Introduction to Financial Accounting U.S. GAAP Adaptation PDF

Introduction to Financial Accounting U.S. GAAP Adaptation D. Annand & H. Dauderis Adapted by T. Jensen & D. Marchand A-D with Open Texts WITH OPEN TEXTS Open Texts and Editorial Support Digital access to our high-quality Access to our in-house support team texts is entirely FREE! All content is is available 7 days/week to provide reviewed and updated regularly by prompt resolution to both student and subject matter experts, and the texts instructor inquiries. In addition, we are adaptable; custom editions can work one-on-one with instructors to be produced by the Vretta-Lyryx provide a comprehensive system, cus- editorial team for those adopting tomized for their course. This can Vretta-Lyryx assessment. Access to include managing multiple sections, the original source files is also open assistance with preparing online to anyone! examinations, help with LMS integra- tion, and much more! 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Jensen, and Vre a-Lyryx. View the original text for free at https://lyryx.com/introduction-to-financial-accounting-usgaap/. Citation Use the informa on below to create a cita on: Author: H. Dauderis, D. Annand, D. Marchand, T. Jensen Publisher: Vre a-Lyryx Inc. Book tle: Introduc on to Financial Accoun ng: U.S. GAAP Adapta on Book version: 2021-A-D Publica on date: December 15, 2020 Loca on: Toronto, Ontario, Canada Book URL: https://lyryx.com/introduction-to-financial-accounting-usgaap/ For questions or comments please contact [email protected] Introduction to Financial Accounting U.S. GAAP Adaptation by D. Annand and H. Dauderis adapted by T. Jensen and D. Marchand Base Text Revision History: Distribution Version — Revision A-D 2021 A Front ma er has been updated including cover, Vre a-Lyryx with Open Texts, copyright, and re- vision pages. A ribu on page has been added. 2019 B Sec on 3.2 and Sec on 7.5: Interest calcula on uses 360-day year instead of 365-day year. Sec on 7.2: Pe y Cash and Cash accounts now reported separately on ﬁnancial statements. Sec on 12.2: Number of days of sales in inventory formula changed. Sec on 12.3: Return on total assets formula changed. 2019 A First edi on of the U.S. GAAP Adapta on. Table of Contents Table of Contents iii 1 Introduc on to Financial Accoun ng 1 Chapter 1 Learning Objec ves.............................. 1 Concept Self-Check.................................... 1 1.1 Accoun ng Deﬁned................................. 3 1.2 Business Organiza ons............................... 3 1.3 Generally Accepted Accoun ng Principles (GAAP)................. 5 1.4 Financial Statements................................ 8 1.5 Transac on Analysis and Double-entry Accoun ng................ 15 Summary of Chapter 1 Learning Objec ves........................ 23 2 The Accoun ng Process 25 Chapter 2 Learning Objec ves.............................. 25 Concept Self-Check.................................... 25 2.1 Accounts....................................... 26 2.2 Transac on Analysis Using Accounts........................ 31 2.3 The Trial Balance.................................. 38 2.4 Using Formal Accoun ng Records......................... 42 iii iv Table of Contents 2.5 The Accoun ng Cycle................................ 46 Summary of Chapter 2 Learning Objec ves........................ 47 3 Financial Accoun ng and Adjus ng Entries 51 Chapter 3 Learning Objec ves.............................. 51 Concept Self-Check.................................... 51 3.1 The Opera ng Cycle................................. 52 3.2 Adjus ng Entries.................................. 58 3.3 The Adjusted Trial Balance............................. 71 3.4 Using the Adjusted Trial Balance to Prepare Financial Statements......... 72 3.5 The Accoun ng Cycle................................ 76 3.6 The Closing Process................................. 77 Summary of Chapter 3 Learning Objec ves........................ 81 4 The Classiﬁed Balance Sheet and Related Disclosures 85 Chapter 4 Learning Objec ves.............................. 85 Concept Self-Check.................................... 85 4.1 Financial Statement Disclosure Decisions...................... 86 4.2 Classiﬁed Balance Sheet.............................. 88 4.3 Notes to Financial Statements........................... 92 4.4 Auditor’s Report................................... 95 4.5 Management’s Responsibility for Internal Control................. 97 Summary of Chapter 4 Learning Objec ves........................ 97 v 5 Accoun ng for the Sale of Goods 101 Chapter 5 Learning Objec ves.............................. 101 Concept Self-Check.................................... 101 5.1 The Basics of Merchandising............................ 103 5.2 The Purchase and Payment of Merchandise Inventory (Perpetual)........ 105 5.3 Merchandise Inventory: Sales and Collec on (Perpetual)............. 108 5.4 Adjustments to Merchandise Inventory (Perpetual)................ 111 5.5 Merchandising Income Statement......................... 115 5.6 Closing Entries for a Merchandiser......................... 117 5.7 Appendix A: The Periodic Inventory System.................... 117 Summary of Chapter 5 Learning Objec ves........................ 121 6 Assigning Costs to Merchandise 125 Chapter 6 Learning Objec ves.............................. 125 Concept Self-Check.................................... 125 6.1 Inventory Cos ng Methods............................. 126 6.2 Financial Statement Impact of Diﬀerent Inventory Cost Flows........... 142 6.3 Lower of Cost and Net Realizable Value (LCNRV) and Lower of Cost or Market (LCM) 144 6.4 Es ma ng the Balance in Merchandise Inventory................. 147 6.5 Appendix A: Ra o Analysis—Merchandise Inventory Turnover.......... 151 6.6 Appendix B: Inventory Cos ng Methods Under the Periodic System........ 152 Summary of Chapter 6 Learning Objec ves........................ 154 7 Cash and Receivables 157 vi Table of Contents Chapter 7 Learning Objec ves.............................. 157 Concept Self-Check.................................... 157 7.1 Internal Control................................... 158 7.2 Pe y Cash...................................... 160 7.3 Cash Collec ons and Payments........................... 163 7.4 Accounts Receivable................................ 172 7.5 Short-Term Notes Receivable............................ 180 7.6 Appendix A: Ra o Analysis—Acid Test....................... 182 7.7 Appendix B: Ra o Analysis—Accounts Receivable Turnover............ 183 Summary of Chapter 7 Learning Objec ves........................ 184 8 Long-lived Assets 187 Chapter 8 Learning Objec ves.............................. 187 Concept Self-Check.................................... 187 8.1 Establishing the Cost of Property, Plant, and Equipment (PPE)........... 188 8.2 Deprecia on..................................... 192 8.3 Par al Year Deprecia on.............................. 199 8.4 Revising Deprecia on................................ 199 8.5 Impairment of Long-lived Assets.......................... 201 8.6 Derecogni on of Property, Plant, and Equipment................. 202 8.7 Intangible Assets.................................. 206 8.8 Goodwill....................................... 209 8.9 Disclosure...................................... 209 vii Summary of Chapter 8 Learning Objec ves........................ 210 9 Debt Financing: Current and Long-term Liabili es 215 Chapter 9 Learning Objec ves.............................. 215 Concept Self-Check.................................... 215 9.1 Current versus Long-term Liabili es........................ 216 9.2 Known Current Liabili es.............................. 218 9.3 Es mated Current Liabili es............................ 220 9.4 Long-Term Liabili es—Bonds Payable....................... 223 9.5 Long-term Liabili es—Loans Payable........................ 231 9.6 Appendix A: Present Value Calcula ons...................... 233 9.7 Appendix B: Addi onal Payroll Transac ons.................... 236 9.8 Appendix C: The Eﬀec ve Interest Rate Method.................. 237 Summary of Chapter 9 Learning Objec ves........................ 242 10 Equity Financing 245 Chapter 10 Learning Objec ves.............................. 245 Concept Self-Check.................................... 245 10.1 The Corporate Structure.............................. 246 10.2 Recording Stock Transac ons............................ 252 10.3 Cash Dividends................................... 256 10.4 Stock Dividends................................... 260 10.5 Appendix A: Repor ng for Mul ple Classes of Stock................ 