Accounting Notes 2022/2023 PDF

2022/2023 I year – I semester ACCOUNTING Prof. Bertoni Summary 00: WHAT IS ACCOUNTING? …………………………………………………………………………………………………………………............... 3 01: INTRODUCTION TO ACCOUNTING ……………………………………………………………………………………………………………….. 6 02: RECORDING BUSINESS TRANSACTIONS………………...

2022/2023 I year – I semester ACCOUNTING Prof. Bertoni Summary 00: WHAT IS ACCOUNTING? …………………………………………………………………………………………………………………............... 3 01: INTRODUCTION TO ACCOUNTING ……………………………………………………………………………………………………………….. 6 02: RECORDING BUSINESS TRANSACTIONS……………………………………………………………………………………………………….. 23 03: THE ADJUSTING PROCESS …………………………………………………………………………………………………………………………… 35 04: COMPLETING THE ACCOUNTING CYCLE ……………………………………………………………………………………………………… 48 05: MERCHANDISING OPERATIONS ………………………………………………………………………………………………………………….. 53 06: MERCHANDISE INVENTORY…………………………………………………………………………………………………………………………. 65 07: RECEIVABLES ………………………………………………………………………………………………………………………………………………. 74 08: PLANT ASSETS…………………………………………………………………………………………………………………………………………….. 88 09: FINANCIAL INVESTMENTS…………………………………………………………………………………………………………………………. 102 10: CURRENT LIABILITIES AND PAYROLL………………………………………………………………………………………………………….. 106 11: LONG-TERM LIABILITIES ……………………………………………………………………………………………………………………………. 112 12: SHAREHOLDER’S EQUITY ………………………………………………………………………………………………………………………….. 126 13: CASH FLOW STATEMENT…………………………………………………………………………………………………………………………… 140 14: INTRODUCTION TO MANAGERIAL ACCOUNTING …………………………………………………………………………………….. 148 15: TOTAL OUTPUT INCOME STATEMENT ………………………………………………………………………………………………………. 157 16: JOB ORDER COSTING ………………………………………………………………………………………………………………………………… 163 17: VARIABLE COSTING …………………………………………………………………………………………………………………………………… 176 18: COST-VOLUME-PROFIT ANALYSIS …………………………………………………………………………………………………………….. 177 19: SHORT-TERM BUSINESSES DECISIONS ………………………………………………………………………………………………………. 181 20: PROFITABILITY, LIQUIDITY, SOLVENCY ……………………………………………………………………………………………………….188 2 00. WHAT IS ACCOUNTING? Accounting is the process of: - Collecting financial information - Analyzing it to determine what information is relevant - Presenting the relevant information in a meaningful form of the user - Assisting the user in interpreting the information and applying it in the decision-making process. Financial information and decision making Business managers, investor, creditors need financial information. Financial information about a business helps decision makers evaluate the potential for success of their decisions. The primary purpose of accounting is to provide decision makers with certain types of financial information. Accounting = the language of business Information presented through the accounting process is the primary line of communication between a firm and its investors and creditors. It is essential that all parties involved in business activities understand the language used to communicate financial information HISTORY 1. Mesopotamia, 2500 BC. The first accounting records are marked on a piece of clay, and they represent transactions among individuals and tributes paid to the king. 2. Barter and physical records à For centuries, most transactions are non- monetary (barter), and accounting records are mainly kept in physical forms (e.g., tally sticks) 3 3. The Renaissance In the 15th century, the following changes happened in Europe: - Monetization of the economy - Modern banking (Florence,Venice and Genoa) - The printing press (Gutenberg, 1439) - More people become literate - Joint/split financing (Venice) 4. Double-entry bookkeeping: Luca pacioli à method all by hand, we don’t have negative numbers because they didn’t know how to deal with them. 5. Further evolution: from cash to accrual accounting - Dutch east india company (Netherlands, 17th century) à in this way they could reduce the risk - Industrial revolution (England, 18th century) - Introduction of the income tax (England, 19th century) - Financial markets become relevant (NYSE) - Many investments with returns in the long term (e.g., American railroads in the 19th century). - Cash is not “king” anymore. A new method is needed for determining net income, i.e. the financial wealth created by a business. We call this method “accrual accounting”. ACCRUAL ACCOUNTING is not cash accounting, but in sets of assets, benefits, physical stuff. If I buy a book, I have less money but I have more books and I can improve myself à the aim is measuring the value of what we have 6. Recent developments - Market crash of 1929 – need for a market authority (US Security and Exchange Commission, founded in 1933) - Accounting standards (US GAAP, etc.) - Globalization of the economy and of financial markets - International Accounting Standards (IFRS – International Financial Reporting Standard). - Fair value accounting - Early 2000s: Accounting frauds in the USA (Enron, Worldcom) and in Europe (Parmalat). - Financial crisis of 2008. - Today: knowledge economy, integrated reporting... Investopedia: biggest companies in the world market cap (= market capitalisation) 1. Apple 2. Saudi Aramco 3. Microsoft 4. Alphabet (Google) 5. Amazon 6. Tesla What Are the Biggest Companies in the World by Revenue? 1. Walmart (WMT) - $576 billion 2. Amazon (AMZN) - $486 billion 3. Petro China (PTR) - $443 billion 4. Saudi Aramco (2222.SR) - $394 billion 5. Apple, Inc. (AAPL) - $388 billion What Are the Biggest Companies in the World by Number of Employees? 4 1. Walmart (WMT) - 2,300,000 2. Amazon (AMZN) - 1,600,000 3. Volkswagen (VOW3.DE) - 645,500 4. Accenture (ACN) - 624,000 5. United Parcel Service (UPS) - 540,000 Wiki: list of largest companies by revenue Decision Makers: The Users of Accounting Information FINANCIAL ACCOUNTING provides information for external decision makers, such as: - Investors who own a portion of the business (the shareholders) - Creditors to whom the business owes money (they lend money and they get the money back, they have the right to check the accounting of the business) - Provides public information à is highly regulated, there are many laws - Taxing authorities, to whom the business owes taxes MANAGERIAL ACCOUNTING it develops information which is internal, that you not commonly find in the internet (to be kept secret, to avoid competitors), provides information to internal decision makers , such as: - Managers - Employees - Individuals - Businesses For example the social environment… Accounting Matters Types of accountants: - Certified Public Accountants (CPAs) are licensed professionals who serve the general public it develops information which is internal, that you not commonly find in the internet private professionals (= commercialisti) 5  - Financial accountants deal with preparing financial statements in public and private firms. - Auditors are independent (external) experts who verify the conformity of financial statements to accounting standards and laws - Certified Management Accountants (CMAs) specialize in cost accounting and managerial control and often work for a single company à managerial accountants Accounting positions: - Public - Private - Governmental WHAT ARE THE ORGANIZATIONS AND RULES THAT GOVERN ACCOUNTING? Governing organizations: - The International Accounting Standards Board (IASB) oversees creation and governance of accounting standards and writes standards that are required internationally. - The EU Commission and individual Member States establish which rules companies should apply, to have similar accounting rules in EU. - National standard setters (OIC in Italy, FASB in the US) prescribe rules for private and small companies, because big companies ally international standards - Market regulators (CONSOB in Italy, the Securities and Exchange Commission (SEC) in the US) oversee financial markets. Accounting guidelines are called Accounting Standards, or Generally Accepted Accounting Principles (GAAP) à these are not laws, are professional standards International accounting standards are called IFRS à international financial reporting standards Useful accounting information must: - Be relevant, allowing users to make a decision - Have faithful representation by being complete, neutral, and free from error à thanks to financial standards 01. INTRODUCTION TO ACCOUNTING THE ECONOMIC ENTITY ASSUMPTION an organization that stands apart as a separate economic unit follows the economic entity assumption. It states that the activities of the company must be kept separate from the activities of the owner An Economic Entity can be a: - Sole Proprietorship à a business that you are the only owner, there is no separation between your own personal wealth and company’s wealth. There is no legally separation, no limited liability - Partnership à 2+ owners, no limited liability - Corporation à limited liability, an “artificial” legal person that separate the business from the owner. legal separation between the owner and the company - Limited-Liability Company (LLC) à legal separation between the owner and the company Features of a corporation: 1. Separate legal entity 2. Continuous life and transferability of ownership 3. No mutual agency 4. Limited liability of stockholders or shareholders (owners of the corporation) à normally in our life we have unlimited liability (they can take our future money). This is why limited liability are 6  invented, to take less risk, the investors share the resources but also the risk. If something happens, the owners are not responsible, the stockholders are à they lose their investment 5. Separation of ownership and management à