Reviewer Notes – Financial Accounting and Reporting 1 PDF

Reviewer Notes – Financial Accounting and Reporting 1 Accounting Principles i.Materiality and Aggregation -Immaterial amounts of similar nature and functions should be grouped or condensed as one line item in the financial statements ii.Entity -the specific business...

Reviewer Notes – Financial Accounting and Reporting 1 Accounting Principles i.Materiality and Aggregation -Immaterial amounts of similar nature and functions should be grouped or condensed as one line item in the financial statements ii.Entity -the specific business enterprise is assumed to be separate from the owners, managers and employees who constitute it; As such the transactions of the enterprise should not be merged with those of the owners, managers and employees -EXAMPLE: If the statement says “Money deposited in the bank account of the owner should be recorded as part of the company’s cash”, then that statement is false. iii.Monetary -Money is used as the unit of measure -Aspects: a. Quantifiability -Transactions are recorded in terms of money b. Stability -Assumes the value of money is constant iv.Cost -Requires the assets should be recorded initially at original acquisition cost v.Objectivity/Reliability a. Objectivity -Requires the financial data entered in the records to be verified and supported by documents like invoices b. Reliability -Degree of confidence users place upon the truthfulness of the representations in the financial statements vi.Going Concern (Continuity Principle) -It is assumed that, in absence of the evidence to the contrary, the business will continue to operate indefinitely to carry out its existing contracts and commitments vii.Materiality (Doctrine of Convenience) -Strict adherence to GAAP is not required especially when the items are not significant enough to affect the fairness of the financial statements viii.Disclosure -All significant and relevant information leading to the preparation of financial statements should be clearly reported so as not to make the financial statements misleading ix.Accounting Equation Assets = Liabilities + Owner’s Equity *Assets=Resources  *Liabilities= Creditor’s Equity *Liabilities + Owner’s Equity=two sources of Assets x.Transactional Analysis a. Transaction -completed action which can be expressed in monetary terms b. Assets -resources controlled by the entity as a result of past transactions and events from which future economic benefits are expected to flow to the entity Classifications: 1. Current Assets -expected to be realized within 12 months or the entity’s normal operating cycle after date of statement of financial position -Example: Cash, Investments in Trading Securities, Accounts Receivable, Notes Receivable, Merchandise Inventory, Accrued Income, Advances to Employees, Prepaid Expenses *Operating Cycle=average time period required for cash to be converted back into cash (Ex. cash- >Inventory->Accounts Receivable -> Cash) 2. Non-Current Assets -all other assets not classified as current -Example: Property, plant and equipment (PPE) *Criteria for PPE: (1) Must have physical existence; (2) permanent in nature; (3) must undergo depreciation; (4) intended for use in operations; (5) not intended for sale c. Liabilities -present obligations of an entity arising from past transactions or events, the settlement of which is expected to result in an outflow from the entity of resources (assets) -Classifications: 1. Current Liabilities -expected to be settled within the entity’s operating cycle -Ex. Notes Payable, Accounts Payable, Accrued Expenses, Unearned Revenue 2. Non-Current Liabilities -liabilities not classified as current -ex. Mortgage Payable, Bonds Payable d. Equity -residual interest in the assets of the entity after deducting all its liabilities -increased by revenue and contributions by the owners; decreased by expenses and drawings -For a single proprietorship, equity is referred to as “Owner’s Equity”; partnership: “Partner’s Equity”; Corporation: “Stockholders’ Equity” -Components: 1. Owner’s Capital -a traditional accounting term to refer to the resources invested by the owner 2. Owner’s Drawing -used to record temporary withdrawal of cash or non-cash assets made by the owner xi.Preparation of Statement of Financial Position The following shows an example of a Statement of Financial Position in Report Form: *Take note that SFPs use the words “as of” before stating the date *REMEMBER that only assets should be recorded according to liquidity! *Take note of all the accounts that fall under certain account titles. *Don’t forget to deduct Allowance for Bad Debts from the Accounts Receivable and this will give you its Net Realizable Value. Pioneer Industries Statement of Financial Position As of December 31, 20XX ASSETS Notes Current Assets Cash 6 P300,000 Investment in