducted from the gross profit.
Statement of Retained Earnings
Statement of Retained Earnings: the portion of net income the company has retained. Net income flows from the income statement to the statement of retained earnings.
Balance sheet
The balance sheet also called the statement of financial position, reports three items: assets, liabilities, and stockholder's equity
Current Assets
Cash and other resources that companies reasonably expect to convert to cash or use up within one year or the operating cycle, whichever is longer.
- Cash, short-term investment, and current receivables are the most liquid assets, in that order
Cash and Cash equivalents
Cash is the liquid asset that is a medium of exchange, and cash equivalents include money-market accounts that are the same as cash
A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded.
Short-terms investments
Short-terms investments include stocks and bonds that a company intends to sell within the next year.
Accounts receivable
Accounts receivable are amounts the company intends to collect from customers
Notes Receivable
Promissory notes that a business accepts from customers
Intangibles are assets with no physical forms, such as patents and trademarks.
Investments are long-term assets because they are not expected to be sold within the next year.
Property, Plant, and equipment
PPE are the tangible, long-lived, productive assets used by a company in its operations to produce revenue. This includes land, buildings, machinery, manufacturing equipment, office equipment, and furniture.
Accumulated Depreciation
the total amount of depreciation expense that has been recorded since the purchase of a plant asset
Current Liabilities
Obligations due to be paid or settled within one year or the company's operating cycle, whichever is longer (e.g., Accounts payable, Income taxes payable, Short-term borrowings, Salaries and wages payable, etc.).
Accounts payable
the amount a company owes to suppliers for goods and services purchased with credit
Retained earnings
the accumulated earnings from a firm's profitable operations that were reinvested in the business and not paid out to stockholders in dividends.
- Retained earnings links the income statement to the balance sheet.
Main components of stockholders' equity
Main components of stockholders' equity:
- Common stock
- Retained earnings
Operating activities
activities that create revenue or expense in the entity's major line of business; a section of the statement of cash flows. operating activities affect the income statement.
Investment activities
activities that increase/decrease (purchases/sales of) the long-term assets available to the business; a section of the statement of cash flows
Financing activities
activities that obtain from investors and creditors the cash needed to launch and sustain the business; a section of the statement of cash flows
Statement of Cash Flows
The statement of cash flows - reports cash receipts and cash payments classified according to the entity's major activities: operating, investing, and financing.
- The cash-flow statement reports whether operations increased cash. Operating activities are most important, and cash flow from operations should always be positive. Negative cash flows from operations can mean bankruptcy.
- Both purchase and sale of long-term assets are investing cash flows.
- Companies need money for financing. When the companies pay off loans. Many companies pay dividends. These payments are financing cash flows.
The income statement for the year end
The income statement for the year end:
1. Reports revenue and expenses of the year. Revenue and expenses are reported only on the income statement.
2. Reports net income if total revenues exceed total expenses . If expenses exceed revenues, there is a net loss.
The statement or retained earnings for the year end
The statement or retained earnings for the year end:
1. Opens with the beginning retained earnings balance
2. Adds net income (or subtracts net loss). Net income comes directly from the income statement
3. Subtracts dividends
4. Reports the retained earnings balance at the end of the year
The balance sheet at end of year
The balance sheet at end of year:
1. Reports assets, liabilities, and stockholders' equity at the end of the year. Only the balance sheet reports assets and liabilities.
2. Reports that assets equals the sum of liabilities plus stockholders' equity. This balancing feature follows the accounting equation and gives the balance sheet its name.
3. Reports retained earnings, which comes from the statement of retained earnings
The statement of cash flows for year end
The statement of cash flows for year end:
1. Reports cash flows from operating, investing, and financing. Each category results in net cash provided (an increase) or used (a decrease).
2. Reports whether cash increased (or decreased) during the year. The statement shows the ending cash balance, as reported on the balance sheet
For more practice and review of accounting cycle concepts,
Double Entry Accounting
Accounting system in which each transaction affects at least two accounts and has at least one debit and one credit.
Accrual Accounting
Accounting that records the impact of a business even as it occurs, regardless of whether the transaction affected cash.
The T-Accounts
An account can be represented by the letter T. The vertical line in the letter divides the account into two sides: The account tittle appears at the top of the T. For example, The Cash can appear as follows : The left side of the account is called the debit side and the right side of the account is called the credit side.
Cash-basis accounting
Accounting system that recognizes revenues when cash is received and records expenses when cash is paid.
The left side of the account
Generally Accepted Accounting principal (GAAP) and Accrual Accounting
Generally Accepted Accounting principal (GAAP) requires the business use accrual accounting. This means that the business records revenues as the are earned and expenses as they are incurred - not necessarily when the cash changes hands.
The right side of the account
Appropriate Accounting Method
Appropriate Accounting Method:
1. Double-entry
2. Accrual basis
Increases and Decreases in Accounts
The type of account determines how we record increases and decreases.
Assets - An increase in assets are recorded on the left side of the left (debit) side of the account
Liabilities and Stockholder's equity - An increase in liabilities or Stockholders' equity are recorded on the right side (credit) of the account
Additional Stockholders Equity accounts:(64)
Time-period concept
ensures that accounting information is reported at regular intervals
Trial Balance
A trial balance lists all accounts with their balances - assets first, then liabilities and stockholders' equity. The trial balance summarizes all of the account balances for the financial statement and shows whether total debits equal total credits. A trial balance may be taken at any time, but the most common time is at the end of the period.
Revenue principle
the basis for recording revenues; tells accountants when to record revenue and the amount of revenue to record.
Chart of Accounts
Organizations use a chart of accounts to list all of their accounts and account numbers.
Matching Principle
Guide to accounting for expenses. Identify all expenses incurred during the period, measure the expenses, and match them against the revenues earned during that same time period.
- Some expenses are paid in cash. Other expenses arise from using an asset such as supplies. Still other expenses occur when a company creates a liability.
The Normal Balance of an Account
An account's normal balance falls on the side of the account - debit or credit - where increases are recorded. The normal balance of assets is on the debit side, so assets are debit-balance accounts. Conversely, liabilities and stockholders' equity usually have a credit balance, so they are credit balance accounts.
Cookie Jar Reserves
companies establich these reserves by using unrealistic assumptons to estimate libilies for such items as loan losses, restructurin charges, and warranty returns. The companies then redue these reserves in the future to increase reported income in the future
Normal Balances of The Accounts
Normal Balances of The Accounts:
Assets - Debit
Liabilities - Credit
Stockholders Equity - Credit
Common Stock - Credit
Retained earnings - Credit
Dividends - Debit
Revenues - Credit
Expenses - Debit
Categories of Accounting Entries
Accounting adjustments fall into three basic categories: deferrals, depreciation, and accruals.
An adjustment for which the business paid or received cash in advance. Exampls include prepaid rent, prepaid insurance, and supplies.
Expense associated with spreading (allocating) the cost of a plant asset over its useful life.
An accrual is the opposite of a deferral. For an accrued expense, the business records an expense before paying cash. For an accrued revenue, it records the revenue before collecting cash.
Prepaid expenses
A category of miscellaneous assets that typically expire or get used up in the near future. Examples include prepaid rent, prepaid insurance, and supplies.
Plant asset
Long-lived assets. such as land buildings, and equipment used in the operation of the business. Also called fixed assets.
Accumulated depreciation
The cumulative sum of all depreciation expenses from the date of acquiring a plant asset.
Contra account
an account that always has a companion account and whose normal balance is opposite that of the companion account
Contra account distinguishing characteristics
A contra account has two distinguishing characteristics:
1. It always has a companion account
2. Its normal balance is opposite that of the companion account
Ex: Accumulated Depreciation is the the contra account to Furniture, so Accumulated Depreciation appears directly after Furniture the balance sheet.
Book value (of a plant asset)
The asset's cost minus accumulated depreciation. Book value represents the part of the assets cost that has not yet been depreciated. Book value is not necessarily related to the amount that an asset can be sold for.
Accrued expenses
An expense incurred but not yet paid in cash.