the stockholders do not always manage the corporations, they just invest their money, they appoint the executives of the corporation 6. Corporate taxation 7. Government regulation à the way the corporation is run Shareholders meet once a year and elect the directors, but this is not democratic à the more shares you have, the more power you get The CEO is the person that runs the corporation, the president just has legal representation Vice presidents are employees 7 Corporation / LLC (=srl) à the difference is how difficult it is to share the portions of the corporation, if you want to sell a LLC it is the same to sell a “house” à you need to sell the whole, with many formalities (while for corporations you just sign a paper). But they do LLC because they don’t want unlimited liabilities LIMITED LIABILITY Obligations arisen in the business must be met by the company with its own assets (resources). Shareholders cannot be held personally liable for the debts of the company. Shareholders can limit their losses to the amount they have paid for their shares. The company is an artificial legal person, with rights and obligations, distinct and separate from the persons of its owners. SHARES Shares are portion of ownership (or equity) of a limited company. When you buy them, you become a small owner of the company Shares are usually equal in size. Their nominal value (or “par value”) is the same for all the shares issued. Shares can be traded in financial markets, greatly enhancing the ease of transferring or adding ownership. Not all companies are public, some of them are private shares (for smaller businesses) à for example Illy coffee, they are owned by the family The world’s stock markets - Capitalization NYSE = New York Stock Exchange (Wall Street) NASDAQ = created 50 years ago, the first computer network à the most high-tech companies are there NYSE has low number of companies, while China has more listed companies. In Italy there are 10.000 corporation, but only 300 are listed à they ask help to banks, most of them are family businesses 8 THE THREE MAIN FINANCIAL STATEMENTS Financial accounting produces three major financial statements, designed to provide a picture of the overall financial position and performance of the business. They provide different information about the life of the company: Balance sheet (statement of financial position) à it shows wher ethe money comes from Income statement (or Profit and loss account) à when you want to know if a company makes profits Cash flow statement à to know if a company produces money, money-in or money-out (accrual accounting) THE BALANCE SHEET It is one of the three basic financial statements used to present financial information. It reports the financial position of a company as of a specific point in time (the end of the year usually). It is a list of: - Resources available for use by the business - Claims of interested parties against those resources à where does the money come from What do you need to start a business? What resources you need? where does the money come from Tax code, ideas, identity, balance, education, your money or someone else’s money. You spend business plan, money (cash), a place, a copyright, your savings to generate more money suppliers, employees Recourses (energy, …) ≠ assets ASSETS: 1. Must generate FUTURE BENEFIT 2. CONTROL à for example if you have a tourism business on a lake, the lake is NOT something that you have control on 3. RELIABLE MEASUREMENT à it must be reliable in money, even if its value won’t be the same forever, even though it is difficult to quantify it (for ex. a logo). The most reliable measurement is how much you paid something Example: we have a building, which is an asset. What are the measurements? - Historical cost à How much I paid for it, something that you can always verify. Less relevant but more reliable! - Current value or fair value à Today’s value, based for example on energy class, its position à it is an estimate, something that the experts can decide. Current value will be more interesting, but you need relevant information. Less reliable but more relevant! But at the same time most of the buildings’ cost in real-estate companies are based on the historical cost Three fundamental accounting terms: 1. ASSETS à Resources that generate future economic benefits through their sale, consumption or utilization in the course of operations; that are under control of an entity; and that can be measured reliably in monetary units. Those are investments or bonds, 2. LIABILITIES à the claims or interests of creditors in the assets of the firm. Also known as debt. 3. OWNERS’ EQUITY à the claims of the owner(s) in the resources of the firm. Also known as net worth or shareholders’ equity (in a corporation). 9 What of these is an asset? - Advertisement is not an asset, because we don’t know if it will be a future benefit à NO, you need to be conservative - The money from investors à YES - Clients à NO, they make you earn money once the business is already started - Banks have to earn some interest, they won’t become owners, they just land you money and you will give their money back à this is difficult for start-ups, because banks don’t trust risky companies - Savings à See: Stellantis annual report 2021 The assets are equal to liabilities and equity (both 171,766) à basic accounting equation. You cant have assets that are worth more than liabilities and equity EQUITY / LIABILITIES o Your own money à owner’s equity (in case of corporation à shareholders’ equity, you are one of the owners even if you don’t always have the right to get your money back, but you can sell your shares to someone else) o Someone else’s money à liabilities (debt) à for example you can lend money to some companies Bonds are the most important financial liabilities Example Owner’s equity 50 Liabilities 30 = assets = 80 If I buy a fridge, I have 10,000 cash, but then you have less cash and a fridge We are looking at: 1. Where does the money come from 2. How is the money used à but it must be the same amount of money THE BASIC ACCOUNTING EQUATION Assets = liabilities + owners’ equity It means that for every resource placed in the balance sheet, there is an offsetting claim against it. All the claims finance the assets Example: if have 20 euros in my pocket (à asset: 20). It can be given by my parents, or it is a loan.. those 20E measure a claim against the asset Then I spend my money for something that will generate future benefits, a book. Now I have less money, but more goods, the value of the book is still 20 E. I still owe 20E, the total value of the asset is the same as before, it is the same financial wealth The balance sheet shows the assets, liabilities, equities à to know the financial position The meaning of owner’s equity Assets – Liabilities = Equity This means that the value of a firm’s equity is equal to the difference between the value of the assets and the value of the resources that will have to be paid back to creditors in the future. 10 For this reason, owner’s equity is sometimes referred to as “net assets”. It is the “book value” of the company (because it is written on bookkeep). Its “market value” could be different from book value, because it also depends on the expectations for the future à for example Tesla (high market value), or Stellantis (market cap: about 40 billion, lower than its book value) Some important accounting conventions 1. ENTITY CONCEPT: the business is an entity separate and distinct from its owners (in case of corporations, also legally). Financial statements are presented for the specific entity. 2. MONEY MEASUREMENT CONVENTION: all items presented in financial statements must be capable of being expressed in monetary terms, it must be measurable in terms of money. 3. HISTORICAL COST CONVENTION: the acquisition of assets is entered in the financial records of the firm at their original cost. Assets are shown in the balance sheet at a value based on their acquisition cost. Important assumptions about valuation (=measuring) 1. Prudence (or conservatism): the most important thing, Assets should be assigned a value close to their rational minimum (the lowest); liabilities should be assigned a value close to their rational maximum (the highest *). Valuations should err on the side of caution. We report good news only when we are sure, while we report bad news immediately. * for example you could have potential liabilities if some famous brand says tat you copied their logo, you could have to pay them. It isn’t just the actual liabilities, but also the possible ones. 2. Going concern convention: a business is supposed to continue operations for the foreseeable future. 