Exam 1 Study Guide PDF

Chapter 1 – Accounting in Business 1. Users of Accounting Information External Users: Investors, creditors, government agencies. ○ Example: A bank reviews a company’s financial statements to determine if they should approve a loan. Internal Users: Management, employ...

Chapter 1 – Accounting in Business 1. Users of Accounting Information External Users: Investors, creditors, government agencies. ○ Example: A bank reviews a company’s financial statements to determine if they should approve a loan. Internal Users: Management, employees, internal auditors. ○ Example: A company's management uses financial reports to assess the performance of different departments and decide on budgets. 2. Generally Accepted Accounting Principles (GAAP) Revenue Recognition Principle: ○ Recognize revenue when it's earned, not necessarily when cash is received. ○ Example: A software company sells a year-long subscription in January for $1,200. Even though it receives cash immediately, it records $100 per month as revenue over the 12-month period. Expense Recognition (Matching) Principle: ○ Match expenses to the revenues they helped generate. ○ Example: A company sells products in December, and the commission to the sales staff is paid in January. The commission expense should still be recorded in December, as it directly relates to December’s sales revenue. Cost Principle: ○ Record assets at their purchase cost, not market value. ○ Example: A business purchases a piece of equipment for $50,000. Even if the market value increases to $55,000 the next year, it should still be reported at $50,000 in the financial statements. 3. Role of Ethics in Accounting Ethics in accounting ensures that financial information is accurate and transparent. Example: If a company is facing financial difficulties, unethical behavior would involve hiding or misreporting losses to make the company appear more profitable. Ethical accountants would disclose all losses. 4. Elements of the Accounting Equation Equation: Assets = Liabilities + Equity Example: ○ A company has assets worth $100,000, liabilities of $60,000, and equity of $40,000 (Assets = Liabilities + Equity). Impact of Transactions:  ○ Example: A company buys a $10,000 machine on credit. Assets (increase): Equipment +$10,000 Liabilities (increase): Accounts Payable +$10,000 5. Analyzing Business Transactions Example: A company pays $5,000 in dividends to its shareholders. ○ Assets: Cash decreases by $5,000. ○ Equity: Retained earnings decrease by $5,000. 6. 4 Financial Statements Income Statement (for a time period): Reports revenues and expenses to show net income. ○ Example: A company reports $50,000 in revenues and $30,000 in expenses, resulting in a $20,000 net income. Statement of Retained Earnings (for a time period): Shows changes in retained earnings. ○ Example: Starting retained earnings = $10,000, + Net Income of $20,000, - Dividends of $5,000 = Ending retained earnings of $25,000. Balance Sheet (at a point in time): Shows assets, liabilities, and equity. ○ Example: A company has $100,000 in assets, $40,000 in liabilities, and $60,000 in equity. Statement of Cash Flows (for a time period): Shows cash inflows and outflows. ○ Example: A company has $10,000 cash inflows from operations and $3,000 cash outflows for investing activities. 7. RATIO – Return on Assets (ROA) Formula: ROA = Net Income / Average Total Assets Example: A company with a net income of $50,000 and average total assets of $200,000 has an ROA of 0.25, or 25%. Interpretation: This means the company generates 25 cents of profit for every dollar of assets. Chapter 2 – Accounting for Business Transactions 1. Source Documents Example: A sales receipt documents a transaction where a customer buys a product for $500. This receipt serves as the basis for recording the sale in the company’s books. 2. Role of Accounts Assets: Cash, Accounts Receivable, Equipment. Liabilities: Accounts Payable, Notes Payable. Equity: Common Stock, Retained Earnings. Revenue: Sales Revenue. Expense: Rent Expense, Salaries Expense. Example: When a company pays rent of $1,000: ○ Debit Rent Expense: $1,000 (increases an expense account) ○ Credit Cash: $1,000 (decreases an asset account) 3. General Journal and General Ledger General Journal: Where transactions are first recorded. ○ Example: A company purchases supplies on credit. The journal entry would be: Debit Supplies $500 (increase an asset) Credit Accounts Payable $500 (increase a liability) General Ledger: The collection of all accounts and their balances. ○ Example: The $500 increase in supplies would be posted to the Supplies account in the general ledger, and the increase in Accounts Payable would be posted to the Accounts Payable ledger. 4. Debits and Credits – Double-Entry Accounting Debits increase assets and expenses, while credits increase liabilities, equity, and revenues. Example: A company receives $1,000 cash for services rendered. ○ Debit Cash $1,000 (increase an asset) ○ Credit Service Revenue $1,000 (increase revenue) 5. Accounting Cycle – First 4 Steps 1. Identify and Analyze: Recognize that an event has financial impact. ○ Example: A company buys equipment for $2,000 on credit. 2. Journalize: Record the transaction. ○ Example: Debit Equipment $2,000 (increase an asset) Credit Accounts Payable $2,000 (increase a liability) 3. Post to General Ledger: Transfer journal entries to individual accounts in the ledger. 4. Prepare Unadjusted Trial Balance: List all accounts with their balances to ensure that total debits equal total credits. ○ Example: The trial balance might show total debits and credits of $50,000 each. 6. Purpose of a Trial Balance  A trial balance ensures that total debits equal total credits and helps prepare financial statements. 7. Journal Entries and Ledger Posting Example: A company makes a $5,000 credit sale. ○ Journal entry: Debit Accounts Receivable $5,000 Credit Sales Revenue $5,000 ○ This entry is posted to the general ledger. 8. RATIO – Debt Ratio Formula: Debt Ratio = Total Liabilities / Total Assets Example: A company with $40,000 in liabilities and $100,000 in assets has a debt ratio of 0.4, or 40%. Interpretation: This means 40% of the company’s assets are financed by debt, indicating potential financial risk.