Accrued revenue
a revenue that has been earned but not yet received in cash
Unearned Revenue
A liability created when a business collects cash from customers in advance of doing work. Also called deferred revenue. The obligation is to provide service in the future.
Summary of Adjusting Process (p. 121)
Two purposes of the adjusting process are to:
1. Measure income
2. Update the balance sheet
Therefore, every adjusting entry affects at least one:
- Revenue or expenses - to measure income
- Assets or liability - to update the balance sheet
Adjusted trial balance
A list of all the ledger accounts with their adjust balances
Closing the Books
the process of preparing the accounts to begin recording the next period's transactions; consists of journalizing and posting the closing entries to set the balances of the revenue, expense, and dividends accoutns to zero
Closing Entries
entries at the end of an accounting period to transfer the balances of temporary accounts to a permanent stockholders' equity account, Retained Earnings
Temporary account
the revenue and expense accoutns that relate to a limited period and are closed at the end of the period are temporary accounts; for a corporation, the dividends acct is also temporary
Permanent account
asset, liability, and stockholders' equity accounts that are not closed at the end of the period
Measures how quickly an item can be converted to cash.
Current assets
cash and other assets expected to be exchanged for cash or consumed within a year
Operating Cycle
Time span during which cash is paid for goods and services, which are then sold to customers from whom the business collects cash.
Long-term assets
Any assets that will NOT be converted to cash or used up within the business's operating cycle, or one year, whichever is greater.
Current liabilitly
A debit due to be paid with in one year or within the entities operating cycle if the cycle is longer than a year.
Long-term liability
An obligation that will not be satisfied within one year or the current operating cycle.
Classified balance sheet
Balance sheet that presents assets and liabilities in relevant subgroups, including current and noncurrent classifications.
Balance sheet formats
Report format - lists the assets at the top, followed by the liabilities and stockholders equity below. 60% of large companies use the report format
Account format - a balance sheet format that lists assets on the left and liabilities and stockholders' equity on the right.
Single-step income statement
an income statement that lists all the revenues together under a heading such as revenues or revenues and gains. Expenses appear in a separate category called expenses or perhaps expenses and losses
Multi-step income statement
An income statement that contains subtotals to highlight important relationships between revenues and expenses
Current ratio
Current assets divided by current liabilities. Measures a company's ability to pay current liabilities with current assets. A company prefers a high current ratio. A strong current ratio is 1.5.
Debt ratio
A ratio of total liabilities to total assets. States the proportion of a company's assets that is financed with debt. This ratios measures the businesses ability to pay both current and long-term debts. A low debt ratio is safer than a high debt ratio. A normal debt ratio is between %60 and %70.
Internal Controls
Organizational plan and related measures adopted by an entity to safeguard assets, encourage adherence to company policies, promote operational efficiency, and ensure accurate and reliable accounting records.
The Sarbanes-Oxley Act (SOX)
SOX revamped corporate governance in the United States and also had sweeping effects on the accounting profession. Here are some of the SOX provisions:
1. A newly created body, the Public Company Accounting Oversight Board, oversees the work or auditors or public companies.
2. Accounting firms may not both audit the financial statements of a public client and also provide certain consulting services for the same client.
3. The same person can serve as the lead auditor on a public client for no more than 7 years. That person can resume prior audit duties only after a 2-year timeout period.
4. Public companies must issue an internal control report, and the outside auditor must evaluate the client's internal controls.
5. Stiff penalties await violators - 25 years in prison for securities fraud; 20 years for destroying records; and 20 years for a CFO or CFO making false sworn statements.
The chief accounting officer of a business.
A periodic examination of a company's financial statements and the accounting system, controls, and records that produce them.
Document instructing a bank to pay a designated person or business the specific amount of money
Bank Statement
A financial report that is prepared at the end of every month and tells you all the transactions which affected your account throughout the month. It should you all your deposits, withdrawals, electronic payments, bills paid etc.
Electronic Fund Transfer (EFT)
System that transfers cash by electronic communication rather than by paper document .
Bank Reconciliation
A report that accounts for the differences between the bank statement and a checkbook balance
The bank reconciliation ensures that the company accounts for all its cash transactions and also that the bank records are correct.
Items of reconciliation
The items that cause differences between the bank balance and the book balance include:
1. Items recorded by the company but not yet recorded by the bank.
2. Items recorded by the bank but not yet recorded by the company. We may learn of these items from the bank statement.
3. Errors by the company or the bank
Deposit in transit
A deposit recorded by the company but not yet by its bank.
Outstanding check
A check issued by the company and recorded on its books but not yet paid by its bank.
Bank collecdtion
Collection of money by the bank on behalf of a depositor
Nonsufficient funds (NSF) check
A "hot" check, one for which the payers bank account has insufficient money to pay the check. NSF checks are cash receipts that turn out to be worthless.
Petty cash
fund containing a small amount of cash that is used to pay minor amounts
Imprest amount
A way to account for petty cash by maintaining a constant balance in the petty cash account, supported by the fund (cash plus payment tickets) totaling the same amount.
A quantitative expression of a plan that helps managers coordinate the entity's activities.
Act of 1934
This act deals with the registration which consists of supplying the SEC with information concerning the firm, the nature of its business and competition, and its financial position
a person to whom money is owed by a debtor
a person who owes a creditor
Debt instrument
a receivable or a payable, usually some form of note
Equity security
a contract that makes the owner of a security a part owner of the company that issued the security.
the date on which a financial obligation must be repaid
The length of time from inception to maturity.
Short-term investment
Short-term investments also called marketable securities, are investments that a company plans to hold for one year or less. These investments allow the company to invest cash temporarily and earn a return until the cash is needed.
Short-term investments are the next most liquid asset after cash.
Three categories of short-term investments
Three categories of short-term investments:
1. Trading
2. Available-for-sale
Trading investments
Stock investments that are to be sold in the near future with the intent of generating profits on the sale.
monetary claims against a business or an individual, acquired mainly by selling goods or services and by lending money
The two major types of receivables are accounts receivable and notes receivables.
Net realizable value
the amount of cash the firm expects to collect
Uncollectible-account expense
cost to the seller of extending credit. Arises from the failure to collect from credit customers.
Allowance method
A method of recording collection losses based on estimates of how much money the business will not collect fro its customers.
Allowance of Uncollectible Accounts
A contra account, related to accounts receivable, that holds the estimated amount of collection losses. Another name for allowance for Doubtful Accounts.
Percent-of-sales method
computes uncollectible-account expense as a percentage of net sales. also called the income statement approach because it focuses on the amount of expense to be reported on the income statement
Aging-of-accounts receivable
A way to estimate bad debts by analyzing individual accounts receivable according to the length of time they have been receivable from the customer. Also called the balance-sheet approach.
Direct write-off method
Method that records the loss from an uncollectible account receivable at the time it is determined to be uncollectible; No attempt is made to estimate bad debts.
The amount borrowed by a debtor and lent by a creditor
Days' Sales in receivables
ratio of average net accounts receivable to one day's sales. indicates how long many days' sales remain in accounts receivable awaiting collection. also called the collection period
Average Net Receivables
Average Net Receivables = (Beginning net receivables + ending net receivables) / 2
Acid test or Quick ratio
Acid-test ratio is a ratio of the sum of cash plus short-term investments plus net current receivables to total current liabilities.Tells whether the entity can pay all its current liabilities if they come due immediately. Also called the quick ratio. The higher the ratio the better
Acid-test ratio
Acid-test ratio = (cash + short-term securities + Net current receivables) / Total current liabilities
(accounting) the value of a firm's current assets including raw materials and work in progress and finished goods
Cost of goods sold
cost of the inventory the business has sold to customers
Gross Profit
(finance) the net sales minus the cost of goods and services sold
Merchandisers have two accounts that service entities don't need:
1. Cost of goods sold on the income statement
2. Inventory on the balance sheet
Gross Profit