262 Summary of Chapter 10 Learning Objec ves....................... 263 viii Table of Contents 11 The Statement of Cash Flows 267 Chapter 11 Learning Objec ves.............................. 267 Concept Self-Check.................................... 267 11.1 Financial Statement Repor ng........................... 268 11.2 Preparing the Statement of Cash Flows....................... 269 11.3 Interpre ng the Statement of Cash Flows..................... 283 11.4 Appendix A: Pu ng It All Together: Corporate Financial Statements....... 285 Summary of Chapter 11 Learning Objec ves....................... 290 12 Financial Statement Analysis 293 Chapter 12 Learning Objec ves.............................. 293 Concept Self-Check.................................... 293 12.1 Introduc on to Ra o Analysis............................ 294 12.2 Liquidity Ra os: Analyzing Short-term Cash Needs................. 297 12.3 Proﬁtability Ra os: Analyzing Opera ng Ac vi es................. 305 12.4 Leverage Ra os: Analyzing Financial Structure................... 309 12.5 Market Ra os: Analysis of Financial Returns to Investors............. 312 12.6 Overall Analysis of Big Dog’s Financial Statements................. 315 12.7 Horizontal and Ver cal Trend Analysis....................... 315 Summary of Chapter 12 Learning Objec ves....................... 321 13 Proprietorships and Partnerships 323 Chapter 13 Learning Objec ves.............................. 323 Concept Self-Check.................................... 323 ix 13.1 Proprietorships................................... 324 13.2 Partnerships..................................... 329 Summary of Chapter 13 Learning Objec ves....................... 334 Chapter 1 Introduction to Financial Accounting Accoun ng involves a process of collec ng, recording, and repor ng a business’s economic ac- vi es to users. It is o en called the language of business because it uses a unique vocabulary to communicate informa on to decision makers. To understand accoun ng, we ﬁrst look at the basic forms of business organiza ons. The concepts and principles that provide the founda on for ﬁnancial accoun ng are then discussed. With an emphasis on the corporate form of business organiza on, we will examine how we communicate to users of ﬁnancial informa on using ﬁnan- cial statements. Finally, we will review how ﬁnancial transac ons are analyzed and then reported on ﬁnancial statements. Chapter Learning Objectives LO1 – Deﬁne accoun ng. LO2 – Iden fy and describe the forms of business organiza on. LO3 – Iden fy and explain the Generally Accepted Accoun ng Principles (GAAP). LO4 – Iden fy, explain, and prepare the ﬁnancial statements. LO5 – Analyze transac ons by using the accoun ng equa on. Concept Self-Check Use the following as a self-check while working through Chapter 1. 1. What is accoun ng? 2. What is the diﬀerence between internal and external users of accoun ng informa on? 3. What is the diﬀerence between managerial and ﬁnancial accoun ng? 4. What is the diﬀerence between a for-proﬁt business organiza on and a not-for-proﬁt busi- ness organiza on? 5. What are the three types of business organiza ons? 1 Introduction to Financial Accounting 6. What is a publicly held corpora on? A privately held corpora on? 7. What does the term limited liability mean? 8. Explain how ethics are involved in the prac ce of accoun ng. 9. Describe what GAAP refers to. 10. Iden fy and explain the six qualita ve characteris cs of GAAP. 11. Describe the accoun ng assump ons and principles that support the GAAP qualita ve char- acteris cs. 12. How is ﬁnancial informa on communicated to external users? 13. What are the four ﬁnancial statements? 14. Which ﬁnancial statement measures ﬁnancial performance? Financial posi on? 15. What informa on is provided in the statement of cash ﬂows? 16. Explain how retained earnings and dividends are related. 17. What are the three primary components of the balance sheet? 18. Equity consists of what two components? 19. How are assets ﬁnanced? 20. Iden fy and explain the three types of ac vi es a business engages in. 21. What are notes to the ﬁnancial statements? 22. What is the accoun ng equa on? 23. What are the dis nc ons among calendar, interim, and ﬁscal year ends? NOTE: The purpose of these ques ons is to prepare you for the concepts introduced in the chap- ter. Your goal should be to answer each of these ques ons as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check ques ons, go back through the content to ﬁnd the answer(s). Solu ons are not provided to these ques ons... Accounting Deﬁned. Accounting Deﬁned LO1 – Deﬁne Accoun ng is the process of iden fying, measuring, recording, and com- accoun ng. munica ng an organiza on’s economic ac vi es to users. Users need in- forma on for decision making. Internal users of accoun ng informa on work for the organiza on and are responsible for planning, organizing, and opera ng the en ty. The area of accoun ng known as managerial accoun ng serves the decision-making needs of internal users. External users do not work for the organiza on and include investors, creditors, labor unions, and customers. Financial accoun ng is the area of account- ing that focuses on external repor ng and mee ng the needs of external users. This book addresses ﬁnancial accoun ng. Managerial accoun ng is covered in other books.. Business Organizations LO2 – Iden fy An organiza on is a group of individuals who come together to pursue a and describe the common set of goals and objec ves. There are two basic types of business forms of business organiza ons: for-proﬁt and not-for-proﬁt. A for-proﬁt business organiza- organiza on. on sells products and/or services for proﬁt. A not-for-proﬁt business or- ganiza on serves charitable, religious, scien ﬁc or educa onal purposes. It exists to meet various societal needs and does not have proﬁt as a goal. Regardless of type, all businesses, record, report, and, most importantly, use accoun ng informa on for making decisions. This book focuses on for-proﬁt business organiza ons. There are three common forms of for-proﬁt business organiza ons — sole proprietorship, partnership, and corpora on. Sole Proprietorship A sole proprietorship is a business owned by one person. It is not a separate legal en ty, which means that the business and the owner are considered to be the same en ty. This means, for example, that from an income tax perspec ve, the proﬁts of a sole proprietorship are taxed as part of the owner’s personal income tax return. Unlimited liability is another characteris c of a sole proprietorship meaning that if the business could not pay its debts, the owner would be responsible even if the business’s debts were greater than the owner’s personal resources. Introduction to Financial Accounting Partnership A partnership is a business owned by two or more individuals. Like the sole proprietorship, it is not a separate legal en ty and its owners are typically subject to unlimited liability. Corporation A corpora on is a business owned by one or more owners. The owners are known as stockholders. A stockholder owns shares of stock in the corpora on. Shares of stock are units of ownership in a corpora on. For example, if a corpora on has 1,000 shares of stock, there may be three stockholders where one has 700 shares, another has 200 shares, and the third has 100 shares. The number of shares held by a stockholder represents how much of the corpora on they own. A corpora on can have diﬀerent types of shares; this topic is discussed in a later chapter. When there is only one type of share, it is usually called common stock. A corpora on’s stock can be privately held or available for public sale. A corpora on that holds its stock privately and does not sell them to the public is known as a privately held corpora on. Privately held corpora ons are also referred to as closely held corpora ons. A corpora on that sells its stock publicly, typically on a stock exchange, is called a publicly held corpora on. Publicly held corpora ons are also referred to as publicly traded corpora ons or issuers. Unlike the sole proprietorship and partnership, a corpora on is a separate legal en ty. This means, for example, that from an income tax perspec ve, a corpora on ﬁles its own tax return. The owners or stockholders of a corpora on are not responsible for the corpora on’s debts so have limited liability, meaning that the most they can lose is what they invested in the corpora on. In larger corpora ons, there can be many stockholders. In these cases, stockholders do not man- age a corpora on but par cipate indirectly through the