3. Stable monetary unit convention: money will not change in value over time, therefore there is no need for systematic adjustments to inflation. Inflation is important because it relates about the power of our money. ASSETS à An asset is an economic resource that is expected to benefit the business in the future. Examples: - Cash - Merchandise Inventory – Furniture – Land LIABILITIES à Liabilities are debts that are owed to creditors. Many liabilities have the word payable in their titles. Examples: – Accounts Payable – Notes Payable – Salaries Payable Assets – Liability = equity Equity is the source of finance, they don’t tell you about how profitable/successful is the firm Apple 2021 à equity has decreased for more than 2 million If the equity of a company decreases, is it bad? It depends on the reasons: - It can be a negative performance à it’s bad, it’s a loss - If the equity changes for some operations, it is good How can the equity change? - The firm paid dividends to its owners, but we need to know how many dividends there were - With business operations à sell iphones can generate losses/profits - If equity was contributed by the owner/shareholders, it has increased by the owners (so this is not a performance) 11 - Decrease in the equity: transactions between owners and business à a contribution, the owner contributes to the business à it is the dividend, the distribution of profits in a company, it is a decrease in equity - When the business pays money to the owners it is a dividend = distribution of profits in corporation à decrease in equity. But it has not linked with the financial performance of a firm, how good you are at your job (= the value creation) Equity can change for reasons that are not connected to the financial performance (= value creation process) Negative change à LOSS Positive change à PROFIT EQUITY The owners’ claims to the assets of the business are called equity. Also called stockholders’ equity Increases in equity result from: Decreases in equity result from. – Contributed capital (owner contributions) – Dividends (owner distributions) – Revenues – Expenses (These are not financial performances) Equity consists of two components: 1. Contributed capital: Also called paid-in capital, contributed capital is the amount invested in the corporation by its owners, the stockholders. Common stock represents the basic ownership of every corporation. 2. Retained earnings: Equity earned from profitable operations that is not distributed to shareholders THE CONCEPT OF INCOME Income (financial performance) is the net increase (profit) or net decrease (loss) in owner’s equity over a period of time, with the exclusions of changes in equity related to transactions between the firm and equity participants (= the owners, shareholders). (E – E ) are the changes of the year t1 t0 Income = (Et1 – Et0) – contributions from owners + distributions to owners Es. For Apple à (63-65) + 3 – 0 = 1 12 The relationship between the balance sheets of two different dates The T is called “T account” à representation of the financial statement Firms, depending on how big they are, calculate the net income every year / 3 months / 1 month If you have an increase of the income for years, the equity is going to increase (while if you have losses, the equity is going to decrease) Some companies do not distribute all their income à so they can increase their equity without debts (for ex. Apple for 10 years, even if they were profitable) Usually, the shareholders meet once a year and vote if to distribute the equity or not. If a shareholder owns 51% of the shares, he decides for all Let’s imagine a company in losses: is there a point that we shall stop? Et0 = 1000 Et1 = 600 Et2 = 300 Et3 = 50 Et4 = is it 0 ? Balance sheet Assets Liabilities 10,000 10,000 Equity = 0 Why is this a difficult/dangerous position? Because the creditors (the banks) are going to be worried à because they worry that they are not going to get their money back, the risk is being insolvent = do not have enough money to pay back the debt Is it possible to not be insolvent in this case? à yes, you could have non-current liabilities (in the short term you can survive, in the meantime you pay the current liabilities) But what if you keep losing money? can be your equity be negative? They can survive, for example Amazon did à founded in 1995, started to sell books: for 7 years they had negative equity. They survived thanks to investors, not clients. 13  Assets Liabilities 10,000 10,100 Equity = -100 à that we write (100) à a deficit, a negative equity Amazon 2004 à stockholder’s deficit The assets are less then the liabilities à total stockholder’s deficit (1,036,107) is negative à negative equity is called deficit Could you get this deficit if you distribute your equity to too many distributors? Yes, it depends on company laws Linking net income to the basic accounting equation: The first line is the equity at the begin of the year. The last line is the equality at the end of the year. ∆ Asset and ∆ Liabilities can either be positive or negative à they determine if equity is positive/negative. To understand where revenues/expenses come from, they have labels: rent,.. Net income gives you the real information Revenues and expenses - REVENUES are increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. They are NOT cash, they are increases in assets or decreases in liabilities - EXPENSES are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. Decrease in assets or increase in liabilities à we pay money to our employees, it is a cash expense. There could be non-cash expense. Examples à You get a kitchen, you use it, its value decreases : it is an expense Liabilities: you buy insurance (to reduce your risk). In case of a fire, you transfer your risk to the insurance company. You signed a contract, it was an expense. It is a liabilities that exists even if the risk hasn’t been a real problem Revenues and expenses are changes in equity: - increases in assets and decreases in liabilities generate revenues à E+ - increases in liabilities and decreases in assets generate expenses à E- 14 Revenues and expenses generated in the production process à separation of the production: 3 phases 1. Purchase of the inputs à you pay someone, or you promise to pay: this is a purchase expense. You have a negative change in financial position, but you also get the things you wanted, so you increased your assets. You get both a revenue and an expense à the equity doesn’t change, revenue and expense neutralize each other (this is called a change in the inventory) 2. Conversion of the inputs into outputs à we combine the input (ex flour) into outputs (bread). Their financial value decreases, but you get a new asset: a product. In manufactory you can keep them and they are in the warehouse, waiting to be sold à we have both a revenue and an expense 3. Sale of outputs à when you have an item in the warehouse, its cost is equal to the sum of the production cost (100$). But when you sell it, you can actually sell it to a higher price (400$). But in exchange of those 400$, I have to give away my iphone. So it is both a revenue and an expense à When you product something, there is no decrease or increase in your financial position In accounting as long as you buy something and DON’T use it it is not a revenue, because your assets increases. Only when you start using it, you have a revenue à if you have flour, you have an asset. When you use the flour, you have the revenue Accrual vs Cash Accounting Accrual Accounting Cash Accounting - Impact of business transactions are recorded - Transactions are recorded when cash is when the transaction occurs received or paid. - Revenues are recognized when earned à you - Revenues are recorded when cash is received. don’t have to wait to get the money - Expenses are recorded when cash is paid. - Expenses are recognized when incurred. à there is a duplation in the assets or a liability Under accrual accounting, cash transactions are recorded as well as noncash transactions such as: - Purchases of inventory on account - Sales on account - Depreciation expense - Accrual of expenses incurred but not yet paid - Usage of prepaid rent, insurance, and supplies 15 Revenue recognition o Realized revenue à these is an actual customer, these are not some hypothetical expectations for the future. Those are not realized until they actually sold the phone, even if the company hasn’t received the money yet. Otherwise, it’s a fraud o Earned revenue à the seller has to fulfill its obligations, such as: deliver the unit or to perform the service à usually both criteria are met when you actually deliver the good MATCHING PRINCIPLE We need to match the revenues to our expenses If you produce a series of iphones, you have some expenses. You produce them in 2022 but you are going to sell them in 2023. Both revenues and expenses will be registered in 2023, when there is going to be the sell of those iphones. They are going to generate an expense just when they are going to generate a revenue! Expenses are costs of assets used up and of liabilities created in earning revenue. Matching involves two steps: 1. Identify all expenses incurred during the period. 