Gross profit, also called gross margin, is the excess of sales revenue over cost of goods sold. It is called gross profit because operating expenses have not yet been subtracted.
Inventory = Number of units of inventory on hand x Cost per unit of inventory
Cost of goods sold (income statement)
Cost of goods sold = Number of units of inventory on hand x Cost per unit of inventory
Goods that are given to a business to sell but for which title to the goods remains with the vendor
Periodic inventory system
an inventory system in which the business does not keep a continuous record of the inventory on hand. instead, at the end of the period, the business makes a physical count of the inventory on hand and applies the appropriate unit costs to determine the cost of the ending inventory
Perpetual inventory system
an inventory system in which the business keeps a continuous record for each inventory item to show the inventory on hand at all times
Perpetual Inventory System
The perpetual inventory system:
- Keeps a running record of all goods bought and sold
- Inventory counted at least ounce a year
- Used for all types of goods
Periodic Inventory System
The periodic inventory system:
- Does not keep a running record of all goods bought and sold
- Inventory counted at least ounce a year
- Used for inexpensive goods
Purchase return
a decrease in the cost of purchases because the buyer returned the goods to the seller
Purchase allowance
A decrease in the cost of purchases because the seller has granted the buyer a subtraction (an allowance)from the amount owed.
Recording transactions in the perpetual system
When a company makes a sale two entries are needed.
company makes the sale - debits Cash or Accounts Receivable and credits Sales Revenue for the sale price of the good.
The company also debits Cost of Goods Sold and credits Inventory for the cost of the inventory sold.
Purchase discount
a decrease in the cost of purchases earned by making an early payment to the vendor
Net purchases
Net Purchases = Purchases
- Purchase returns and allowances
- Purchase discounts
+ Freight-in
Net sales
Net Sales = Sales revenue
- Sales returns and allowances
- Sales discounts
the transportation cost to ship goods OUT of the warehouse; therefore, it is freight on goods sold to a customer
Inventory cost
The cost of inventory on a company's' balance sheet represents all the cost that the company incurred to bring its inventory to the point of sale. The following cost principle applies to all assets: The cost of any asset, such as inventory, is the sum of all the costs incurred to bring the asset to its intended use, less any discounts.
Four generally accepted accounting methods
Four generally accepted accounting methods:
1. Specific unit cost
2. Average cost
3. First-in, First-out (FIFO) cost
These methods can have very different effects on reported profits, income taxes, and cash flow.
Specific-unit-cost method
Inventory costing method based on the specific cost of particular units of inventory. Also called the specific identification method.
First-in, First-out (FIFO) cost
Inventory costing method by which the first costs into inventory are the first costs out to cost of goods sold. Ending inventory is based on the costs of the most recent purchases
Last-in, first-out (LIFO) cost
Inventory costing method by which the last costs into inventory are the first costs out to cost of goods sold. This method leaves the oldest costs-those of beginning inventory and the earliest purchases of the period- in ending inventory
When inventory costs are increasing
When inventory costs are increasing:
- LIFO cost of goods sold is the highest because it is based on the most recent costs. Gross profit is lowest.
- FIFO cost of goods sold is lowest because it is based on the oldest costs. Gross profit is the highest.
When inventory costs are decreasing
When inventory costs are decreasing:
- FIFO cost of goods sold is highest
- LIFO cost of goods sold is lowest
Tax advantage of LIFO
When prices are rising, LIFO results in the lowest taxable income and the lowest income taxes
Why more companies use FIFO
Why more companies use FIFO:
1. Some companies perfer to report higher profits, which FIFO provides when prices are rising.
2. Some companies are in declining-cost industries. These companies, therefore, use FIFO to save on income taxes
3. When prices aren't changing much, FIFO, LIFO and average cost all produce similar results. FIFO is much less expensive to apply in actual practice.
LIFO inventory liquidiation
When a company using the LIFO (Last In, First Out) method of inventory costing liquidates their older LIFO inventory. A LIFO liquidation would occur if current sales are higher than current purchases, as a result, any inventory not sold in previous periods must be liquidated.
Accounting Principles Related to Inventory
Accounting Principles Related to Inventory:
- Consistency
- Disclosure
- Conservatism
Consistency principle
a business must use the same accounting methods and procedures from period to period
Disclosure principle
a business's financial statements must report enough information for outsiders to make knowledgeable decisions about the business. The company should report relevant, reliable, and comparable information about its economic affairs
Accounting Conservatism
When ESTIMATING, present the lowest asset value, the highest liability amount, and the lowest net income possible
1 recognize losses as soon as you know about them
2 recognize gains when your collect the cash
Do no deliberately understate assets and profits
requires that an asset be reported in the financial statements at whichever is lower-its historical cost or its market value (current replacement cost for inventory)
- LCM is not optional it is required by GAAP
Gross profit percentage
Gross profit divided by net sales revenue. A measure of profitability. Also called gross margin percentage. The higher the percentage the better.
Gross profit percentage
Gross profit = sales - COGS is a key indicator of a company's ability to sell inventory at a profit. Merchandisers strive to increase gross profit percentage.
Gross profit percentage
gross profit/net sales
Inventory turnover
the number of times the average inventory has been sold and replaced in a given period of time.
Inventory turnover
COGS/Average Inventory
Cost-of-goods-sold model
Formula that brings together all the inventory date for the entire accounting period: Beginning inventory + Purchases = Goods Available. Then, Goods Available - Ending Inventory = Cost of Goods Sold
Gross Profit Method
A way to estimate inventory on the basis of the cost-of-goods-sold model: Beginning inventory + Net purchases = Cost of goods available for sale. Cost of goods available for sale - Cost of goods sold = Ending inventory.
Plant assets
long-lived assets, such as land, buildings, and equipment, used in the operation of the business. Also called fixed assets. The expense associated with plant assets is called depreciation.
Intangible assets
An asset with no physical form, a special right to current and expected future benefits
Determining the cost of an asset
The cost of any asset is the sum of all the costs incurred to bring the assets to its intended use. The cost of a plant asset includes purchase price, plus any taxes, commissions, and other amounts paid to make the asset ready for use.
Cost of Land
The cost of land includes its purchase price (cash plus any note payable given), brokerage commission, survey fees, legal fees, and any back property taxes that the purchaser pays.
The cost of buildings, machinery, and equipment
When an existing building (new or old) is purchased, its cost includes the purchase price, brokerage commissions, sales and other taxes paid, and all expenditures to repair and renovate the building for its intended purpose.
Leasehold improvements
Alterations or improvements to leased property such as partitions and storefronts
- Most companies call the depreciation on leasehold improvements amortization, which is the same concept as depreciation.
Relative-sales-value method
Method of allocating the total cost (100%) of multiple assets purchased at one time. Total cost is divided among the assets according to their relative sales values.
Capital expenditures
Increase the productive life, operating efficiency, or capacity of the asset and are recorded as increases in asset accounts, not as expenses
Measuring Depreciation
To measure depreciation for a plant asset, we must know its:
1. Cost
2. estimated useful life
3. Estimated residual value
Estimated useful life
length of a service that a business expects to get from an asset; may be expressed in years, units of output, miles, or other measures
Estimated residual value
expected cash value of an asset at the end of its useful life. also called residual value, scrap value, or salvage value.
Depreciable cost
the cost of a plant asset less its salvage value
Depreciation methods
Three are three main depreciation methods:
1. Straight-line
2. Units-of-production
3. Double-declining-balance (an accelerated depreciation method)
Straight-line (SL) method
Depreciation method in which an equal amount of depreciation expense is assigned to each year of asset use.
Depreciation decreases the asset (through accumulated depreciation) and also decreases equity (through depreciation expense).
Straight-line (SL) method
Straight-line (SL) method = (Cost
- residual value)
/ Useful life
Units of production method (UOP)
depreciation method by which a fixed amount of depreciation is assigned to each unit of output produced by the plant asset.
Units of production method (UOP)
Units of production method (UOP) = Cost
- residual value
/ (useful life, in units of production)
Accelerated depreciation method
A depreciation method that provides for a higher depreciation amount in the first year of the asset's use, followed by a gradually declining amount of depreciation.
Double-declining-balance method (DDB) method
an accelerated depreciation method that computes annual depreciation by multiplying the asset's decreasing book value by a constant percentage, which is two times the stright-line rate.
Double-declining-balance method (DDB) method
Double-declining-balance method (DDB) method =
(1 / useful life, in years) x 2