Trading 200,000 Securities Trade and Other Receivables 7 250,000 Prepaid Expenses 8 105,000 Total Current Assets P855,000 Non-Current Assets Property, Plant and Equipment 9 1,750,000 TOTAL ASSETS P2,605,000 LIABILITIES & OWNER’S EQUITY Current Liabilities Trade and Other Payables 10 P395,000 Non-Current Liabilities Notes Payable P400,000 Mortgage Payable 550,000 Bonds Payable 550,000 Total Non-Current Liabilities 1,500,000 Total Liabilities P1,895,000 Owner’s Equity Mae Aquino, Capital 710,000 TOTAL LIABILITIES & P2,605,000 OWNER’s EQUITY Notes to Financial Statements Note 6-Cash Cash on Hand P200,000 Cash in Bank 100,000 Total P300,000 Note 7-Trade and Other Receivables Accounts Receivable P250,000  Less: Allowance for Bad Debts 50,000 P200,000 Interest Receivable 5,000 Advances to Employees 20,000 Accrued Income 25,000 Total P250,000 Note 8-Prepaid Expenses Office Supplies P30,000 Prepaid Rent 75,000 Total P105,000 Note 9-Property, Plant and Equipment Land P800,000 Building P600,000 Less: Accumulated Depreciation 100,000 500,000 Equipment P500,000 Less: Accumulated Depreciation 50,000 450,000 Total P1,750,000 Note 10-Trade and Other Payables Accounts Payable P200,000 Accrued Expenses 195,000 Total P395,000 Nature and Form of Income Statement a. NATURAL FORM- under this form of income statement, all income accounts are grouped and all expense accounts are grouped as well. After that, the total of the expense accounts are then deducted from the total of income accounts to arrive at the net income or net loss for the period. Notes to remember: 1. Do not forget the heading, with the company name on the first line, the title of the statement at the second line and the period ended at the third line 2. Revenues will be first presented. Arrange the revenues given in order of magnitude, thus the revenue account with the largest balance goes first. Do it in a descending order. 3. In a separate column, foot or add the total revenues 4. After presenting the revenues, expenses will be next. Present them as well in a descending manner. The expense account with the largest balance will go first, then the next, so on and so forth. However, remember that MISCELLANEOUS EXPENSE, must always be the last, no matter how big or small it is 5. In a separate column, add the total expenses 6. Subtract total expenses from total revenues to arrive at the net income or net loss for the period. If Revenues exceed Expenses, a Net Income occurs while if Expenses exceed Revenues, a (Net Loss) occurs. b. FUNCTIONAL FORM- under this form of income statement, specific sections of income, costs and expenses are shown. This is more of relying on arithmetic operations since items such as the cost of goods sold would have to be solved and deducted from total revenues to arrive at net income. This is common to a merchandising form of business.  Related Accounting Concepts Time Period- also known as periodicity concept. This concept divides the entire life of the business into specific time periods from which financial statements are prepared. It may be annually or quarterly as long as a reasonable report of the economic activities undertaken can be made. Income Recognition- the critical point on when to recognize an income or revenue as earned. It is important to take note that revenue recognition occurs when the corresponding revenue is earned by rendering services or delivering goods or other ways, even though there has been no cash received. Expense Recognition or Matching- under this principle, the corresponding expense incurred is matched alongside with the revenue being generated. An entity, on the process of earning revenue incurs expenses and thus, there is a need for matching. Expenses are recognized when earned, regardless whether or not cash has been paid. Accrual- under the accrual concept, it reiterates that income is recognized or recorded when earned regardless if there has been cash received or none and expense is recognized when incurred regardless whether or not cash has been paid. Consistency-the consistency principle states that once a method has been adopted for one period, it must not be changed unless there is a need to. The purpose of such is to make financial statements consistent and comparable from one period to another. Prudence- this is also known as conservatism principle. In the light of this principle, accountants take caution in reporting assets and income accounts. They would rather have understatements than overstatements of balances. Disclosure- this principle reiterates the fact that all material and relevant matters affecting the financial position of an entity must be disclosed. This is in line with the fact that financial statements are guides in terms of decision making, thus there is a need to make them reliable to avoid misleading the public. Expanded Accounting Equation ASSETS = LIABILITIES + EQUITY ASSETS = LIABILITIES+ Capital Beginning + Additional Investment – Withdrawals + Net Income/ - Net Loss ASSETS = LIABILITIES + Capital Beginning + Additional Investment – Withdrawals + Revenues – Expenses The expanded accounting equation expands the owners’ equity side of the original accounting equation. It further elaborates the components that are basically affecting an entity’s equity. ADDITIONAL INVESTMENT Increases Equity WITHDRAWALS Decreases Equity REVENUES Increases Equity EXPENSES Decreases Equity If you will carefully look at the expanded equation, the difference between your revenues and expenses will be the net income or loss for the period, which, if it is a net income, increases equity, and if it is a net loss, decreases equity. Transactions Analysis (Revenue and Expenses)REVENUE TRANSACTIONS- these transactions are the sources of the entity’s earnings. Revenues for the period represent income earned by the entity, and thus, a result of its operation. Typical revenue transactions: 1. Rendered services in exchange of cash 2. Rendered services in exchange of notes 3. Rendered services on account 4. Earned interest on a notes receivable 5. Earned rent for a specific period. The effect of revenue transactions is to increase net income in a particular period and thus, subsequently increase equity. EXPENSE TRANSACTIONS- transactions necessary for the conduct of the entity’s business. These are costs associated with the fact that the entity continues to do business in line with generating revenues Typical expense transactions: 1. Expenses incurred on rent 2. Expenses incurred on insurance 3. Expenses incurred in the form of interest on a liability 4. Miscellaneous expenses 5. Expenses incurred for advertisement Expenses incurred are deductions to the income earned in the same period since those income will not be earned if these necessary expenses were not incurred. In the end, expenses decrease owner’s equity.  Statement of Changes in Equity MODAUD SERVICE CENTER Statement of Owner’s Equity For the year ended December 31, 20XX Modaud, Capital, January 1 P XXXXX Add: Net Income XXXXX Additional Investment XXXXX Sub-Total P XXXXX Less: Modaud Withdrawals XXXXX Modaud, Capital, December 31 P XXXXX - A statement of changes in owner’s equity simply shows all the changes that affected the owner’s equity account for a given period. Transactions that would affect the owner’s equity account are as follows: Net Income Increase owner’s equity Additional Investment Increase in equity (IN the form of cash, equipment, supplies or other assets) Net Loss Decreases owner’s equity Withdrawals Decreases owner’s equity (These are assets of the entity taken by the owner for personal use) Accounting Cycle -the cycle through which accounting information goes through from collecting and analyzing of information to preparation of financial statements -the steps in the accounting cycle are: 1.Analyzing transactions and events 2. Journalizing accounting transactions 3. Posting to the Ledger 4. Preparing Unadjusted trial Balance 5. Making adjusting Entries 6. Preparing Adjusted Trial Balance 7. Preparing Financial Statements 8. Making Closing Entries 9. Preparing Post-Closing Trial Balance 10. Preparing reversing entries(optional) Analyzing business transactions -Double-entry bookkeeping records both sides of a transaction — debits and credits — and the accounting equation remains in balance as transactions are recorded -In summary: -T-accounts-the left side of the "T" for Debit (dr) transactions and the right side of the "T" for Credit (cr) transactions. Posting to the General Ledger Journals –books of original entry General Ledger –book of final entry Things to remember when posting to the general ledger: 1. In order not to be misled, refer to the chart of accounts to see the available list of accounts for posting. 2. When posting a debit, first enter the date, including the year. Then on the debit side, put the amount. If posting a credit, do the same procedure. The only difference is the date and amount will be then placed on the credit side 3. Do not forget to fill the P/R Column with the journal posting reference. This will serve as your guide. 4. After accomplishing the P/R for the ledger, go back to the journal, put the general ledger reference on the P/R Column. This indicates that posting of the journal entry has been done. *Posting to the General Ledger is somehow clerical but prone to a lot of errors *Always maintain the equality of debits and credits when posting. However, equal debits and credits will not assure an error-free posting.  Trial Balance Use: To prove the equality of debits and credits in the ledger, but NOT a proof of accuracy in recording transactions. Limitations: The Trial Balance will remain in balance even if… 1. The transaction is recorded with a wrong account Example: If Salaries Expenses were recorded as: Miscellaneous Expense 8000 Cash 8000 The trial balance will still be equal and the wrong account will not be disclosed in the Trial Balance. 