elec on of a Board of Directors. The Board of Directors does not par cipate in the day-to-day management of the corpora on but delegates this responsibility to the oﬃcers of the corpora on. An example of this delega on of responsibility is illustrated in Figure 1.1... Generally Accepted Accounting Principles (GAAP) STOCKHOLDERS (Owners) Elect BOARD OF DIRECTORS (Represent Owners) Appoint VICE PRES. VICE PRES. VICE PRES. PRESIDENT MARKETING FINANCE PRODUCTION Figure 1.1: Generalized Form of a Corporate Organiza on Stockholders usually meet annually to elect a Board of Directors. The Board of Directors meets regularly to review the corpora on’s opera ons and to set policies for future opera ons. Unlike stockholders, directors can be held personally liable if a company fails. The focus of these chapters will be on the corporate form of business organiza on. The sole proprietorship and partnership organiza ons will be discussed in more detail in Chapter 13.. Generally Accepted Accounting Principles (GAAP) LO3 – Iden fy The goal of accoun ng is to ensure informa on provided to decision mak- and explain the ers is useful. To be useful, informa on must be relevant and faithfully rep- Generally Ac- resent a business’s economic ac vi es. This requires ethics, beliefs that cepted Account- help us diﬀeren ate right from wrong, in the applica on of underlying ac- ing Principles coun ng concepts or principles. These underlying accoun ng concepts or (GAAP). principles are known in the United States as Generally Accepted Account- ing Principles (GAAP). In 1934 Congress created the Securi es and Exchange Commission (SEC). The SEC was given broad powers to oversee the ﬁnancial markets and accoun ng standard-se ng bodies. The SEC recog- nizes the Financial Accoun ng Standards Board (FASB) as the designated accoun ng standard- se er for publicly held corpora ons. The SEC relies on FASB to develop the accoun ng standards that all publicly held corpora ons in the United States must follow. The oﬃcial pronouncements made by FASB are called Accoun ng Standards Codiﬁca on. These pronouncements are the sin- gle source of U.S. GAAP. Outside of the United States many countries have adopted Interna onal Financial Repor ng Standards (IFRS). IFRS are the accoun ng standards issued by the Interna- 6 Introduction to Financial Accounting onal Accoun ng Standards Board (IASB). The focus in this book will be on U.S. GAAP for publicly held corpora ons. Accoun ng prac ces are guided by GAAP which are comprised of qualita ve characteris cs. These characteris cs are intended to enhance decision usefulness of informa on. As already stated, relevance and faithful representa on are the primary qualita ve characteris cs. Comparability, veriﬁability, meliness, and understandability are enhancing qualita ve characteris cs. Informa on that possesses the quality of: relevance has the ability to make a diﬀerence in the decision-making process. faithful representa on is complete, neutral, and free from error. comparability tells users of the informa on that businesses u lize similar accoun ng prac- ces. veriﬁability means that others are able to conﬁrm that the informa on faithfully represents the economic ac vi es of the business. meliness is available to decision makers in me to be useful. understandability is clear and concise. Table 1.1 lists the four basic assump ons that underlie GAAP. Accoun ng Assump on Explana on/Example Economic En ty Assump on An assump on that all economic events can be iden ﬁed with a speciﬁc economic en ty. Requires a dis nc on between the economic ac vi es of the company and those of the owners. Example: A business owner keeps separate accoun ng records for business transac ons and for personal transac ons. Going Concern Assump on An assump on that a business will con nue to operate indeﬁ- nitely. Example: All indica ons are that Business X will con nue so it is reported to be a ’going concern’. Business Z is being sued for $20,000,000 and it is certain that it will lose. The $20,000,000 loss will force the business to close. Business Z must not only disclose the lawsuit but it must also indicate that there is a ’going concern’ issue... Generally Accepted Accounting Principles (GAAP) Accoun ng Assump on Explana on/Example Time Period Assump on An assump on that the economic life of a company can be divided into ar ﬁcial me periods for ﬁnancial repor ng. Example: Business X has selected March 31st as its ﬁscal year end. The business will report all ac vi es of the business to external users that cover the me period from April 1st to March 31st of the following year. Monetary Unit Assump on An assump on that the measurement used in repor ng to ex- ternal users is nominal units of money and that no adjustment for inﬂa on or deﬂa on is necessary. Example: Land was purchased in 1940 for $5,000. It is maintained in the accoun ng records at $5,000 and is not adjusted. Table 1.1: Accoun ng Assump ons Table 1.2 lists the basic recogni on, measurement, and disclosure principles that underlie GAAP. Accoun ng Principle Explana on/Example Revenue Recogni on Principle Requires that revenues be recorded when earned, which is not necessarily when cash is received. Example: A sale occurred on March 5. The customer received the product on March 5 but will pay for it on April 5. The business records the sale on March 5 when the sale occurred even though the cash is not received un l April 5. Matching Principle Requires that expenses be reported when incurred, which is not necessarily when cash has been paid. Some mes referred to as the expense recogni on principle. Example: Supplies were purchased March 15 for $700. They will be recorded as an asset on March 15 and expensed as they are used. Historical Cost Principle Requires that each economic transac on be recorded and based on the acquisi on (original) cost. Example: The business purchases a delivery truck ad- ver sed for $75,000 and pays $70,000. The truck must be recorded at the cost of $70,000, the amount actually paid. 8 Introduction to Financial Accounting Accoun ng Principle Explana on/Example Full Disclosure Principle Requires that accoun ng informa on communicate suﬃcient informa on to allow users to make knowledgeable decisions. Example: A business is applying to the bank for a $1,000,000 loan. The business is being sued for $20,000,000 and it is certain that it will lose. The business must tell the bank about the lawsuit even though the lawsuit has not yet been ﬁnalized. Table 1.2: Accoun ng Principles Note: Some of the assump ons and principles discussed above may be challenging to understand because related concepts have not yet been introduced. Therefore, most of these assump ons and principles will be discussed again in more detail in a later chapter.. Financial Statements LO4 – Iden fy, Recall that ﬁnancial accoun ng focuses on communica ng informa on to explain, and pre- external users. That informa on is communicated using ﬁnancial state- pare the ﬁnancial ments. There are four ﬁnancial statements: the income statement, state- statements. ment of stockholders’ equity, balance sheet, and statement of cash ﬂows. Each of these is introduced in the following sec ons using an example based on a ﬁc ous corporate organiza on called Big Dog Carworks Corp. The Income Statement An income statement communicates informa on about a business’s ﬁnancial performance by summarizing revenues less expenses over a period of me. Revenues are created when a business provides products or services to a customer in exchange for assets. Assets are resources result- ing from past events and from which future economic beneﬁts are expected to result. Examples of assets include cash, equipment, and supplies. Assets will be discussed in more detail later in this chapter. Expenses are the assets that have been used up or the obliga ons incurred in the course of earning revenues. When revenues are greater than expenses, the diﬀerence is called net income or proﬁt. When expenses are greater than revenue, a net loss results. Consider the following income statement of Big Dog Carworks Corp. (BDCC). This business was started on January 1, 2015 by Bob “Big Dog” Baldwin in order to repair automobiles. At January 31, the income statement shows total revenues of $10,000 and various expenses to-.. Financial Statements taling $7,800. Net income, the diﬀerence between $10,000 of revenues and $7,800 of expenses, equals $2,200. The heading shows the Big Dog Carworks Corp. name of the en ty, Income Statement the type of ﬁnancial For the Month Ended January 31, 2015 statement, and the period-in- me date. Revenues Repair