* Last-year depreciation is the "plug" amount needed to reduce asset book value to the residual amount
How the DDB method differs from other depreciation methods
The DDB differs from the other methods in two ways:
1. Residual value is ignored initially; first-year depreciation is computed on the asset's cost.
2. Depreciation expense in the final years is the "plug" amount needed to reduce the asset's book value to the residual amount
Modified Accelerated Cost Recovery System (MACRS)
A special depreciation method used only for income-tax purposes. Assets are grouped into classes, and for a given class depreciation is computed by the double-declining-balance method, the 150%-declining balance method, or for most real estate, the straight-line method
Disposal of equipment
The loss on Disposal of Equipment is reported as Other income (expense) on the income statement. Losses decrease net income exactly as expenses do. Gains increase net income in the same manner as revenues.
Depletion expense
That portion of a natural resource's cost that is used up in a particular period. Depletion expense is computed in the same way as units-of-production depreciation
- Accumulated Depletion is a contra account similar to Accumulated Depreciation
Accounting procedure that gradually reduces the cost value of a limited life or intangible asset through periodic charges to income. For fixed assets the terms used is DEPRECIATION, and for wasting assets (natural resources) it is depletion, both terms meaning essentially the same thing as amortization.
Accounting for intangible Assets
Amortization is often computed on a straight-line basis. Amortization expense for a intangible asset can be written off directly against the asset account rather than held in an accumulated amortization account. The residual value of most intangibles is zero.
government documents giving an inventor the exclusive right to make and sell an invention for a specific number of years
the exclusive, legal right of a person to reproduce, publish, and sell his or her own literary, musical, or artistic creations
a name, symbol, or other device identifying a product; it is officialy registered with the U.S. government and its use is legally restricted to its owner
Franchise and licenses
Privileges granted by a private business/government to sell a product/service in accordance with specified conditions.
the excess of the purchase price of a business over the fair value of the business's assets and liabilities
-Goodwill is recorded only when it is purchased in the acquisition of another company
- According to GAAP goodwill is not amortized because the goodwill of many entities increases in value
Accounting for the Impairment of an intangible asset.
Some intangibles such as goodwill, licenses, and some trademarks have indefinite lives and therefore are not subject to amortization. But all intangibles are subject to a write-down when their values decrease. In the event of a write-down financial statement will report the following, credit Goodwill and debit Loss on Goodwill
Accounting for Research and Development
GAAP requires companies to expense R&D costs as they incur them. Only in limited circumstances may the company may the company capitalize R&D cost as an asset (R&D costs incurred under a contract guaranteeing that costs will be recovered).
Accounts Payable
the amount a company owes to suppliers for goods and services purchased with credit
- One of a merchandiser's most common transaction is the credit purchase of inventory.
Short-term note payable
Promissory note payable due within one year - a common form of financing.
Notes payable accrue interest expense and interest payable at the end of the period
Purchase of inventory journal entry
Purchase of inventory journal entry:
Note payable, short-term....... 8,000
Accrual of interest expense journal entry
Accrual of interest expense journal entry:
Interest Expense
(8,000 x .10 x 3/12).............200
Interest payable.............. 200
Note's payment at maturity journal entry
Note's payment at maturity journal entry:
Note payable, short-term.......... 8,000
Interest Payable........................ 200
Interest Expense
(8,000 x .10 x 9/12).................. 600
Cash [8,000 x .10]............... 8,800