2. Measure the expenses and match the expenses against revenues earned. Expenses may: - be paid in cash. - result from using up an asset such as supplies - result from creating a liability (payable) Accrued and prepaid items o Pre-paid expenses are assets arising from the advance payment of services that will be consumed in a future accounting period. Also known as: deferrals, deferred assets, etc... o Accrued expenses are liabilities arising from the consumption of services in the current period, but that will be paid in a future accounting period. o Accrued income (or “accrued revenue”) is an asset, while pre- paid income is a liability. «Accrual accounting», or how we measure profits Cash accounting was not sufficient anymore, for examples in long-term investments. Suppose a firm buys an item for €10, pays it, and then sells it on credit for €12. Cash will be collected in the following period. Which one is a better indicator of the “earning power” of the firm? à accrual accounting tells us something about the future of the firm: 2€ 16 EQUITY Equity is composed by: - Capital from the owners (commons stock) - Retained earnings à the result over the years: dividends (not expenses, but they do decrease the equity), revenues and expenses The accounting equation is expanded to show the components of equity: Net income (profit) à Revenues > Expenses Net loss à Revenues < Expenses HOW DO YOU ANALYZE A TRANSACTION? A transaction is any event that affects the financial position of the business and can be measured with faithful representation. To analyze transactions, we use the basic accounting equation Is it a transaction? à YES: Buying a computer for the office for $2,000 cash NO: Hiring a new employee Example: Transaction Analysis for Smart Touch Learning Transaction 1 — Owner Contribution Sheena Bright contributes $30,000 cash to Smart Touch Learning, a corporation which serves lessons, in exchange for stock. The effect of this transaction on the accounting equation is: The first trans is the cash from the owner (asset). The assets increase from 0 to 30,000. It is not a performance because it comes from the owner. Common stock is the contributed capital of the firm 17 Transaction 2 — Purchase of Land for Cash Smart Touch Learning purchases land for an office location, paying cash of $20,000. The second transaction is to purchase some land/building (an asset). The cash decreases and the assets increase. There are revenues and expenses, but they just cancel each other out, so the equity is still 30,000$. Your business is less liquid (less cash, different financial position), but the total value of the assets has increased. The equity hasn’t changed Transaction 3 — Purchase of Office Supplies on Account Smart Touch Learning buys office supplies on account agreeing to pay $500 within 30 days. We buy office supplies (paper/pens..), which are consumable. We agree to purchase on account: we will pay in 30 days. The main difference is that we are going to use these supplies very quickly and only once. On the liabilities part, we are going to write an account payable (= an obligation to pay something). Trick: if it has the word “payable” in it, it is a liability Transaction 4 — Earning of Service Revenue for Cash Smart Touch Learning earns service revenue by providing training services for clients. The business collects $5,500 revenue in cash. The assets change, because we have more money from the service (/sales) revenue = 5,500 The assets change, because cash is +5,500 18 Transaction 5 — Earning of Service Revenue on Account Smart Touch Learning performs a service for clients who do not pay immediately. The clients promise to pay $3,000 within one month. The fact that you haven’t still collected the money is no relevant, because you have the right to collect money à accounts receivable in assets column. We can’t wait to recognize the revenue. Now you have more equity (see retained earnings) If your customers do not pay you in time, you risk to get an insurance Transaction 6 — Payment of Expenses with Cash Smart Touch Learning pays $3,200 in cash expenses: $2,000 for office rent and $1,200 for employee salaries. We pay salaries to our employees à it means that they have “used” the employees’ work. The cash decreases, but we are making a performance Transaction 7 — Payment on Account (Accounts Payable) Smart Touch Learning pays $300 to the store from which it purchased office supplies in Transaction 3. We pay 300, so cash decreases but so do the liabilities. 19 Transaction 8 — Collection on Account (Accounts Receivable) Smart Touch Learning now collects $2,000 from the client from Transaction 5. We have collected the accounts receivables, but we also don’t have the right to collect it anymore. Cash increases by 2000, but assets decrease by 2000. These is no change in the equity Transaction 9 — Payment of Cash Dividend Smart Touch Learning distributes a $5,000 cash dividend to the stockholder, Sheena Bright. To pay dividends, your assets (cash) decreases, even though it is not an expense (à so it has nothing to do with your financial performance). Both sides (assets/liabilities+equity) have always been in balance. 20 HOW DO YOU PREPARE FINANCIAL STATEMENTS? Financial statements are business documents that are used to communicate information needed to make business decisions. 1) INCOME STATEMENT The income statement reports the net income or net loss of the business for a specific period. Revenues – expenses = net income or loss 21  2) STATEMENT OF RETAINED EARNINGS The statement of retained earnings reports how the company’s retained earnings balance changed from the beginning to the end of the period. The initial retained earnings are $0 because it is a new start up. Right now the equity has a profit of $300, because of dividends (Dividends are not an expense, they are not performances!) 3) THE BALANCE SHEET The balance sheet reports on the assets, liabilities, and stockholders’ equity of the business as of a specific date. Common stock is the contribution of the owners. Dividends would make the equity decrease. In this balance sheet, the retained earnings = profit – dividends 22  4) THE STATEMENT OF CASH FLOWS The statement of cash flows reports the change in cash during the period. Receipts à cash collected from customers We want net cash provided by operating activities to be positive. Cash T0: 100 Cash T1: 120 Cash flow = +20 à why did we increase cash by 20? We need to register this info in cash flow statements, to know how our cash is used 02. RECORDING BUSINESS TRANSACTIONS Learning Objectives 1. Explain accounts as they relate to the accounting equation and describe common accounts 2. Define debits, credits, and normal account balances using double-entry accounting and T-accounts 3. Record transactions in a journal and post journal entries to the ledger 4. Prepare the trial balance and illustrate how to use the trial balance to prepare financial statements 5. Use the debt ratio to evaluate business performance Double Entry Bookkeeping à in Venice, formalized by Luca Pacioli, in 1500. Then people were not so familiar with negative numbers 23 WHAT IS AN ACCOUNT? The accounting equation contains three categories: assets, liabilities, and equity. Each part contains accounts (assets account, liabilities account, equity account). An account is the detailed record of all increases and decreases that have occurred in an account during a specified period. 1. ASSETS ACCOUNT 2. LIABILITIES ACCOUNT Usually when you see “payable” it is a liability. Unearned revenue à you collect the money from a customer in advance, but in exchange you have the obligation to provide services. But the point is that until you haven’t actually provided this service, this revenue cant be recognized. You have earned some cash, but you also know that you have to perform a service. Some liabilities are money debts, and some other obligations consist in doing something. 24  3. EQUITY ACCOUNTS CHART OF ACCOUNTS A chart of accounts is used to organize a company’s accounts (assets’, liabilities’ and equity’s accounts). A ledger is a record holding all the accounts of a business, the changes in those accounts, and their balances (an amount). TWO CLASSES OF ACCOUNTS (1st and 2nd) - Assets accounts: Cash, Accounts receivable, Prepaid expenses, Property, Plant, Equipment, Inventory... - Liabilities accounts: Accounts payable, Loans payable, Bonds payable, Accrued liabilities... - Equity accounts include: Common stock, Retained earnings, Dividends, Revenues, Expenses Double entry bookkeeping is useful to record the transactions from two different perspective: - 1st class account describes nature of transaction - 2nd class account describes cause of the transaction For ex: Sale of 1,000 on credit 1st class account: Accounts receivable +1,000 2nd class account: Service revenue +1,000 25 It is just one transaction, but we need to report the amount twice. First we increase the assets account, and then the revenue account, even though the transaction is one à double entry bookkeeping We are not going to use + and -, we are going to use debit and credit (not collected to the concept of plus and minus, it depends) Debit (dare) ≠ debt Credit (avere) ≠ accounts receivable What is double-entry accounting? o Transactions always involve at least two accounts. o Accounting uses the double-entry system to record the dual effects of each transaction. o Transactions are recorded as changes in an account of the 1st class (nature of the transaction) and, at the same time, as changes in an account of the 2nd class (explanation of the change in the 1st class account). For example: salaries are paid requiring an increase in Salary expense and a decrease in Cash 1st: cash -5000 2nd: salary expense -5000 à which is the reason why these was a change in cash? The T-Account A shortened form of the ledger is called the T-account, a record for transactions. o The left side of the T-account is called the debit. o The right side of the T-account is called a credit. These are no + or - , just left or right section DEBIT AND CREDIT: THE ACCOUNTING SIGNS à liabilities are negative, so + and – have the opposite sign (ex. you have a debt, if you make that debt go -1000 it’s good news) Assets and liabilities are 1st class accounts, while equity are 2nd class account In equity expenses and dividends are bad news Memo sentence à ALL ELEPHANTS DO LOVE ROWDY CHILDREN - assets, expenses, and dividends all have increases in debit - liabilities, revenues, and contributions all have increases in credit 26 THE THREE PROPERTIES OF DOUBLE-ENTRY BOOKKEEPING o ∑ 1st Class = ∑ 2nd Class (∑ means sum, the amount) o ∑ all debited amounts (1st + 2nd) = ∑ all credited amounts (1st + 2nd) à comes from the switch of signs o ∑ all debit balances (1st + 2nd) = ∑ all credit balances (1st + 2nd) Assets can only have a debit balance, you can’t have a negative asset (the lowest can be 0) INCREASES AND DECREASES IN THE ACCOUNTS How we record increases and decreases to an account is determined by the account type. To increase the Cash account, a business would record a debit to Cash. To decrease the Cash account, a business would record a credit to Cash. EXPANDING THE RULES OF DEBIT AND CREDIT The accounting equation is expanded to include the rules of debits and credits for the elements of equity: THE NORMAL BALANCE OF AN ACCOUNT All accounts are summarized on one side of the T-account, called the normal balance, which appears on the increase side of the account. - Assets increase with a debit, so the normal balance is a debit. - Liabilities and equity increase with a credit, so the normal balance is a credit. 