Chapter 1: Learning Objectives
1.
Identify the forms of business organization and the uses of accounting information.
2.
Explain the three principle types of business activity.
3.
Describe the four financial statements and how they are prepared.
4.
Describe the impact of international accounting standards on U.S. financial reporting.
Study Guide:
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Sole proprietorship - a business owned by one person (Examples include hair salons,
auto repair shops, and free-lance editors)
o Advantages
 Simple to establish
 Owner controlled
 Tax advantages that are more favorable than a corporation
o Disadvantages
 Proprietor personally liable for all business debts
 Financing may be difficult to transfer of ownership may be difficult
Partnership - a business owned by two or more people (Examples include retail and
service type businesses including professional practices (lawyers, doctors, etc.)
o Advantages:
 simple to establish
 shared control
 broader skills and resources o tax advantages that are more favorable than
a corporation
o Disadvantages:
 partners personally liable for all business debts o transfer of ownership
may be difficult
Corporation - a separate legal entity owned by stockholders (Examples include CocaCola, Exxon-Mobil, General Motors, Citigroup, and Microsoft)
o Advantages:
 easier to transfer ownership
 easier to raise funds
 no personal liability for stockholders
o Disadvantages:
 unfavorable tax treatment resulting in higher taxes paid by stockholders
 The emphasis of this text is the corporate form of business. The purpose of
financial information is to provide inputs for decision making.
Accounting ( def ) is the information system that identifies, records, and communicates
the economic events of an organization to interested users.
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The users of accounting information fall into two groups:
o internal users and external users.
o Internal users - users within the organization may ask
 Marketing What price will maximize the company’s net income?
 Human Resources Can we afford to give employees pay raises this year?
 Finance Is cash sufficient to pay dividends to stockholders?
 Management Which product line is most profitable? What should be
eliminated? 
o External users - users who are outside the organization and questions they may
ask:
 Investors (current and potential) Is the company earning satisfactory
income? How does the company compare in size and profitability with
competitors? Should I buy, sell, or hold this stock?
 Creditors (suppliers and bankers) Will the company be able to pay its
debts as they come due? How risky is this company?
 IRS, SEC, FTC, labor unions, customers Is the company complying
with rules and regulations? Is the company properly paying its taxes? Can
the company afford to pay increased wage and salaries? Will the company
be able to stand behind its warranties?
o Ethics in financial reporting (How would you like to do business or invest in a
business if you couldn’t trust their financial statements?)
 In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to reduce
unethical corporate behavior and decrease the likelihood of future
corporate scandals. As a result of SOX:
 Top management must now certify the accuracy of financial
information
 The penalties for fraudulent financial activity are much more
severe
 There is now increased independence of the outside auditor who
review the accuracy of corporate financial statements o Increased
the oversight role of boards of directors.
 Effective financial reporting depends on sound ethical behavior.
 Steps for solving ethical dilemmas:
 1. Recognize an ethical situation and the ethical issues involved.
 2. Identify and analyze the principal elements in the situation.
 3. Identify the alternatives and weigh the impact of each alternative
on various stakeholders.
Explain the Three Principal Types of Business Activity:
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All businesses are involved in three types of activity. The accounting information system
keeps track of the results of each of these activities.
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Financing activities: Cash is often obtained from outside sources to start or expand a
business.
o The two primary sources are:
 Borrowing from creditors which creates liabilities
 bank loan (note payable)
 debt securities (bonds payable)
 goods on credit from suppliers (accounts payable)
o Issuing ownership interests in the corporation to investors (selling common stock
to shareholders)
o In addition, financing activities include using cash to pay dividends to
stockholders.
Investing activities – Cash raised through financing activities is used for investing in
resources (assets) needed to operate the business (i.e., land, buildings, delivery trucks,
equipment, computers, furniture, etc.).
Operating activities: Once a business has the assets it needs to get started, it begins its
operations. Operating activities involve revenue and expenses.
o Revenue is the increase in assets resulting from the sale of goods or the
performance of services, Sources of revenue common to many businesses are
sales revenue, service revenue, and interest revenue. Assets that result from
operating activities include supplies, inventory, and accounts receivable.
o Expenses are the cost of assets consumed or services used in generating revenues
– Expenses take their name from the type of asset consumed or service used. Cost
of goods sold, selling expenses, marketing expenses, administrative expenses,
interest expense, and income taxes are common types of expenses.
o The related liabilities created include accounts payable, wages payable, interest
payable, sales taxes payable, and income taxes payable
Learning Objective 3 - Describe the Four Financial Statements and how They are
Prepared.
Accounting information is communicated through four different financial statements:
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Income Statement:
o Reports the success or failure of the company’s operations for a period of time.
o Summarizes all revenue and expenses for period—month, quarter, or year.
o If revenues exceed expenses, the result is a net income.
o If expenses exceed revenue, the result is a (net loss).
o Dividends are payments to the stockholders and are not expenses.
o Amounts received from issuing stock or obtaining loans are not revenues.