Payment of a note payable and interest at maturity
To Record cash sales and the related sales tax
To Record cash sales and the related sales tax (5%):
Cash (200,000 1.05).......... 210,000
Sales Revenue............ 200,000
Sales Tax Payable
(200,000 x .05)........... 10,000
Current installment of long-term debt
amount of principal that is payable within 1 year.
- At the end of each year, a company reclassifies (from long-term debt to current liability) the amount of its long-term debt that must be paid during the upcoming year.
Accrued expense
An expense incurred but not yet paid in cash. Also called accrued liability.
There are several categories of accrued liabilities:
- Salaries and wages payable
- Interest payable
- Income Taxes Payable
Payroll (employee compensation)
employee compensation, a major expense of many businesses
To record salary expense
Accounting for all forms of compensation:
Salary Expense..................... 10,000
Employee Income Tax Payable ..... 1,200
FICA Tax Payable............................ 800
Salary Payable to Employees......... 8,000
Salary expense
Salary expense represents gross pay (that is, employees pay before subtractions for taxes and other deductions). Salary expense creates several payroll liabilities:
- Salary payable
- Employee Income Tax Payable
- FICA Tax Payable
Salary Payable
represents amounts of future cash payments to employees for work that has already been performed
Employee Income Tax payable
the account title used to journalize the federal income tax the employee had deducted from the payroll
FICA Tax Payble
FICA Tax Payable includes the employees' Social Security tax and Medicare tax, which also are withheld from paychecks. (FICA stands for Federal Insurance Contributions Act, which created the social security tax.)
Unearned Revenue
Income received but not yet earned (usually considered a current liability on a company's balance sheet). Also called differed revenues.
Estimated Warranty Payable
(Liability account)
the matching principle demands that the company record the warrant expense in the same period that the business records sales revenue; the warranty is part of what motivates customers to buy products, so the company must recognize a warranty expense
Accounting for warranty
The exact amount of warranty expense can not be known, so the business must estimate warranty expense and the related warranty liability.