revenues $10,000 Expenses Rent expense $1,600 Salaries expense 3,500 Supplies expense 2,000 Fuel expense 700 Total expenses 7,800 The net income is transferred to Net income $2,200 the statement of stockholders’ equity. The Statement of Stockholders’ Equity The statement of stockholders’ equity provides informa on about how the balances in common stock and retained earnings changed during the period. Common stock is a heading in the stock- holders’ equity sec on of the balance sheet and represents how much stockholders have invested. When stockholders buy shares, they are inves ng in the business. The number of shares they purchase will determine how much of the corpora on they own. The type of ownership unit purchased by Big Dog’s stockholders is known as common stock. Other types of shares will be dis- cussed in a later chapter. When a corpora on sells its shares, the corpora on is said to be issuing shares. In the statement of stockholders’ equity shown below, common stock and retained earnings bal- ances at January 1 are zero because the corpora on started the business on that date. During Jan- uary, common stock of $10,000 was issued to stockholders so the January 31 balance is $10,000. Retained earnings is the sum of all net incomes earned by a corpora on over its life, less any distribu ons of these net incomes to stockholders. Distribu ons of net income to stockholders are called dividends. Stockholders generally have the right to share in dividends according to the percentage of their ownership interest. To demonstrate the concept of retained earnings, recall that Big Dog has been in business for one month in which $2,200 of net income was reported. Addi onally, $200 of dividends were distributed, so these are subtracted from retained earnings. Big Dog’s retained earnings were therefore $2,000 at January 31, 2015 as shown in the statement of stockholders’ equity below. Introduction to Financial Accounting The heading shows the Big Dog Carworks Corp. name of the en ty, Statement of Stockholders’ Equity the type of ﬁnancial For the Month Ended January 31, 2015 statement, and the period-in- me date. Common Retained Total Stock Earnings Equity Opening balance $ -0- $ -0- $ -0- Stock issued 10,000 10,000 Net income 2,200 2,200 Dividends (200) (200) Ending balance $10,000 $2,000 $12,000 These totals are transferred to the balance sheet at Jan- uary 31, 2015. To demonstrate how retained earnings would appear in the next accoun ng period, let’s assume that Big Dog reported a net income of $5,000 for February, 2015 and dividends of $1,000 were given to the stockholder. Based on this informa on, retained earnings at the end of February would be $6,000, calculated as the $2,000 January 31 balance plus the $5,000 February net income less the $1,000 February dividend. The balance in retained earnings con nues to change over me because of addi onal net incomes/losses and dividends. The Balance Sheet The balance sheet, or statement of ﬁnancial posi on, shows a business’s assets, liabili es, and equity at a point in me. The balance sheet of Big Dog Carworks Corp. at January 31, 2015 is shown below... Financial Statements Big Dog Carworks Corp. The heading shows the name of Balance Sheet the en ty, the type of ﬁnancial statement, and the point-in- me At January 31, 2015 date. Assets Liabili es Cash $ 3,700 Accounts payable $ 700 Accounts receivable 2,000 Unearned revenue 400 Prepaid insurance 2,400 Notes payable 6,000 Equipment 3,000 Total liabili es $ 7,100 Truck 8,000 Equity Common stock $10,000 Retained earnings 2,000 Total equity 12,000 Total assets $19,100 Total liabili es and equity $19,100 Total assets ($19,100 here) always equal Total liabili es ($7,100) plus Equity ($12,000). What Is an Asset? Assets are economic resources that provide future beneﬁts to the business. Examples include cash, accounts receivable, prepaid expenses, equipment, and trucks. Cash is coins and currency, usually held in a bank account, and is a ﬁnancial resource with future beneﬁt because of its pur- chasing power. Accounts receivable represent amounts to be collected in cash in the future for goods sold or services provided to customers on credit. Prepaid expenses are assets that are paid in cash in advance and have beneﬁts that apply over future periods. For example, a one-year in- surance policy purchased for cash on January 1, 2015 will provide a beneﬁt un l December 31, 2015 so is a prepaid asset. The equipment and truck were purchased on January 1, 2015 and will provide beneﬁts for 2015 and beyond so are assets. What Is a Liability? A liability is an obliga on to pay an asset in the future. For example, Big Dog’s bank loan represents an obliga on to repay cash in the future to the bank. Accounts payable are obliga ons to pay a creditor for goods purchased or services rendered. A creditor owns the right to receive payment from an individual or business. Unearned revenue represents an advance payment of cash from a customer for Big Dog’s services or products to be provided in the future. For example, Big Dog collected cash from a customer in advance for a repair to be done in the future. Introduction to Financial Accounting What Is Equity? Equity represents the net assets owned by the owners (the stockholders). Net assets are assets minus liabili es. For example, in Big Dog’s January 31 balance sheet, net assets are $12,000, cal- culated as total assets of $19,100 minus total liabili es of $7,100. This means that although there are $19,100 of assets, only $12,000 are owned by the stockholders and the balance, $7,100, are ﬁnanced by debt. No ce that net assets and total equity are the same value; both are $12,000. Equity consists of common stock and retained earnings. Common stock represents how much the stockholders have invested in the business. Retained earnings is the sum of all net incomes earned by a corpora on over its life, less any dividends distributed to stockholders. In summary, the balance sheet is represented by the equa on: Assets = Liabili es + Equity. As- sets are the investments held by a business. The liabili es and equity explain how the assets have been ﬁnanced, or funded. Assets can be ﬁnanced through liabili es, also known as debt, or eq- uity. Equity represents amounts that are owned by the owners, the stockholders, and consists of common stock and retained earnings. Investments made by stockholders, namely common stock, are used to ﬁnance assets and/or pay down liabili es. Addi onally, retained earnings, comprised of net income less any dividends, also represent a source of ﬁnancing. The Statement of Cash Flows (SCF) Cash is an asset reported on the balance sheet. Ensuring there is suﬃcient cash to pay expenses and liabili es as they come due is a cri cal business ac vity. The statement of cash ﬂows (SCF) explains how the balance in cash changed over a period of me by detailing the sources (inﬂows) and uses (ou lows) of cash by type of ac vity: opera ng, inves ng, and ﬁnancing, as these are the three types of ac vi es a business engages in. Opera ng ac vi es are the day-to-day ac v- i es involved in selling products and/or services to generate net income. Examples of opera ng ac vi es include the purchase and use of supplies, paying employees, fueling equipment, and ren ng space for the business. Inves ng ac vi es are the buying of assets needed to generate revenues. For example, when an airline purchases airplanes, it is inves ng in assets required to help it generate revenue. Financing ac vi es are the raising of money needed to invest in assets. Financing can involve issuing common stock (receiving cash or other assets in exchange for stock in the corpora on) or borrowing. Figure 1.2 summarizes the interrela onships among the three types of business ac vi es... Financial Statements Cash ﬂows result- Opera ng Cash ﬂows resul ng ing from opera ng Ac vi es from opera ng ac vi es can be ac vi es can be reinvested in (creates net used to pay down income) Inves ng Financing Ac vi es Ac vi es (buys assets to (raises money to generate revenues) Cash ﬂows resul ng invest in assets) from ﬁnancing ac vi es can be used to buy assets Figure 1.2: Rela onships Among the Three Types of Business Ac vi es The statement of cash ﬂows for Big Dog is shown below. Introduction to Financial Accounting The heading shows Big Dog Carworks Corp. the name of the en- Statement of Cash Flows ty, the type of ﬁnan- cial statement, and For the Month Ended January 31, 2015 the period-in- me date. Opera ng ac vi es: Net income $ 2,200 Adjustments: Increase in accounts receivable (2,000) Increase in prepaid insurance (2,400) Increase in