1st assets, liabilities (are negative, credit is bad), revenues, common stock à debit is good 27 Determining the Balance of a T-Account Use the T-account to determine the ending balance in an account. The ending balance is shown on the side with the larger number. Left: debit / right: credit The left side must always be lower than the right side Ledger = a book that contains all the T account and their balances HOW DO YOU RECORD TRANSACTIONS? Accountants use source documents to provide evidence and data for recording transactions. The documents help businesses determine how to record the transactions. Other source documents used include: - Purchase invoices - Bank checks - Sales invoices Journalizing and Posting Transactions = report the amounts in the t account After reviewing source documents, accountants record the transactions in a journal, the record of the transactions in date order (chronological). The data from the journal is then transferred to the ledger, a process called posting. First debit and then credit! We read “credit cash and credit common stock” Cash is 1st class, common stock is 2nd class à cash has increased because we received a contribution The journalizing and posting process has five steps: 1) Identify the accounts and the account types (asset, liability, or equity) à start from 1st class account! 2) Decide whether each account increases or decreases, then apply the rules of debits and credits. 3) Record the transaction in the journal. 4) Post the journal entry to the ledger. 5) Determine whether the accounting equation is in balance. 28 Transaction 1 — Stockholder Contribution On November 1, the e-learning company received $30,000 cash from Sheena Bright, and the business issued common stock to her. Date Name of the account Amounts debit and credit (which are the same) Short explanation We read debit cash, credit common stock: 30,000 Examples: Nov. 1 Debit (dr): cash (A+) 30,000 à A+ means assets increase Credit (cr): common stock (Q+) 30,000 à Q+ means equity increase Nov. 1 Debit (dr): cash (A+) 30,000 à A+ means assets increase Credit (cr): loans payable (L+) 30,000 à L+ means liabilities increase You “open an account” when you use it for the first time 29 Transaction 2—Purchase of Land for Cash On November 2, Smart Touch Learning paid $20,000 cash for land. We have no expenses because land is an asset, the equity doesn’t change A+ A- Land is a special asset, because it doesn’t lose value by using it, it is for life, unlikely most of the other assets à no changes in the equity Transaction 3 — Purchase of Office Supplies on Account Smart Touch Learning buys $500 of office supplies on account on November 3. Even though office supplies are going to be consumed, they are still assets. You can store then and use them in the future A+ L+ Transaction 4—Earning of Service Revenue for Cash On November 8, Smart Touch Learning collected cash of $5,500 for service revenue that the business earned by providing e-learning services for clients. They have to provide a service, they earn a revenue and they get paid. A+ R+ (revenues) Service revenues are recognized when performed. The equity changes 30 Transaction 5 — Earning of Service Revenue on Account On November 10, Smart Touch Learning performed services for clients, for which the clients will pay the company later: the right to collect money is an asset. The business earned $3,000 of service revenue on account. A+ R+ Transaction 6 — Payment of Expenses with Cash Smart Touch Learning paid the following cash expenses on November 15: office rent, $2,000, and employee salaries, $1,200. E+ (expenses) We credit cash because we E+ are going to pay salaries… A+ Note: A compound journal entry is a journal entry with multiple debits and/or credits. To write this on paper: Dr Cr Dr: rent expense Cr: cash 2,000 3,200 Dr: salary expense 1,200 Transaction 7 — Payment on Account (Accounts Payable) On November 21, Smart Touch Learning paid $300 on the accounts payable created in Transaction 3. L- A- 31 Once you pay a liability, you don’t have to pay it anymore: it’s good news (even though here he paid just on part, he has still accounts payable). Cash decreases is bad news. They cancel each other out: equity is the same Transaction 8 — Collection on Account (Accounts Receivable) On November 22, Smart Touch Learning collected $2,000 cash from a client in Transaction 5. The equity doesn’t change A+ A- 1,000 Transaction 9 — Payment of Cash Dividend On November 25, a payment of $5,000 cash was paid for dividends (owners of the firm). This is NOT and expense Q- (2nd class) A- Transaction 10 — Prepaid Expenses On December 1, Smart Touch Learning prepays three months’ office rent of $3,000. If you prepay rent you have an asset, you have the right to use your office à prepaid expenses are not expanses, they are assets! (ex. the same for insurance) We assume that the passing of time will allow us to recognize the expense. A+ A- Transaction 11 — Payment of Expense with Cash On December 1, Smart Touch Learning paid employee salaries of $1,200. The resource is the labor of the employees. We recognize the expense. The equity decreases E+ A- Transaction 12 — Purchase of Building with Notes Payable On December 1, Smart Touch Learning purchased a $60,000 building in exchange for a note payable. A+ L+ 32 Note payable = you promise to pay the rent, you don’t pay cash right now à we have a long-term liability, but a new asset. Equity is the same Transaction 13 — Stockholder Contribution On December 2, Smart Touch Learning received a contribution of furniture with a fair market value of $18,000 from Sheena Bright. In exchange, Smart Touch Learning issued common stock. It is common stock, but here it is not cash, it’s furniture. A+ Q+ Transaction 14 — Accrued Liability On December 15, Smart Touch Learning received a telephone bill for $100 and will pay this expense next month. Utility payable is a liability, but we have used the service so we have to recognize the expense, even though it’s 15th December and we are going to pay in January. This is an accrued liability A+ L+ Transaction 15 — Payment of Expense with Cash On December 15, Smart Touch Learning paid employee salaries of $1,200. Transaction 16 — Unearned Revenue On December 21, a law firm engages Smart Touch Learning to provide e-learning services and agrees to pay $600 in advance. But we can’t recognize the revenue because we haven’t provided the service yet. What do we credit? A promise to do something, a liability/obligation. Unearned revenue is tricky, it’s not a real revenue but a liability A+ L+ 33 Transaction 17 — Earning of Service Revenue for Cash On December 28, Smart Touch Learning collected cash of $8,000 for Service Revenue that the business earned by providing e-learning services for clients. A+ R+ The Ledger Accounts After Posting The exhibit shows Smart Touch Learning’s accounts after posting journal entries in November and December. Notice the total assets of $114,700 equals the total liabilities of $60,900 + equity of $53,800. 34 WHAT IS THE TRIAL BALANCE? A trial balance is a list of all ledger accounts with their balances at a point in time. It verifies the equality of DEBITS and CREDITS The asset accounts are listed first, followed by liabilities, and then equity. We want to verify the third property of accounts à ∑ all debit balances = ∑ all credit balances total debit is equal to total credit: the balance is right Balance = debit (left) – credit (right) à amount of cash at the end of the month But we need to make sure that the amounts are right. Adjustments are needed due to accrual accounting. 