Warranty Expense......................6,000
Estimated Warranty Payable.......... 6,000

To accrue warranty expense

Actual defects are 5,800 a company would record the following:

Estimated Warranty Payable.......5,800
Inventory................................ 5,800

To replace defective products sold under warranty
Contingent Liabilities
potential liabilities that have arisen as a result of a past transaction or event; their ultimate outcome will not be known until a future event occurs or fails to occur
- Record an actual liability if it is probable that the loss (or expense) will occur and the amount can be reasonably estimated.
- Report the contingency in the financial statement note if it is reasonably possible that a loss or expense will occur
Bonds payable
long-term liabilities that represent money lent to the firm that must be paid back
Maturity value
The amount that is due on the maturity date of a note
organization that purchases the bonds from an issuing company and resells them to its clients or sells the bonds for a commission, agreeing to buy all unsold bonds.
Term bonds
Bonds scheduled for payment (maturity) at a single specified date.
Serial bonds
bonds that mature in installments over a period of time
Unsecured bonds backed only by the general faith and credit of the borrowing company.
Premium (on a bond)
Excess of a bond's issue price over its face (par) value
Discount (on a bond)
Excess of a bond's face (par) value over its issue price
Present value
The amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money
Stated interest rate
interest rate that determines the amount of cash interest the borrower pays and the investor receives each year
Market interest rate
interest rate that investors demand for loaning their money. Also called effective interest rate
Bonds payable at pat value issuance entry
Issuing Bonds Pay able at Par Value:

Bonds Payable......................50,000,000
Accounting for Interest payments
Accounting entry to record the first semiannual interest payment is:

Interest Expense..................XXX
Cash................................. XXX
Accounting for issuing bonds payable at a discount
Issuing bonds payable at a discount is recorded as:

Discount on Bonds Payable.... 3,851
Bonds Payable ............... 100,000

Discount on Bonds Payable is a contra account to Bonds Payable, a decrease in the company's liabilities
Callable bonds
bonds that may be called for early retirement at the option of the issuer
Convertible bonds (or notes)
Bonds or notes that may be converted into the issuing company's common stock at the investor's option
Earnings Per Share (EPS)
A measure of the net income earned on each share of common stock; computed as net income minus preferred stock dividends divided by the average number of common shares outstanding during the year.
Trading on the Equity
Earning more income on borrowed money than the related interest expense, thereby increasing the earnings for the owners of the business. Also called leverage.
Times-interest-earned ratio
Ratio of income from operations to interest expense. Measures the number of times that operating income can cover interest expense. Also called the interest-coverage ratio
- A high times-interest-earned ratio indicates ease of paying interest expense.
a contract granting use or occupation of property during a specified time for a specified payment
Tenant in the lease agreement
Property owner in a lease agreement
Operating lease
Usually a short-term or cancelable rental agreement
Capital lease
Lease agreement that meets any 1 of 4 criteria: 1-The lease transfers title of the leasd asset to the lessee. 2-The lease contains a bargain purchase option. 3-The lease term is 75% or more of the estimated useful life of the leased asset. 4-The present value of the lease payments is 90% or more of the market value of the leased asset
sum of money paid to people on a regular basis after they retire
A person who owns stock in a corporation. Also called a shareholder.
Limited liability
legal principle that facilitates capital investment by offering protection for individual investors, who, in cases of legal claims for bankruptcy, cannot be held responsible for more than the value of there individual shares.
Double taxation
Situation in which taxes may be payable both by a corporation on its profits and by shareholders on dividend incomes
Advantages of the corporate form of business
Advantages of the corporate form of double taxation:
1. Can raise more capital than a partnership or a proprietorship can
2. Continuous life
3.Ease of transferring ownership
4. Limited liability of stockholders
Disadvantages of the corporate form of business
Disadvantages of the corporate form of business:
1. Separation of ownership and management
2. Corporate taxation
3. Government regulation
A registered business that acts as a separate entity (company); the owners have limited liability
The rules and regulations by which a corporation is governed; (Bylaws can be changed or amended).
Board of Directors
A group of people elected by the stockholders of a corporation to set the policies for the corporation.
elected by a corporation's board of directors, usually the most powerful person in the corporation
Chief operating officer in charge of managing the day-to-day operations of a corporation.
Stockholders' rights
1) Right to vote
2) Right to share in profits when dividends are declared
3) Pre-empitve right- Share in new issues of stock
4) Right to share in distribution of assets in liqiudation
preemptive right
the right granting to shareholders the first opportunity to buy a new issue of stock
Stockholders' equity
The claim of a corporation's owners to the assets of the business.
- Stockholders' equity is divided into two main parts:
1. Paid-in capital
2. Retained earnings
Paid-in capital
Total amount of cash and other assets paid in to the corporation by stockholders in exchange for capital stock.
Retained earnings
the accumulated earnings from a firm's profitable operations that were reinvested in the business and not paid out to stockholders in dividends
Stockholders' equity
Companies report stockholders' equity by source. They report paid-in capital separately from retained earnings because most states prohibit the declaration of cash dividends from paid-in capital. Thus, cash dividends are declared from retained earnings.
Outstanding stock
Stock in the hands of stockholders
Common stock
Represents ownership in a publicly held company which entitles owners to dividends (if declared by the company's Board of Directors), voting rights on matters affecting the company, and in the elections of Boards members.
Preferred stock
Stock that gives its owners preference in the payment of dividends and an earlier claim on assets than common stockholders if the company is forced out of business and its assets sold. Most companies don't use preferred stock (16% us it).
Par value stock
An arbitrary value assigned to common stock on a firm's balance sheet. Most companies set the par value of their common stock low to avoid legal difficulties from issuing their stock below par.
Legal capital
minimum amount of stockholders' equity that a corporation must maintain for the protection of creditors; for coporations with par-value stock, this is the par value of the stock issued
No-par stock
No-par stock does not have a par value. But some no-par stock has a stated value, which make sit similar to par value stock. Only around 9% of companies have this type of stock outstanding.
Stated value
an arbitrary amount assigned to no-par stock; similar to par value.
Additional paid-in capital
the amount a company receives from selling stock to investors above par value
Treasury stock
stock that has been bought back by the issuing corporation and is available for retirement or resale
- The Treasury Stock account has a debit balance, the opposite of other equity accounts. Therefore, Treasury Stock is contra stockholders equity, Reported beneath Retained Earnings on the balance sheet. - Purchasing treasury stock shrinks assets and equity
Retirement of stock
When a company retires its stock, the journal entry debits the stock account and any additional paid-in capital on the stock and credits cash.
An excess of liabilities over assets (usually over a certain period)
A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
Passing the dividend
when companies fail to pay a dividend to preferred stockholders
Cumulative preferred stock
preferred stock whose owners must receive all dividends in arrears before the corporation can pay dividends to the common stockholders
- Most preferred stock is cumulative.
arrears (ar-rears)
an unpaid overdue debt
Stock dividend
A Stock dividend is a proportional distribution by a corporation of its own stock to stockholders. Stock dividends increase the stock account and decrease Retained Earnings. Total equity is unchanged, and no asset or liability is affected.
Stock split
an increase in the number of outstanding shares of a corporation without changing the shareholders' equity
Market value of a stock
price for which a person could buy or sell a share of stock
Redeemable preferred stock
Preferred stock which, by its terms, enables the stock holder to require that the issuer redeem (or repurchase) the preferred stock for a specific amount within or following a specific time period. The redemption feature is also referred to as a put option or put right.
Rate of return on total assets
Rate of return on total assets or simply ROA.
ROA = net income + interest expense / average total assets