accounts payable 700 Increase in unearned revenues 400 Net cash used by opera ng ac vi es $(1,100) Inves ng ac vi es: Purchase of equipment $(3,000) Purchase of truck (3,000) Net cash used by inves ng ac vi es (6,000) Financing ac vi es: Issued shares of stock $10,000 Borrowed from bank 3,000 Payment on bank loan (2,000) Paid dividends (200) Net cash provided by ﬁnancing ac vi es 10,800 Net increase in cash 3,700 Cash balance, January 1 -0- Cash balance, January 31 $3,700 This agrees with the Cash amount shown on the Balance Sheet at January 31, 2015. The statement of cash ﬂows is useful because cash is one of the most important assets of a corpo- ra on. Informa on about expected future cash ﬂows are therefore important for decision makers. For instance, Big Dog’s bank manager needs to determine whether the remaining $6,000 loan can be repaid, and also whether or not to grant a new loan to the corpora on if requested. The state- ment of cash ﬂows helps inform those who make these decisions. Notes to the Financial Statements An essen al part of ﬁnancial statements are the notes that accompany them. These notes are generally located at the end of a set of ﬁnancial statements. The notes provide greater detail about various amounts shown in the ﬁnancial statements, or provide non-quan ta ve informa on that is useful to users. For example, a note may indicate the es mated useful lives of long-lived assets, or loan repayment terms. Examples of note disclosures will be provided later... Transaction Analysis and Double-entry Accounting. Transaction Analysis and Double-entry Accounting LO5 – Analyze The accoun ng equa on is founda onal to accoun ng. It shows that the transac ons total assets of a business must always equal the total claims against those by using the assets by creditors and owners. The equa on is expressed as: accoun ng equa on. ASSETS = LIABILITIES + EQUITY (economic resources (creditors’ claims (owners’ claims owned by an en ty) on assets) on assets) When ﬁnancial transac ons are recorded, combined eﬀects on assets, liabili es, and equity are always exactly oﬀse ng. This is the reason that the balance sheet always balances. Each economic exchange is referred to as a ﬁnancial transac on — for example, when an orga- niza on exchanges cash for land and buildings. Incurring a liability in return for an asset is also a ﬁnancial transac on. Instead of paying cash for land and buildings, an organiza on may borrow money from a ﬁnancial ins tu on. The company must repay this with cash payments in the fu- ture. The accoun ng equa on provides a system for processing and summarizing these sorts of transac ons. Accountants view ﬁnancial transac ons as economic events that change components within the accoun ng equa on. These changes are usually triggered by informa on contained in source documents (such as sales invoices and bills from creditors) that can be veriﬁed for accuracy. The accoun ng equa on can be expanded to include all the items listed on the Balance Sheet of Big Dog at January 31, 2015, as follows: ASSETS = LIABILITIES + EQUITY Cash + Accounts + Prepaid + Equipment + Truck = Accounts + Unearned + Notes + Common + Retained Receivable Insurance Payable Revenue Payable Stock Earnings If one item within the accoun ng equa on is changed, then another item must also be changed to balance it. In this way, the equality of the equa on is maintained. For example, if there is an increase in an asset account, then there must be a decrease in another asset or a corresponding increase in a liability or equity account. This equality is the essence of double-entry accoun ng. The equa on itself always remains in balance a er each transac on. The opera on of double- entry accoun ng is illustrated in the following sec on, which shows 10 transac ons of Big Dog Carworks Corp. for January 2015. 6 Introduction to Financial Accounting Eﬀect on the Accoun ng Equa on Transac on Number Date Descrip on of Transac on ASSETS = LIABILITIES + EQUITY 1 Jan.1 Big Dog Carworks Corp. issued 1,000 shares to Bob Baldwin, the owner or shareholder, for $10,000 cash. The asset Cash is increased while the equity item Common stock is also increased. The impact on the equa on is: CASH +10,000 COMMON STOCK +10,000 2 Jan.2 Big Dog Carworks Corp. borrowed $3,000 from the bank and de- posited the cash into the business’s bank account. The asset Cash is increased and the liability Notes payable is also in- creased. The impact on the equa- on is: CASH +3,000 NOTES PAYABLE +3,000 3 Jan.2 The corpora on purchased $3,000 of equipment for cash. There is an increase of the asset Equipment and a decrease to an- other asset, Cash. The impact on the equa on is: EQUIPMENT +3,000 CASH -3,000 4 Jan.2 The corpora on purchased a tow truck for $8,000, paying $3,000 cash and incurring an addi onal bank loan for the balance. The asset Cash is decreased while the asset Truck is increased and the liability Notes payable is also in- creased. The impact on the equa- on is: CASH -3,000 TRUCK +8,000 NOTES PAYABLE +5,000.. Transaction Analysis and Double-entry Accounting Eﬀect on the Accoun ng Equa on Transac on Number Date Descrip on of Transac on ASSETS = LIABILITIES + EQUITY 5 Jan.5 Big Dog Carworks Corp. paid $2,400 for a one-year insurance policy, ef- fec ve January 1. Here the asset Prepaid Insurance is increased and the asset Cash is de- creased. The impact on the equa- on is: PREPAID INSURANCE +2,400 CASH -2,400 Since the one-year period will not be fully used at January 31 when ﬁnancial statements are prepared, the insurance cost is considered to be an asset at the payment date. The transac on does not aﬀect lia- bili es or equity. 6 Jan.10 The corpora on paid $2,000 cash to the bank to reduce the loan out- standing. The asset Cash is decreased and there is a decrease in the liability Notes payable. The impact on the equa on is: NOTES PAYABLE -2,000 CASH -2,000 7 Jan.15 The corpora on received $400 as an advance payment from a cus- tomer for services to be performed over the next two months as fol- lows: $300 for February, $100 for March. The asset Cash is increased by $400 and a liability, Unearned revenue, is also increased since the revenue will not be earned by the end of Jan- uary. It will be earned when the work is performed in later months. At January 31, these amounts are repayable to customers if the work is not done (and thus a liability). The impact on the equa on is: CASH +400 UNEARNED REVENUE +400 8 Introduction to Financial Accounting Eﬀect on the Accoun ng Equa on Transac on Number Date Descrip on of Transac on ASSETS = LIABILITIES + EQUITY 8 Jan.20 Automobile repairs of $10,000 were made for a customer; $8,000 of repairs were paid in cash and $2,000 of repairs will be paid in the future. Cash and Accounts receivable as- sets of the corpora on increase. The repairs are a revenue; rev- enue causes an increase in net in- come and an increase in net income causes an increase in equity. The impact on the equa on is: CASH +8,000 ACCOUNTS RECEIVABLE +2,000 REPAIR REVENUE +10,000 This ac vity increases assets and net income. 9 Jan.31 The corpora on paid opera ng ex- penses for the month as follows: $1,600 for rent; $3,500 for salaries; and $2,000 for supplies expense. The $700 for truck opera ng ex- penses (e.g., oil, gas) was on credit. There is a decrease in the asset Cash. Expenses cause net income to decrease and a decrease in net income causes equity to decrease. There is an increase in the liability Accounts payable. The impact on the equa on is: RENT EXPENSE -1,600 SALARIES EXPENSE -3,500 SUPPLIES EXPENSE -2,000 TRUCK OPERATING EXPENSE -700 CASH -7,100 ACCOUNTS PAYABLE +700 10 Jan.31 Dividends of $200 were paid in cash to the only shareholder, Bob Bald- win. Dividends cause retained earnings to decrease. A decrease in retained earnings will decrease equity. The impact on the equa on is: DIVIDENDS -200 CASH -200 These various transac ons can be recorded in the expanded accoun ng equa on as shown below: ASSETS = LIABILITIES + EQUITY Trans. Cash + Acc. + Prepaid + Equip. + Truck = Acc. + Unearned + Notes + Common + Retained Rec. Insur. Pay. Revenue Pay. Stock Earnings 1. +10,000 +10,000 2. +3,000 +3,000 3. -3,000 +3,000.. Transaction Analysis and Double-entry Accounting 4. -3,000 +8,000 +5,000 5. -2,400 +2,400 6. -2,000 -2,000 7. +400 +400 8. +8,000 +2,000 +10,000 9. -7,100 +700 -1,600 These numbers are used to pre- -3,500 pare the Income -2,000 Statement. -700 10. -200 -200 3,700 + 2,000 + 2,400 + 3,000 + 8,000 = 700 + 400 + 6,000 + 10,000 + 2,000 Figure 1.3: Transac ons Worksheet for January 31, 2015 Transac ons in these columns are used to prepare the Statement of Shareholders’ Eq- uity. Column totals are used to prepare the Balance Sheet. ASSETS = $19,100 LIABILITIES + EQUITY = $19,100 Introduction to Financial Accounting Transac ons summary: 1. Issued common stock for $10,000 cash. 2. Received a bank loan for $3,000. 