03. THE ADJUSTING PROCESS Learning objectives: 1. Differentiate between cash basis accounting and accrual basis accounting 2. Define and apply the time period concept, revenue recognition, and matching principles 3. Explain the purpose of and journalize and post adjusting entries 4. Explain the purpose of and prepare an adjusted trial balance 5. Identify the impact of adjusting entries on the financial statements 6. Explain the purpose of a worksheet and use it to prepare adjusting entries and the adjusted trial balance 7. Understand the alternative treatments of recording deferred expenses and deferred revenues (Appendix 3A) WHAT IS THE DIFFERENCE BETWEEN CASH BASIS ACCOUNTING AND ACCRUAL BASIS ACCOUNTING? CASH BASIS ACCOUNTING ACCRUAL BASIS ACCOUNTING Revenues are recorded when cash is received Revenues are recorded when earned Expenses are recorded when cash is paid Expenses are recorded when incurred Not allowed under GAAP (general accepted Used by most businesses accounting principles) Provides a better picture of a business’s Easier method to follow; requires less revenues and expenses knowledge of accounting concepts and principles 35 ACCRUAL BASIS ACCOUNTING: CONCEPTS and PRINCIPLES THE TIME PERIOD CONCEPT The time period concept assumes business activities are sliced into small time segments and that financial statements can be prepared for specific periods, such as a month, quarter, or year à it is just an assumption, the business doesn’t just stop working. A fiscal year is an accounting year of any 12 consecutive months that may or may not coincide with the calendar year à for ex. Apple closes the account in September, or a sky-firm: they cant close the account on 31st December, in the middle of the season THE REVENUE RECOGNITION PRINCIPLE The revenue recognition principle tells accountants when to record revenue and requires companies follow a five step process: Step 1: Identify the contract with the customer. A contract is an agreement between two or more parties that creates enforceable rights and obligations. Step 2: Identify the performance obligations in the contract. A performance obligation is a contractual promise with a customer to transfer a distinct good or service. Step 3: Determine the transaction price. The transaction price is the amount that the entity expects to be entitled to as a result of transferring goods or services to the customer. Step 4: Allocate the transaction price to the performance obligations in the contract. If the transaction has multiple performance obligations, the transaction price will need to be allocated among the different performance obligations. Step 5: Recognize revenue when (or as) the entity satisfies each performance obligation. - The business will recognize revenue when (or as) it satisfies each performance obligation by transferring a good or service to a customer. - A good or service is considered transferred when the customer obtains control of the good or service. - The amount of revenue recognized is the amount allocated to the satisfied performance obligation. Ex. Sometimes there are sales that combine more obligations à you buy a phone with phone plan included (= you buy the physical phone and the right to do calls, have internet..). Those are two different obligations: providing the item and providing the communication service. It is something particular, especially when you want to return the item because you don’t want it anymore. à If you sell an item, and you know that the customer can return this item, is the revenue recognized? THE MATCHING PRINCIPLE The matching principle guides accounting for expenses and ensures: - All expenses are recorded when they are incurred during the period. - Expenses are matched against the revenues of the period. The revenue is not an expectation about the future, you need to have an actual customer that will buy the item, even though you don’t need the money right now. The goal is to compute an accurate net income/net loss for the time period. We need to know how to recognize revenues ADJUSTING ENTRIES What are adjusting entries, and how do we record them? An unadjusted trial balance lists the revenues and expenses, but these amounts are incomplete because they omit various revenue and expense transactions. This is not sufficient for a financial statement 36 Adjusting entries are made at the end of the accounting period to record revenues to the period in which they are earned and expenses to the period in which they occur. - Adjusting entries also update asset and liability accounts, but not cash (because to update cash you need an actual transaction) - The two basic categories are deferrals and accruals. DEFERRALS ACCRUALS Defer the recognition of revenue or expense to a Record an expense before the cash is paid, or date after the cash is received or paid records revenue before the cash is received Two types of deferrals: Two types of accruals: 1. Deferred expenses 1. Accrued expenses 2. Deferred revenues 2. Accrued revenues The key is whether to determine if we used a resource or not. DEFERRED EXPENSES Deferred expenses are advance payments of future expenses (also called prepaid expenses). - They are assets, until you haven’t used them, those will generate a benefit in the future. - They are recognized as an expense by an adjusting journal entry when the prepayment is used Types of deferred expenses: 1. Prepaid rent à you have the right to use the asset, and that is an asset itself (you only have an expense when you use it) 2. Office supplies à you will have an expense when you will use it 3. Depreciation à if you buy equipment, those are assets. Their value will decline when you use them 1. Prepaid Rent (*) Smart Touch Learning prepaid three months’ office rent of $3,000 ($1,000 per month x 3 months) on December 1, 2018. We credit cash, but you debit an asset because you haven’t used them yet. At the end of December we are going to recognize the expense as 1000$ because we have used just one month à prepaid rent (asset) becomes 2000 (= -1000$). On February 28th (after 3 moths) the prepaid rent will be 0$. A+ A- Prepaid Rent has a $3,000 balance on Dec. 1 As of December 31, Prepaid Rent should be decreased for the amount that has been used up. 37  The adjusting entry transfers $1,000 ($3,000 * 1/3) from Prepaid Rent to Rent Expense. At the end of January, the E+ asset will expire (asset=0) A- After posting: this is not a transaction, it is an adjustment 2. Office Supplies On November 3, Smart Touch Learning purchased $500 of supplies on account. As of December 31, $100 of supplies remain on hand. Supplies are resources that you will use in the future (so this is an asset) Balance = amount bought – supplies used By lowering the value of the asset (from 500 to 100) you create an expense (400) Expenses are decreases in A and increases in L. The December 31 adjusting entry should be: E+ A- After posting: Deferred expenses are expenses that are recognized after the payment 3. Depreciation Property, plant, and equipment (PPE) represent long-lived, tangible assets used in the operations of the business. Anything that is going to be used for more than one year. Examples: Land, Buildings, Equipment We are going to determine the expense (and also the revenue that they generate) in each year of utilization. This is about how long can I use these assets before I have to change them, or for how long I’m going to use them à useful life of the assets 38  What is the easiest way to define the decreasing value of the asset? à we can say that the value is going to decline for the same amount every year. So you can just divide the value of the asset for the years that you are going to use them à straight line depreciation The allocation of plant asset’s cost over its useful life is called depreciation. It is the decrease in the value of the asset during a period. The adjusting entry records cost allocation to Depreciation Expense. Accounting for plant assets is similar to prepaid expenses. The expected value of a depreciable asset at the end of its useful life is called the residual value à at the and of the period, the asset’s value can’t be 0 The straight-line method allocates an equal amount of depreciation each year and is calculated as: (useful life is the period) The decision about useful life is up to you. It can depend on the business itself, about how they use it. Example 1 à replacing a car: a family replaces its car every 10 years, while a car-rental business will change cars every 2 years (it is a matter of business, people don’t want to rent an old car) Example 2: Equipment $10,000 (original cost) Useful life 5 yrs à depreciation charge (expense) = 10,000 – 1,000 / 5 = $ 1,800/year Residual value $1,000 Purchase: Dr equipment 10,000 Cr Cash 10,000 à then the expense that you are going to make will be called depreciation The adjustment will be lowering the value of the asset and recognizing the expense. !! it is not a cash expense, but the recognition of using an asset and so creating an expense On December 2, Smart Touch Learning received a contribution of furniture with a market value of $18,000 from Sheena Bright in exchange for shares of stock. After posting: A+ Q+ Smart Touch Learning believes the furniture will remain useful for five years and will have no value at the end of its life. The straight-line method is used for depreciation. (we calculate 1 month of depreciation because we bought the furniture on 2nd Dec.) 39 Adjusting entry: E+ CA+ = contra assets increase CA+ (bad news) furniture furniture 18,000 300 (1st month) 18,000 3600 (1st year) 17,700 (net value) 14,100 (net value) Accumulated depreciation is the total depreciation accumulated over the total years (300+3600) 𝑎𝑐𝑐𝑜𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑢𝑡𝑖𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 𝑔𝑟𝑎𝑑𝑒 = 𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑐𝑜𝑠𝑡 Utilization grade = acc. Depr. / original cost = 3900 / 18,000 = 22% We create a new account: Accumulated Depreciation. Acc. Depr. on furniture It is reported in the asset part, 300 (1st month) 3600 (1st year) in the credit side 3900 à now the net value can be seen as: original cost - Acc. Depr. on furniture à 18,000 – 3,900 = 14,100 Contra-asset It is not a liability, because we don’t owe anything to anyone, we already paid for the equipment, it is just a CONTRA-ASSET Balance sheet Furniture 18,000 - Acc depr. (300) Net value 17,700 Balance sheet YEAR 2 Furniture 18,000 Dr depr. Exp. 3600 - Acc depr. (3900) Cr. Accum. Depr. 3600. Net value 14,100 ACCUMULATED DEPRECIATION The Accumulated Depreciation account is the sum of all depreciation expense recorded for the depreciable asset to date. It is a contra asset. A contra account has two main characteristics: 1. It is paired with and is listed immediately after its related account in the chart of accounts and associated financial statement. 