, net income plus interest expense divided by average total assets. this ratio measures a company's success in using its assets to earn income for the persons who finance the business. Also called return on assets
Return on Equity (ROE)
Return on Equity (ROE) = Net Income/Average common stockholders equity

- ROE shows the relationship between net income and average common stockholders' equity.
- ROE is computed only on common stock because the return to preferred stock holders is a specified dividend.
- In most industries, 15% is considered a good ROE.
Average common stockholders equity
Average common stockholders equity = Average Stockholders' Equity
- Average Preferred Stock
Common stock
common stock = Number of shares issued
x Par value per share
Additional paid-in capital
Additional paid-in capital combines paid-in capital in excess of Par plus Paid-in Capital from Treasury Stock Transaction plus Paid-in capital from retirement of preferred stock. Additional paid-in capital belongs to the common stockholders.
- Retained earnings comes after the paid-in capital accounts.
- Treasury stock can come last, as a subtraction at arriving at total stockholders' equity.
- Outstanding stock equals issued stock minus treasury stock
Short-term Investment
investment that a company plans to hold for 1 year or less; aka marketable securities
Long-term investment
any investment that does not meet the criteria of a short-term investment; an y investment that the investor expects to hold longer than a year or that is not readily marketable
Reporting Investments on the Balance Sheet
Assets are listed in order of liquidity. Long-term assets are less liquid than Current Assets but more liquid than Property, plant and equipment.

Current Assets
Short-term investments.........................xxx
Accounts Receivable............................xxx
Prepaid Expenses.................................xxx
Total current assets............................xxx
Long-term investments..............................................xxx
Property, Plant, and equipment.................................xxx
Intangible assets........................................................xxx
Other assets...............................................................xxx
Available-for-sale investments
All investments not classified as held-to-maturity or trading securities. Classified as current assets.
Available-for-sale investments are accounted for at market value because of the company expects to sell the stock at its market price.
Receipt of Stock Dividend
Receipt of stock dividend is different of cash dividend. For stock dividend, the investor records no dividend revenue. Instead, the investor makes a memorandum entry in the accounting records to denote the new number of shares of stock held as an investment. Cost per share decreases.
Allowance to Adjust Companion to Market
Allowance to Adjust Companion to Market is a companion account to Long-term Investment. When the market value of an investment increases debit (increase) the Allowance to Adjust Companion to Market account. However, if market value drops debit the unrealized loss on investment account. (P. 473)
Other Comprehensive Income
Measure of the amounts of all gains and losses in a period that bypass the income statement but affect stockholders' equity. These amounts arise from such items as unrealized gains or losses on certain investments and unrealized gains and losses on certain hedging transactions.
Accumulated Other Comprehensive Income
An entry in the stockholders' equity section of the balance sheet that reports the cumulative amounts of Other Comprehensive Income. Other Comprehensive Income measures the amounts of all gains and losses in a period that bypass the income statement but affect stockholders' equity. These amounts arise from such items as unrealized gains or losses on certain investments and unrealized gains and losses on certain hedging transactions. (p. 473).
- Includes tax reduction because this account comes after net income, an after tax figure.
Equity-Method Investments
Investments where the company owns 20% to less than 50% of outstanding stock, and thus has "significant influence."
Accounting for Equity-Method Investments
Accounting for Equity-Method Investments are recorded initially as follows for the purchase of an equity investment:
Long-term Investment.......................400
Cash.............................................. 400

- Both are asset accounts.
The Investors Percentage of Investors income (P.476)
Accounting for the Investors Percentage of Investors income is recorded as follows:
Long-term Investment
(Net income x ownership %)...................................75
Equity-Method Investment Revenue............... 75

- Asset and revenue accounts get increased
- The investor increases the Investment account and records Investment Revenue when the investee reports income.
- As the investee's owners' equity increases, so does the Investment account on the investor's books.
Receiving dividends under the Equity Method
Accounting for receiving cash dividends under the Equity Method is recorded as follows:

Long-Term Investment.............. 30

- The Investment account is decreased for the receipt of a dividend on an equity-method investment because the dividend decreases the investee's owners' equity and thus the investor's investment.
Loss on Sale of Investment
Gain or loss on the sale of an equity-method is measured as the difference between the sale proceeds and the carrying amount of the investment. Account entry for a loss on sale of an investment:

Loss on Sale of Investment.........8
Long-term Investment ......... 89
Controlling (majority) interest
Ownership of more than 50% of an investee company's voting stock.
Parent company
A company that has effective control over another company. Usually this means owning more than 50% of the company's stock
Subsidiary company
An investee company in which a parent company owns more than 50% of the voting stock.
Consolidated statements
financial statements that present the assets and liabilities controlled by the parent company and the total revenues and expenses of the subsidiary companies
Consolidated statements and stockholders' equity
The consolidated stockholders equity excludes the equity of the Subsidiary Corporation because the Stockholders equity of the consolidated company is that of the parent only. Also, the subsidiary's equity and the parent company's investment balance represent the same resources. Including both would amount to double counting.
Minority interest
a subsidiary company's equity that is held by stockholders other than the parent company