3. Purchased equipment for $3,000 cash. 4. Purchased a truck for $8,000; paid $3,000 cash and incurred a bank loan for the balance. 5. Paid $2,400 for a comprehensive one-year insurance policy eﬀec ve January 1. 6. Paid $2,000 cash to reduce the bank loan. 7. Received $400 as an advance payment for repair services to be provided over the next two months as follows: $300 for February, $100 for March. 8. Performed repairs for $8,000 cash and $2,000 on credit. 9. Paid a total of $7,100 for opera ng expenses incurred during the month; also incurred an expense on account for $700. 10. Dividends of $200 were paid in cash to the only stockholder, Bob Baldwin. The transac ons summarized in Figure 1.3 were used to prepare the ﬁnancial statements de- scribed earlier, and reproduced in Figure 1.4 below... Transaction Analysis and Double-entry Accounting Big Dog Carworks Corp. Big Dog Carworks Corp. Balance Sheet Income Statement At January 31, 2015 For the Month Ended January 31, 2015 Assets Cash $ 3,700 Accounts receivable 2,000 Prepaid insurance 2,400 Equipment 3,000 Truck 8,000 Revenue $19,100 Repairs $10,000 Liabili es Expenses Accounts payable $ 700 Rent $ 1,600 Unearned revenue 400 Salaries 3,500 Notes payable 6,000 7,100 Supplies 2,000 Truck opera on 700 Equity Total expenses 7,800 Common stock $10,000 Retained earnings 2,000 Net income $2,200 12,000 $19,100 The components of Net Income be- equity are shown on comes part of Re- the Balance Sheet. Big Dog Carworks Corp. tained Earnings. Statement of Stockholders’ Equity For the Month Ended January 31, 2015 Common Retained Total Stock Earnings Equity Opening balance $ -0- $ -0- $ -0- Shares issued 10,000 10,000 Net income 2,200 2,200 Dividends (200) (200) Ending balance $10,000 $2,000 $12,000 Figure 1.4: Financial Statements of Big Dog Carworks Corp. Accounting Time Periods Financial statements are prepared at regular intervals — usually monthly or quarterly — and at the end of each 12-month period. This 12-month period is called the ﬁscal year. The ming of the ﬁnancial statements is determined by the needs of management and other users of the ﬁnancial statements. For instance, ﬁnancial statements may also be required by outside par es, Introduction to Financial Accounting such as bankers and stockholders. However, accoun ng informa on must possess the qualita ve characteris c of meliness — it must be available to decision makers in me to be useful — which is typically a minimum of once every 12 months. Accoun ng reports, called the annual ﬁnancial statements, are prepared at the end of each 12- month period, which is known as the year-end of the en ty. Some companies’ year-ends do not follow the calendar year (year ending December 31). This may be done so that the ﬁscal year coincides with their natural year. A natural year ends when business opera ons are at a low point. For example, a ski resort may have a ﬁscal year ending in late spring or early summer when business opera ons have ceased for the season. Corpora ons listed on stock exchanges are generally required to prepare interim ﬁnancial state- ments, usually every three months, primarily for the use of stockholders or creditors. Because these types of corpora ons are large and usually have many owners, users require more up-to- date ﬁnancial informa on. The rela onship of the interim and year-end ﬁnancial statements is illustrated in Figure 1.5. Jan. 1, 2015 Jan. 31, 2015 Dec. 31, 2015 (commencement (interim) (ﬁscal year end) of opera ons) INTERIM INCOME INTERIM YEAR STATEMENT BALANCE END INTERIM STATE- SHEET BALANCE MENT OF STOCK- (prepared SHEET HOLDERS’ EQUITY on this (prepared date) on this INTERIM STATEMENT date) OF CASH FLOWS (for the month of January) These may be prepared. YEAR END INCOME STATEMENT YEAR END STATEMENT OF STOCKHOLDERS’ EQUITY YEAR END STATEMENT OF CASH FLOWS These must be prepared. Figure 1.5: Rela onship of Interim and Year-end Financial Statements Summary of Chapter Learning Objectives Summary of Chapter Learning Objectives LO – Deﬁne accounting. Accoun ng is the process of iden fying, measuring, recording, and communica ng an organiza- on’s economic ac vi es to users for decision making. Internal users work for the organiza on while external users do not. Managerial accoun ng serves the decision-making needs of internal users. Financial accoun ng focuses on external repor ng to meet the needs of external users. LO – Identify and describe the forms of business organization. The three forms of business organiza ons are a sole proprietorship, partnership, and corpora on. The following chart summarizes the key characteris cs of each form of business organiza on. Characteris c Sole Proprietorship Partnership Corpora on Separate legal en ty No No Yes Business income is taxed as part of the No1 No2 Yes business Unlimited liability Yes Yes No One owner permi ed Yes No Yes3 Board of Directors No No Yes LO – Identify and explain the Generally Accepted Accounting Principles (GAAP). GAAP are the accoun ng standards that govern ﬁnancial accoun ng and repor ng. GAAP must be followed in the United States when a company distributes its ﬁnancial statements to external users. LO – Identify, explain, and prepare the ﬁnancial statements. The four ﬁnancial statements are: income statement, statement of stockholders’ equity, balance sheet, and statement of cash ﬂows. The income statement reports ﬁnancial performance by de- tailing revenues less expenses to arrive at net income/loss for the period. The statement of stock- 1 Business income is added to the owner’s personal income and the owner pays tax on the sum of the two. 2 Business income is added to the owner’s personal income and the owner pays tax on the sum of the two. 3 A corpora on can have one or more owners. Introduction to Financial Accounting holders’ equity shows the changes during the period to each of the components of equity: com- mon stock and retained earnings. The balance sheet iden ﬁes ﬁnancial posi on at a point in me by lis ng assets, liabili es, and equity. Finally, the statement of cash ﬂows details the sources and uses of cash during the period based on the three business ac vi es: opera ng, inves ng, and ﬁnancing. LO – Analyze transactions by using the accounting equation. The accoun ng equa on, A = L + E, describes the asset investments (the le side of the equa- on) and the liabili es and equity that ﬁnanced the assets (the right side of the equa on). The accoun ng equa on provides a system for processing and summarizing ﬁnancial transac ons re- sul ng from a business’s ac vi es. A ﬁnancial transac on is an economic exchange between two par es that impacts the accoun ng equa on. The equa on must always balance. Vretta-Lyryx Online and Text Exercises! Vre a-Lyryx oﬀers forma ve online exercises! The educa onal so ware captures instructors’ experience using algorithms to analyze and evaluate students’ work, iden fying common errors and providing personalized feedback. Students are encouraged to try these randomized problems repeatedly, learning from their mistakes un l mastery. Vre a-Lyryx also oﬀers end-of-chapter exercises for Vre a-Lyryx users. Visit us at https://lyryx.com to register and access Vretta-Lyryx exercises! Chapter 2 The Accounting Process Chapter 2 looks more closely at asset, liability, and equity accounts and how they are aﬀected by double-entry accoun ng, namely, debits and credits. The transac ons introduced in Chapter 1 for Big Dog Carworks Corp. are used to explain debit and credit analysis. The prepara on of a trial balance will be introduced. Addi onally, this chapter will demonstrate how transac ons are recorded in a general journal and posted to a general ledger. Finally, the concept of the accoun ng cycle is presented. Chapter Learning Objectives LO1 – Describe asset, liability, and equity accounts, iden fying the eﬀect of debits and cred- its on each. LO2 – Analyze transac ons using double-entry accoun ng. LO3 – Prepare a trial balance and explain its use. LO4 – Record transac ons in a general journal and post in a general ledger. LO5 – Deﬁne the accoun ng cycle. Concept Self-Check Use the following as a self-check while working through Chapter 2. 1. What is an asset? 2. What is a liability? 3. What are the diﬀerent types of equity accounts? 4. What is retained earnings? 5. How are retained earnings and revenues related? 