2. Its normal balance (debit or credit) is the opposite of the normal balance of the related account. 40 Example: Accumulated Depreciation—Furniture is the contra account that follows the Furniture account on the balance sheet. They have two different balances (Forniture: debit / AD: credit) Book value (net value of the asset) is a depreciable asset’s cost minus accumulated depreciation. Ex: Book value of Smart Touch Learning’s furniture on December 31: A.D. is shown as an adjustment ! Suppose that Smart Touch Learning purchased a building on December 1. The monthly depreciation is $250. The following adjusting entry would record depreciation for December: Partial balance sheet of STL: We don’t depreciate land because it doesn’t lose value because of its utilization. It can lose value for market reason, but not because you use it We depreciate the building but not land! à File: Brembo reports DEFERRED REVENUES - Unearned revenue - Occurs when a company receives cash before it does the work or delivers a product - Is a liability (obligation to perform the service/deliver the good) because the business owes the customer the product, the service, or a refund - Also called unearned revenue Upon performance or delivery, deferred revenue is converted to earned revenue. 41 Example: insurance à you pay in advance and you wait for the event to happen. What is the service that the insurance company is providing? The transfer of risk to another party Rent à they usually ask for 3 months in advance, in case that you ruin something (= caparra) Preorder of an album à this album will be released in a month, but you preorder it now On December 21, a law firm engages Smart Touch Learning to provide e-learning services for the next 30 days, paying $600 in advance. A+ L+ Sometimes the obligations are fulfilled just partially, so the revenue will be partial: During the last 10 days of the month, Smart Touch Learning will earn 1/3 of the revenue. Adjusting entry: We are settling the liability with L- R+ services After posting: We have a total service revenue account, we just add 200 to the other service revenues ACCRUED EXPENSES Accrued expenses are expenses a business has incurred but has not yet paid. Examples: – Salaries Expense à for ex. they work in October but they get paid in November – Interest Expense à if you borrow money today, you will pay the money back (and interests) tomorrow – Utilities Expense à electricity bill, first you use the energy and then you get the bill 1. Accrued Salaries Expense Smart Touch Learning pays its employee a monthly salary of $2,400 — half on the 15th and half on the first day of the next month (half on Dec. 15th and half on Jan. 1st ) During December, the company paid the first half-month salary on Thursday, December 15, and made this entry: E+ A- 42 Adjusting entry on December 31: After posting: E+ L+ The adjusting entry at December 31 creates a liability that will be paid on January 1. L- A- 2. Accrued Interest Expense On December 1, Smart Touch Learning purchased a $60,000 building in exchange for a one-year loan. The formula for computing the interest is as follows: (today 2% interest would be really good) The company must record an adjusting entry for the $100 of interest expense that has been incurred by December 31. After the adjusting entry posts, Interest Expense and Interest Payable now have the following correct balances: (Balance sheet) (Income statement) 43 ACCRUED REVENUES Accrued revenues arise when: - A company performs a service but has not yet collected cash - A company delivers a product but has not yet collected cash Record accrued revenues with a: Debit to Accounts Receivable / Credit to Service Revenue Smart Touch Learning is hired on December 15 to perform e-learning services, beginning on December 16. The business will earn $1,600 monthly and receive payment on January 15. As of December 31, $800 is earned. Adjusting entry: A+ R+ Smart Touch Learning’s account balances after posting the adjusting entry are: When Smart Touch Learning receives the payment on January 15, the business will record the following entry: A+ R+ Service revenue is for Jan. 1st A- Accounts receivable is for Dec. 15th (Prepaid rent *) à This method is called Perpetual method. The other option is Periodic method: Dec. 1 Prepaid rent Dr rent expense 3,000 2,000 Cr cash 3,000 Dec. 31 Rent expense Dr prepaid rent 2,000 3,000 2,000 Cr rent expense 2,000 1,000 44 Learning Objective 7 Understand the alternative treatment of recording deferred expenses and deferred revenues (Appendix 3A) WHAT IS AN ALTERNATIVE TREATMENT OF RECORDING DEFERRED EXPENSES AND DEFERRED REVENUES? Deferred Expenses Rather than record the prepayment of an expense as a current asset, record the prepayment as an expense on the date of payment. Deferred Expense Recorded Initially as an Expense The asset created by a deferred expense my be so short lived that it will expire in the current period. Thus, the accountant may decide to debit the prepayment to an expense account at the time of payment. The entry could, alternatively, be recorded as follows: E+ A- As of December 31, only one month’s prepayment has expired, leaving two months of rent still prepaid. In this case, the accountant must transfer two-thirds of the original prepayment of $3,000, or $2,000, to the asset account Prepaid Rent with an adjusting entry: (I need to make an adjustment) A+ E- This is an alternative method (periodic method), but there is the “standard/default” method à see deferred expenses – prepaid rent After posting, the two accounts appear as follows: Deferred Revenues Rather than record the early cash receipt from a customer as a current liability, record the cash receipt as a revenue on the date of receipt. For example, Smart Touch Learning is paid $600 in advance for monthly e-learning services on December 21. 45 Deferred Revenues Recorded Initially as a Revenue Another way to account for the receipt of cash is to credit a revenue account when the business receives cash: A- L- If the business then earns all the revenue within the same accounting period, no adjusting entry is needed. However, if the business earns only part of the revenue in that period, it must make an adjusting entry. For example, if Smart Touch Learning earned only $200, by December 31: R- L+ After posting, the total amount, $600, is properly divided between the liability account—$400, and the revenue account—$200, as follows: 46 Learning Objective 4 Explain the purpose of and prepare an adjusted trial balance WHAT IS THE PURPOSE OF THE ADJUSTED TRIAL BALANCE, AND HOW DO WE PREPARE IT? At the end of the fiscal period, an adjusted trial balance is prepared. An adjusted trial balance is a list of all the accounts with their adjusted balances. (these are just adjustments of preexisting transactions) The purpose is to ensure total debits equal total credits (Post = update the ledgers) The adjusted trial balance includes the balances after posting the adjusting journal entries. Financial statements are prepared from the adjusted trial balance We are going to use the adjustments written in the file to modify the ledgers (accounts with no balances are closed ) à file: adjusted trial balance Dec. 31 Dr supplies expense (E+) 1800 Dr insurance expense (E+) 620 Cr supplies (A- ) 1800 Cr prepaid insurance (A-) 620 Dr depreciation expense (E+) 460 Dr salary expense (E+) 310 Cr accumulated depreciation (CA+) 460 Cr salary payable (L+) 310 Dr unearned revenue (L-) 360 Cr service revenue (R+) 360 à first we make the adjustments, then we update the total balance 47 04. COMPLETING THE ACCOUNTING CYCLE Learning Objectives 1. Explain the purpose of, journalize, and post closing entries 2. Prepare the post-closing trial balance 3. Describe the accounting cycle 4. Prepare the financial statements including the classified balance sheet 5. Use the current ratio to evaluate business performance Learning Objective 1 Explain the purpose of, journalize, and post closing entries WHAT IS THE CLOSING PROCESS, AND HOW DO WE CLOSE THE ACCOUNTS? The closing process zeroes out all revenue and expense accounts in order to measure each period’s net income separately from all other periods. Temporary accounts relate to a particular accounting period and are closed at the end of that period. à Revenues, Expenses, Income Summary, and Dividends accounts. Permanent accounts are not closed at the end of the period, they are going to be continued in the next physical year. Its balance in the new year are going to be the same à Asset, Liability, Common Stock, and Retained Earnings accounts. Closing entries transfer revenues, expenses, and Dividends to Retained Earnings. à in the new year are going to be 0, they are restarted Revenues and expenses may be transferred first to an account titled Income Summary. Income Summary is a temporary account that summarizes the net income (or net loss) for the period. We have two accounts, A and B à we transfer the balance of A (debit) to the credit of B. We zero-out the account A, we transfer the balance to the account A à in this case account A are expenses and revenues, account B is the income summary. It will have its own balance. We close the income summary and we create the retained earnings account. We transfer the balance of the income summary into retained earnings (if they are