2. The transaction is recorded with a wrong amount. Example: If the salaries expenses incurred by an entity is P300000 but was recorded as: Salaries Expense 200000 Cash 200000 The wrong amount will not affect the Trial Balance as long as the debit and credit entries are equal. 3. The transaction is not recorded. Example: If the entity incurred salaries expenses of P300000 but was not recorded in the company’s journal, the Trial Balance will still show the same total. Trial Balance Errors and their Location If the total of the debits and credits in the trial balance don’t match, first, get the difference of the two amounts and… 1. If the difference is 1, 100, 1000, etc., a wrong addition of the accounts occurred, so just re- foot the balances. 2. If the difference is exactly divisible by 2, there are two possible causes of the error. Look for the difference in the debits and credits as one account may be in the wrong column (like an expense account was recorded as a credit). If the difference cannot be found, the entry might have been omitted. 3. If the amount of error is exactly divisible by 9, the error may be due to: a. Transposition Error  - Interchange in the order of digits of a number - Example: An amount that should have been recorded as P2570 was actually recorded as P2750. - Course of Action: Look for an account where when the first two digits are transposed, the difference of the original and new number is divisible by 9 Example: As in the example above, if the first two digits of the recorded amount (P2750) are transposed an subtracted from each other (P7250 – P2750), the difference is P4500 which is divisible by 9. That account may have caused the error. b. Transplacement Error - Slide Error - Incorrect placement of the decimal point either 1 or 2 places to eh left or right - Example: P825.00 was recorded as P82.50 - Course of Action: Find the difference of the totals, divide it by 9 and this will give you the number that was transplaced. Example: If the difference is found to be P742.50, divide this by 9 and you get P82.50 which was the transplaced amount as stated in the above example. Correcting Entries These are not the same as Adjusting Entries. Steps in making the correcting entry: 1. Write the wrong entry made Example: Salaries Expense 12000 Cash 12000 2. Write the entry that should have been made Example: Owner, Drawing 12000 Cash 12000 3. Debit or credit the wrong entry that was credited/debited Example: Owner, Drawing 12000 Salaries Expense 12000  Adjusting Entries a required part of the accounting cycle done at the end of the period to update the balances of certain accounts o to record revenues earned or expenses incurred that were not previously recorded o to state the correct balance of revenues and expenses for the current period o to recognize changes in the balances of assets or liabilities o to recognize the existence of an asset or liability done in line with the accrual, revenue recognition and matching principles can be accruals, deferrals, depreciation or doubtful accounts o accruals – recognizes unrecorded revenues and expenses ▪ accrued expense/payable ▪ accrued income/receivable o deferrals – delays the recognition of revenues and expenses ▪ prepaid expenses ▪ unearned income o depreciation – decreases the value of a property, plant and equipment by apportioning its cost over the number years that it is useful to the business; the reduction in value can be caused by: ▪ physical wear and tear ▪ the sprouting of better PPE ▪ obsolescence of the products/services it makes o doubtful accounts – a loss anticipated due to the uncertainty of collecting customers’ accounts in time recording usually involves two accounts: one real and one nominal PRO-FORMA JOURNAL ENTRIES ACCRUALS Accrued Expenses Expense xxx Accrued expense/payable xxx Accrued Revenues Accrued revenue/receivable xxx Revenue xxx DEPRECIATION Depreciation expense xxx Accumulated depreciation xxx  DOUBTFUL ACCOUNTS Doubtful accounts expense xxx Allowance for doubtful accounts xxx SAMPLE ENTRIES ACCRUALS Accrued Expenses Interest expense 5000 Accrued interest expense/Interest payable 5000 Adjusting journal entry Accrued Revenues Accounts receivable 14500 Service revenue 14500 Adjusting journal entry DEPRECIATION Depreciation expense - Truck 40000 Accumulated depreciation - Truck 40000 Adjusting journal entry DOUBTFUL ACCOUNTS Doubtful accounts expense 2500 Allowance for doubtful accounts 2500 Adjusting journal entries Accruals Accrued Expenses – an expense already incurred but not yet paid Recognizes unrecorded expense and records a liability account What will happen if accrued expenses are not