6. Why are T-accounts used in accoun ng? 25 6 The Accounting Process 7. How do debits and credits impact the T-account? 8. What is a chart of accounts? 9. Are increases in equity recorded as a debit or credit? 10. Are decreases in equity recorded as a debit or credit? 11. Does issuing shares and revenues cause equity to increase or decrease? 12. Are increases in the common stock account recorded as a debit or credit? 13. Are increases in revenue accounts recorded as debits or credits? 14. Do dividends and expenses cause equity to increase or decrease? 15. Are increases in the dividend account recorded as a debit or credit? 16. Are increases in expense accounts recorded as debits or credits? 17. How is a trial balance useful? 18. What is the diﬀerence between a general journal and a general ledger? 19. Explain the pos ng process. 20. What is the accoun ng cycle? NOTE: The purpose of these ques ons is to prepare you for the concepts introduced in the chap- ter. Your goal should be to answer each of these ques ons as you read through the chapter. If, when you complete the chapter, you are unable to answer one or more the Concept Self-Check ques ons, go back through the content to ﬁnd the answer(s). Solu ons are not provided to these ques ons.. Accounts LO1 – Describe Chapter 1 reviewed the analysis of ﬁnancial transac ons and the resul ng asset, liabil- impact on the accoun ng equa on. We now expand that discussion by ity, and equity introducing the way transac on is recorded in an account. An account accounts, iden - accumulates detailed informa on regarding the increases and decreases fying the eﬀect in a speciﬁc asset, liability, or equity item. Accounts are maintained in of debits and a ledger also referred to as the books. We now review and expand our credits on each. understanding of asset, liability, and equity accounts... Accounts Asset Accounts Recall that assets are resources that have future economic beneﬁts for the business. The primary purpose of assets is that they be used in day-to-day opera ng ac vi es in order to generate rev- enue either directly or indirectly. A separate account is established for each asset. Examples of asset accounts are reviewed below. Cash has future purchasing power. Coins, currency, checks, and bank account balances are examples of cash. Accounts receivable occur when products or services are sold on account or on credit. When a sale occurs on account or on credit, the customer has not paid cash but promises to pay in the future. Notes receivable are a promise to pay an amount on a speciﬁc future date plus a predeter- mined amount of interest. Oﬃce supplies are supplies to be used in the future. If the supplies are used before the end of the accoun ng period, they are an expense instead of an asset. Merchandise inventory are items to be sold in the future. Prepaid insurance represents an amount paid in advance for insurance. The prepaid insur- ance will be used in the future. Prepaid rent represents an amount paid in advance for rent. The prepaid rent will be used in the future. Land cost must be in a separate account from any building that might be on the land. Land is used over future periods. Buildings indirectly help a business generate revenue over future accoun ng periods since they provide space for day-to-day opera ng ac vi es. Liability Accounts As explained in Chapter 1, a liability is an obliga on to pay for an asset in the future. The primary purpose of liabili es is to ﬁnance inves ng ac vi es that include the purchase of assets like land, buildings, and equipment. Liabili es are also used to ﬁnance opera ng ac vi es involving, for example, accounts payable, unearned revenues, and wages payable. A separate account is created for each liability. Examples of liability accounts are reviewed below. Accounts payable are debts owed to creditors for goods purchased or services received as a result of day-to-day opera ng ac vi es. An example of a service received on credit might be a plumber billing the business for a repair. 8 The Accounting Process Wages payable are wages owed to employees for work performed. Short-term notes payable are a debt owed to a bank or other creditor that is normally paid within one year. Notes payable are diﬀerent than accounts payable in that notes involve interest. Long-term notes payable are a debt owed to a bank or other creditor that is normally paid beyond one year. Like short-term notes, long-term notes involve interest. Unearned revenues are payments received in advance of the product or service being pro- vided. In other words, the business owes a customer the product/service. Equity Accounts Chapter 1 explained that equity represents the net assets owned by the owners of a business. In a corpora on, the owners are called stockholders. Equity is tradi onally one of the more challeng- ing concepts to understand in introductory ﬁnancial accoun ng. The diﬃculty stems from there being diﬀerent types of equity accounts: common stock, retained earnings, dividends, revenues, and expenses. Common stock represents the investments made by owners into the business and causes equity to increase. Retained earnings is the sum of all net incomes earned over the life of the corpora on to date, less any dividends distributed to stockholders over the same me pe- riod. Therefore, the Retained Earnings account includes revenues, which cause equity to increase, along with expenses and dividends, which cause equity to decrease. Figure 2.1 summarizes equity accounts. EQUITY Retained Common Stock Earnings Dividends Revenues Expenses Recall that revenues less expenses equals net in- come/net loss. Net income/net loss is not an ac- count but is the result of subtrac ng expenses from revenues. Figure 2.1: Composi on of Equity Accounts.. Accounts T-accounts A simpliﬁed account, called a T-account, is o en used as a teaching/learning tool to show increases and decreases in an account. It is called a T-account because it resembles the le er T. As shown in the T-account below, the le side records debit entries and the right side records credit entries. Account Name Debit Credit (always on le ) (always on right) The type of account determines whether an increase or a decrease in a par cular transac on is represented by a debit or credit. For ﬁnancial transac ons that aﬀect assets, dividends, and expenses, increases are recorded by debits and decreases by credits. This guideline is shown in the following T-account. Assets, Dividends, Expenses Debits are Credits are always always increases decreases For ﬁnancial transac ons that aﬀect liabili es, common stock, and revenues, increases are recorded by credits and decreases by debits, as follows: Liabili es, Revenues, Common Stock Debits are Credits are always always decreases increases Another way to illustrate the debit and credit rules is based on the accoun ng equa on. Remem- ber that dividends, expenses, revenues, and common stock are equity accounts. The Accounting Process Assets = Liabili es + Equity Increases are recorded as: Debits Credits Credits1 Decreases are recorded as: Credits Debits Debits2 The following summary shows how debits and credits are used to record increases and decreases in various types of accounts. ASSETS LIABILITIES DIVIDENDS COMMON STOCK EXPENSES REVENUE Increases are DEBITED. Increases are CREDITED. Decreases are CREDITED. Decreases are DEBITED. This summary will be used in a later sec on to illustrate the recording of debits and credits regard- ing the transac ons of Big Dog Carworks Corp. introduced in Chapter 1. The account balance is determined by adding and subtrac ng the increases and decreases in an account. Two assumed examples are presented below. Cash Accounts Payable 10,000 3,000 700 5,000 3,000 3,000 400 2,400 4,300 Balance 8,000 2,000 7,100 200 Balance 3,700 The $3,700 debit balance in the Cash account was calculated by adding all the debits and subtract- ing the sum of the credits. The $3,700 is recorded on the debit side of the T-account because the debits are greater than the credits. In Accounts Payable, the balance is a $4,300 credit calculated by subtrac ng the debits from the credits. No ce that Cash shows a debit balance while Accounts Payable shows a credit balance. The Cash account is an asset so its normal balance is a debit. A normal balance is the side on which increases occur. Accounts Payable is a liability and because liabili es increase with credits, the normal bal- ance in Accounts Payable is a credit as shown in the T-account above. 1 Revenues and the issuance of common stock are equity accounts. They cause equity to increase so increases in these account types are recorded as credits. 