negative, you put them into the credit side). Retained earnings is an account that can’t be closed, they are permanent! Then there are dividends, they have a debit balance (bc they are negative), we don’t close them in the income summary (they aren’t performances) and we transfer them into retained earnings 48 Closing Temporary Accounts—Net Income for the Period Step 1: Make the revenue accounts equal zero via the Income Summary account. Example: Smart Touch Learning has a $17,500 credit balance in Service Revenue. The closing entry would be: X Step 2: Make expense accounts equal zero via the Income Summary account. Example: Smart Touch Learning has a $3,000 debit balance in Rent Expense account. It will be closed with a credit to Rent Expense: (X means that the account is closed) X In a compound closing entry, each individual expense account is credited and the Income Summary account is debited for the total amount of expenses: The new Income Summary T-account after closing revenues and expenses is: à here we have a credit balance: the revenues are greater than the expenses, it is positive Step 3: Make the Income Summary account equal zero via the Retained Earnings account. Example: Smart Touch Learning’s $8,550 credit balance in the Income Summary account will be closed to Retained Earnings: Retained earnings have an initial balance of 0, we have to recognize that we have an income of 8550 Step 4: Make the Dividends account equal zero via the Retained Earnings account. Example: Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed to Retained Earnings: (Contra equity account) Contra equity account is an adjustment to the equity account, it decreases the equity (not an expense) Smart Touch Learning’s $5,000 debit balance in the Dividends account will be closed to Retained Earnings 49 Closing Temporary Accounts—Net Loss for the Period If a business had a net loss for the period, the closing entry to close the Income Summary account would be different. Example: If a business had a net loss of $2,000: Retained earnings can be negative, because of your negative performances Equity: Retained earnings Common stock 30,000 Beginning 2,000 Retained earnings (2,000) 6,000 net income Shareholder’s equity 28,000 4,000 ending balance à the equity in lower than the contribution, we generate a loss (to balance sheet) Closing Temporary Accounts— Summary All the accounts have a 0 balance, they are closed (they were not permanent ) 50 Learning Objective 4 Prepare the financial statements including the classified balance sheet HOW DO WE PREPARE FINANCIAL STATEMENTS? The financial statements: Income statement à Reports revenues and expenses and calculates net income or net loss for the period Statement of retained earnings à Shows how retained earnings changed during the period due to net income (or net loss) and dividends. Balance sheet à Reports assets, liabilities, and stockholders’ equity as of the last day of the period. The financial statements are prepared from the adjusted trial balance. Relationships Among the Financial Statements The financial statements relate to each other. - Net income or net loss from the income statement flows to the statement of retained earnings. - Ending Retained Earnings from the statement of retained earnings flows to the balance sheet. Net income flows to the statement of retained earnings. The ending Retained Earnings flows to the balance sheet. The ending value of Retained Earnings from the statement of retained earnings flows to the balance sheet. 51 CLASSIFIED BALANCE SHEET A classified balance sheet places each asset and each liability into a specific category. - Assets are shown in order of liquidity. - Liabilities are classified as current (due within one year) or long term (due after one year). LIQUIDITY measures how quickly and easily an account can be converted to cash. à in EU we classify first the least liquid and then the most liquid (last: cash) ASSETS Current assets will be converted to cash, sold, or used up during the next 12 months (or within the business’s operating cycle if the cycle is longer than a year) The operating cycle is the time span when 1. Cash is used to acquire goods and services. 2. These goods and services are sold to customers. 3. The business collects cash from customers. à inventory: they are considered short-term assets, in reality some inventories are kept for a long period, they are not going to be sold in the short-term. Long-term assets are all the assets that will not be converted to cash or used up within the business’s operating cycle or one year, whichever is greater. They are not just related to their sale, but also to their use (in a restaurant, the room in which we serve the customers) - Long-term Investments are investments in bonds or stocks that the company intends to hold for longer than one year. - Property, Plant, and Equipment are long-lived, tangible assets, used in the operation of a business. - Intangible Assets are assets with no physical form that are valuable because of the special rights carried (software, copyrights, patterns, logos..) LIABILITIES Current liabilities must be paid either with cash or with goods and services within one year or within the entity’s operating cycle. Examples: Accounts Payable, Salaries Payable, Unearned Revenue à typically they are not financial liabilities (debt), but they are operating liabilities Long-term liabilities are liabilities that do not need to be paid within one year or within the operating cycle. STOCKHOLDERS’ EQUITY Stockholders’ equity represents the stockholders’ claims to the assets of the business. - Reflects the stockholders’ contributions through common stock - Represents the amount of assets left over after the corporation has paid its liabilities Learning Objective 5 Use the current ratio to evaluate business performance HOW DO WE USE THE CURRENT RATIO TO EVALUATE BUSINESS PERFORMANCE? The current ratio measures a company’s ability to pay its current liabilities with its current assets. The ratio is computed as follows: A company prefers to have a high current ratio. Increases in current ratio indicates improvement in ability to pay debts. 52 Kohl’s had the following total current assets and current liabilities, found on the balance sheet. January 30, 2015: January 30, 2016: The decrease in current ratio from 2015 to 2016 indicates Kohl’s has deteriorated slightly in ability to pay current debts, even though they are both > 1, so they are both good. 05. MERCHANDISING OPERATIONS 1. Describe merchandising operations and the two types of merchandise inventory systems 2. Account for the purchase of merchandise inventory using a perpetual inventory system 3. Account for the sale of merchandise inventory using a perpetual inventory system 4. Adjust and close the accounts of a merchandising business 5. Prepare a merchandiser’s financial statements 6. Use the gross profit percentage to evaluate business performance 7. Account for the purchase and sale of merchandise inventory using a periodic inventory system (Appendix 5B) Learning Objective 1 Describe merchandising operations and the two types of merchandise inventory systems WHAT ARE MERCHANDISING OPERATIONS? MERCHANDISERS use resources such as: goods (which are an output for them, because they buy the product and they resell it to us), a shop, dependents, and above all an inventory (some goods in the wharehouse that are waiting to be sold) They are different from service-businesses, because they can store the items à ex. You can find out-of-season fruit in the stores thanks to merchandising operations A merchandiser is a business that sells merchandise, or goods, to customers. The merchandise that this type of business sells is called merchandise inventory. A wholesaler buys goods from a manufacturer and sells them to retailers. A retailer buys merchandise from manufacturers or a wholesaler and then sells the goods to consumers. Merchandisers need to have a tax-code (p.iva) 53  The Operating Cycle of a Merchandising Business The operating cycle: 1. It begins when the company purchases inventory from an individual or a business, called a vendor. 2. The company then sells the inventory to a customer. 3. Finally, the company collects cash from customers. The income statement of a merchandiser reports: - Sales Revenue rather than Service Revenue - The cost of merchandise sold to customers, called Cost of Goods Sold (COGS) à they use the historical cost - The difference between those two is the Gross Profit à Sales Revenue minus Cost of Goods Sold - Operating expenses, which are expenses other than Cost of Goods Sold FINANCIAL STATEMENTS: SERVICE COMPANY VS. MERCHANDISING COMPANY Service revenues Merchandising expenses: merchandise inventory! Operating expenses (= items you bought but haven’t sold yet) Labor Businesses need to determine the value of merchandise inventory on hand and the value sold. The two inventory accounting systems: o A periodic inventory system requires a physical count of inventory to determine inventory on hand. à update the inventory at the and of the period o A perpetual inventory system keeps a running computerized record of merchandise inventory. à more complex, we need a computer, but we have a real-time update about the inventory 54 Learning Objective 2 Account for the purchase of merchandise inventory using a perpetual inventory system HOW ARE PURCHASES OF MERCHANDISE INVENTORY RECORDED IN A PERPETUAL INVENTORY SYSTEM? The cycle of a merchandiser begins with the purchase of merchandise inventory. An invoice (or bills = fattura) is the sell