recorded? Expenses will be understated Liabilities will be understated Net income will be overstated Owner’s equity will be overstated Example: Shooshie Company occupies a building in Taft Ave. which has a monthly rent of P50,000. For the current year 2011, the rent for months October to December are still unpaid. Rent expense 150000 Rent payable 150000 Adjusting journal entry (50,000 x 3) Accrued Revenue – revenue already earned but not yet received Recognizes unrecorded revenue and records an asset account What will happen if accrued expenses are not recorded? Revenue will be understated Asset will be understated Net income will be understated Owner’s equity will be understated Example: Weclean Company occupies renders janitorial services to Shooshie Company. A one-year contract amounts to P60,000 with payments to be paid monthly. As of December 31, 2011, Shooshie still has four months worth of services to pay. Accounts receivable 20000 Janitorial Service revenue 20000 Posting Journal Entries -At the end of the accounting period, journal entries are transferred to the Ledger, in a process called. Posting -Posting is required to adjust the balances of the accounts for making correct financial statement reports. Below is an example of posting of a journal entry. General Journal Page: 1 Date Account Titles/Explanation Ref Debit Credit 20XX 5 Cash 11 800.00 Jan You the Owner, Capital 31 800.00 Owner Investment 6 Office Supplies 14 15.00 Office Furniture 18 300.00 Cash 11 315.00 Bought office supplies & Furniture with cash. Account 11 - Cash Date Item Ref Debit Credit Balance Jan 5 GJ1 800.00 800.00 6 GJ1 315.00 485.00  Account 31 - You the Owner, Capital Date Item Ref Debit Credit Balance Jan 5 GJ1 800.00 800.00 Account 14 - Office Supplies Date Item Ref Debit Credit Balance Jan 6 GJ1 15.00 15.00. Account 18 - Office Furniture Date Item Ref Debit Credit Balance Jan 6 GJ1 300.00 300.00 Preparation of Financial Statements Financial Statements – reports made by a company to inform interested parties on the current status of the company based on its financial performance and position Basically, it tells whether the company has done good or bad, or improved in the reporting period Provides financial information which helps the company’s owners make necessary business decisions Helps outsiders (i.e. government, creditors, customers) assess if the company is profitable Complete Set 1. Statement of Financial Position shows the financial condition of the company in a given point in time summarizes a company’s assets, liabilities and owner’s equity can be made even at the start of the business 2. Statement of Comprehensive Income Shows the financial performance of the company at a given period Can be just one statement (statement of comprehensive income) or two statements (income statement and statement of comprehensive income) Income statement – shows the income and expenses of the company Statement of comprehensive income – shows the net income (derived from the income statement) and the other comprehensive income can only be made after a period of time, when transactions are already being done in the company 3. Statement of Changes in Owner’s Equity Shows a summary of the activities which affected the Owner’s capital account Involves Owner’s capital and drawing accounts, and net income(loss)  4. Notes to Financial Statements Supports the amounts shown in the other statements by showing computations Gives other important information which helps readers understand the current situation of the company better Closing Entries *Closed Account = An account with a zero balance When? This is done at the end of each accounting period. Why? To prepare the nominal accounts for the next accounting period (Remember that nominal accounts are temporary accounts such as income statement accounts which are recorded on a year- to-year basis so they must start the next period with a zero balance) What? The closing entries are made for Nominal accounts (ex. income statement accounts = revenues and expenses). How? 1. Debit revenue accounts, credit Income Summary 2. Debit Income Summary, credit all expense accounts 3. If the Income Summary has a debit balance, Debit Owner, Drawing and Credit Income Summary. If the Income Summary has a credit balance, Debit Income Summary and Credit Owner, Drawing. 4. If the Owner, Drawing account now has a debit balance, Debit Owner, Capital and Credit Owner, Drawing. Otherwise, if the Owner, Drawing account now has a credit balance, Debit Owner, Drawing and Credit Owner, Capital. Example: 1. Service Revenue 90,000 Income Summary 90,000 2. Income Summary 120,000 Salaries Expense 60,000 Utilities Expense 30,000 Depreciation Expense 10,000 Interest Expense 10,000 Miscellaneous Expense 10,000 3. Owner, Drawing 30,000 Income Summary 30,000 4. Owner, Capital 40,000 Owner, Drawing 40,000