2 Expenses, and Dividends are equity accounts. They cause equity to decrease. Decreases in equity are always recorded as debits so as expenses and dividends are realized, they are debited... Transaction Analysis Using Accounts Chart of Accounts A business will create a list of accounts called a chart of accounts where each account is assigned both a name and a number. A common prac ce is to have the accounts arranged in a manner that is compa ble with the order of their use in ﬁnancial statements. For instance, Asset accounts begin with the digit ‘1’, Liability accounts with the digit ‘2’. Each business will have a unique chart of accounts that corresponds to its speciﬁc needs. Big Dog Carworks Corp. uses the following numbering system for its accounts: 100-199 Asset accounts 200-299 Liability accounts 300-399 Common stock, retained earnings, and dividend accounts 500-599 Revenue accounts 600-699 Expense accounts. Transaction Analysis Using Accounts LO2 – Analyze In Chapter 1, transac ons for Big Dog Carworks Corp. were analyzed to de- transac ons us- termine the change in each item of the accoun ng equa on. In this next ing double-entry sec on, these same transac ons will be used to demonstrate double-entry accoun ng. accoun ng. Double-entry accoun ng means each transac on is recorded in at least two accounts where the total debits ALWAYS equal the total credits. As a result of double-entry accoun ng, the sum of all the debit balance accounts in the ledger must equal the sum of all the credit bal- ance accounts. The rule that debits = credits is rooted in the accoun ng equa on: ASSETS = LIABILITIES + EQUITY3 Increases are: Debits Credits Credits Decreases are: Credits Debits Debits Illustrative Problem—Double-Entry Accounting and the Use of Accounts In this sec on, the following debit and credit summary will be used to record the transac ons of Big Dog Carworks Corp. into T-accounts. 3 The issuance of common stock and revenues cause equity to increase; as indicated above, increases in equity are recorded as credits. Dividends and expenses cause equity to decrease; decreases in equity are recorded as debits. The Accounting Process ASSETS LIABILITIES DIVIDENDS COMMON STOCK EXPENSES REVENUE Increases are DEBITED. Increases are CREDITED. Decreases are CREDITED. Decreases are DEBITED. Transac on 1 Jan. 1 – Big Dog Carworks Corp. issued 1,000 shares to Bob Baldwin, a stockholder, for a total of $10,000 cash. Analysis: Cash Debit: An asset account, Cash, is increased resul ng in a debit. 10,000 Common Stock Credit: Common Stock, an equity account, is increased resul ng in a credit.* 10,000 *Note: An alternate analysis would be that the issuance of shares causes equity to increase and increases in equity are always recorded as a credit. Transac on 2 Jan. 2 – Borrowed $3,000 from the bank. Analysis: Cash Debit: An asset account, Cash, is increased resul ng in a debit. 3,000 Notes Payable Credit: A liability account, Notes Payable, is increased resul ng in a credit. 3,000 Transac on 3 Jan. 3 – Equipment is purchased for $3,000 cash. Analysis:.. Transaction Analysis Using Accounts Equipment Debit: One asset is acquired in exchange for another asset. An asset account, Equipment, is increased resul ng in a debit. 3,000 Cash Credit: The account, Cash, also an asset, is decreased resul ng in a credit. 3,000 Transac on 4 Jan. 3 – A truck was purchased for $8,000; Big Dog paid $3,000 cash and incurred a $5,000 bank loan for the balance. Analysis: Truck Debit: An asset account, Truck, is increased resul ng in a debit. 8,000 Cash Credit: An asset account, Cash, is decreased resul ng in a credit. 3,000 Notes Payable Credit: A liability account, Notes Payable, is increased resul ng in a credit. 5,000 Note: Transac on 4 involves one debit and two credits. No ce that the total debit of $8,000 equals the total credits of $8,000 which sa sﬁes the double-entry accoun ng rule requiring that debits ALWAYS equal credits. Transac on 5 Jan. 5 – Big Dog Carworks Corp. paid $2,400 cash for a one-year insurance policy, eﬀec ve January 1. Analysis: Prepaid Insurance Debit: An asset account, Prepaid Insurance, is increased resul ng in a debit. Because the insurance provides future beneﬁt, it is recorded as an asset un l it is used. 2,400 Cash Credit: Payment of the insurance results in a decrease in the asset account, Cash, resul ng in a credit. 2,400 The Accounting Process Transac on 6 Jan. 10 – The corpora on paid $2,000 cash to reduce the bank loan. Analysis: Notes Payable Debit: This payment decreases the liability, Notes Payable, resul ng in a debit. 2,000 Cash Credit: The payment also decreases the asset, Cash, resul ng in a credit. 2,000 Transac on 7 Jan. 15 – The corpora on received an advance payment of $400 for repair services to be per- formed as follows: $300 in February and $100 in March. Analysis: Cash Debit: An asset, Cash, is increased at the me the cash is received resul ng in a debit. 400 Unearned Repair Revenue Credit: Since the revenue rela ng to this cash receipt is not earned as of this date, a liability account, Unearned Repair Revenue, is credited because Big Dog ‘owes’ the customer $400 of work. 400 Transac on 8 Jan. 31 – A total of $10,000 of automo ve repair services is performed for a customer who paid $8,000 cash. The remaining $2,000 will be paid in 30 days. Analysis:.. Transaction Analysis Using Accounts Cash Debit: An asset, Cash, is increased resul ng in a debit. 8,000 Accounts Receivable Debit: An asset, Accounts Receivable, is increased resul ng in a debit. 2,000 Repair Revenue Credit: An equity, Repair Revenue, is increased resul ng in a credit. 10,000 Transac on 9 Jan. 31 – Opera ng expenses of $7,100 were paid in cash: Rent expense, $1,600; salaries expense, $3,500; and supplies expense of $2,000. $700 for truck opera ng expenses (e.g., oil, gas) were incurred on credit. Analysis: Rent Expense Debit: This transac on increases four expense accounts resul ng in a debit to each. 1,600 Salaries Expense 3,500 Supplies Expense 2,000 Truck Opera ng Expense 700 Note: Each expense is recorded in an individual account. Cash Credit: An asset, Cash, is decreased resul ng in a credit. 7,100 Accounts Payable Credit: A liability, Accounts Payable, is increased resul ng in a credit. 700 Transac on 10 6 The Accounting Process Jan. 31 – Dividends of $200 were paid in cash to the only stockholder, Bob Baldwin. Analysis: Dividends Debit: Dividends, an equity account, is increased resul ng in a debit. 200 Note: An alternate analysis would be that dividends cause equity to decrease and that decreases in equity are always recorded as a debit. Cash Credit: An asset, Cash is decreased resul ng in a credit. 200 A er the January transac ons of Big Dog Carworks Corp. have been recorded in the T-accounts, each account is totaled and the diﬀerence between the debit balance and the credit balance is calculated, as shown in the following diagram. The numbers in parentheses refer to the transac- on numbers used in the preceding sec on. To prove that the accoun ng equa on is in balance, the account balances for each of assets, liabili es, and equity are added. No ce that total assets of $19,100 equal the sum of total liabili es of $7,100 plus equity of $12,000. ASSETS LIABILITIES EQUITY Cash Notes Payable Common Stock Dividends Repair Revenue (1) 10,000 (3) 3,000 (6) 2,000 (2) 3,000 (1) 10,000 (10) 200 (8) 10,000 (2) 3,000 (4) 3,000 (4) 5,000 (7) 400 (5) 2,400 (8) 8,000 (6) 2,000 Bal. 6,000 (9) 7,100 (10) 200 Accounts Payable Rent Expense Bal. 3,700 (9) 700 (9) 1,600 Accounts Receivable Unearned Repair Revenue Salaries Expense.. Transaction Analysis Using Accounts (8) 2,000 (7) 400 (9) 3,500 Prepaid Insurance Supplies Expense (5) 2,400 (9) 2,000 Equipment (3) 3,000 Truck Opera on Expense (9) 700 Truck (4) 8,000 19,1001 = 7,1002 + 12,0003 1. 3,700 + 2,000 + 2,400 + 3,000 + 8,000 = 19,100 2. 6,000 + 700 + 400 = 7,100 3. 10,000 - 200 + 10,000 - 1,600 - 3,500 - 2,000 - 700 = 12,000 8 The Accounting Process. The Trial Balance LO3 – Prepare a To help prove that the accoun ng equa on is in balance, a trial balance trial balance and is normally prepared instead of the T-account lis ng shown in the previ- explain its use. ous sec on. A trial balance is an internal report that lists all the account balances at a point in me. The total debits must equal total credits on the trial balance. The form and content of a trial balance is illustrated be- low, using the account numbers, account names, and account balances of Big Dog Carworks Corp. at January 31, 2

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