Retained Earnings Statement
o Reports the amount paid out in dividends and the amount of net income or net
loss for a specific period of time.
o Shows changes in the retained earnings balance during period covered by
statement.
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o Ending retained earnings represents net income since the inception of the business
that has not been paid out as dividends.
Balance Sheet
o Shows the relationship between assets and claims on assets which include
liabilities (claims of the creditors) and stockholders’ equity (claims of the
owners) at a specific point in time..
o Assets and claims (liabilities and stockholders’ equity) must balance.
o The basic accounting equation;
 Assets = Liabilities + Stockholders’ Equity.
o The accounting equation is just that. It is an equation. The components can be
moved in the same way the components of an algebraic equation can be moved.
o Assets - resources owned by the business (things of value)
o Liabilities - creditors claims on total assets (obligations or debts of the business)
o Stockholders’ Equity - ownership claim on total asset
Statement of Cash Flows
o Provides information about cash receipts and cash payments for a specific period
of time.
o Reports the cash effects of a company’s operations for a period of time.
o Shows cash increases and decreases from investing and financing activities.
o Indicates the increase or decrease in cash as well as the ending cash balance.
o Provides answers to three important questions:
 Where did the cash come from during the period?
 How was cash used during the period?
 What was the change in the cash balance during the period?
Interrelationship of Statements
o Retained earnings statement uses the results of the income statement.
o Balance sheet and retained earnings statement are also interrelated.
o The retained earnings amount on the balance sheet is the ending amount on the
retained earnings statement.
o Statement of cash flows relates to balance sheet information. It shows how the
Cash account changed during the period.
Publicly traded U.S. Companies that are must provide shareholders with an annual report which
always includes financial statements. In addition, the annual report includes the following
information:
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Management Discussion and Analysis - covers three aspects of a company:
o Its ability to pay near-term obligations
o Its ability to fund operations and expansion
o Its results of operations
Notes to the Financial Statements
o Clarify information presented in the financial statements
o Provide additional detail (i.e. Describe accounting policies or explain
uncertainties and contingencies)
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Auditor’s Report
o An auditor, a CPA, conducts an independent examination of the company’s
financial statements.
o The auditor gives an opinion if the financial statements provide a fair
representation of the firm’s financial position and results of operations in
accordance with generally accepted accounting principles. If they do, the auditor
expresses an unqualified opinion.
o If the auditor doesn’t express an unqualified opinion, users of the financial
statements are skeptical that the statements give an accurate picture of the firm’s
financial health.
IFRS International Financial Reporting Standards
Learning Objective 4 – Describe the impact of international accounting standards on U.S.
financial reporting.
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Most agree that there is a need for one set of international accounting standards. Here is
why:
o Multinational corporations.
 Today’s companies view the entire world as their market.
 For example, Coca-Cola, Intel, and McDonald’s generate more than 50%
of their sales outside the United States, and many foreign companies, such
as Toyota, Nestle, and Sony, find their largest market to be the United
States.
o Mergers and acquisitions.
 The mergers between Fiat/Chrysler and Vodafone/Mannesmann suggest
that we will see even more such business combinations in the future.
o Information technology.
 As communication barriers continue to topple through advances in
technology, companies and individuals in different countries and markets
are becoming more comfortable buying and selling goods and services
from one another.
o Financial markets.
 Financial markets are of international significance today. Whether it is
currency, equity securities (stocks), bonds, or derivatives, there are active
markets throughout the world trading these types of instruments.
o KEY POINTS Following are the key similarities and differences between GAAP
and IFRS as related to accounting fundamentals.
o Similarities
 The basic techniques for recording business transactions are the same for
the U.S. and international companies.
 Both international and U.S. accounting standards emphasize transparency
in financial reporting.
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Both sets of standards are primarily driven by meeting the needs of
investors and creditors.
 The three most common forms of business organizations, proprietorships,
partnerships, and corporations, are also found in countries that use
international accounting standards.
o Differences
 International standards are referred to as International Financial Reporting
Standards (IFRS), developed by the International accounting Standards
Board. Accounting standards in the United States are referred to as
generally accepted accounting principles (GAAP) and are developed by
the Financial Accounting Standards Board .
 IFRS tends to be simpler in its accounting and disclosure requirements;
some people say it is more “principles-based”. GAAP is more detailed;
some people say it is more “rules-based”.
 The internal control standards applicable to Sarbanes-Oxley (SOX) apply
only to large public companies listed on U.S. exchanges. There is
continuing debate as to whether non-U.S. companies should have to
comply with this extra layer of regulation.
LOOKING TO THE FUTURE Both the IASB and the FASB are hard at work
developing standards that will lead to the elimination of major differences in the way
certain transactions are accounted for and reported
INTERRELATIONSHIPS OF STATEMENTS
Net income from the income statement is added to beginning retained earnings to determine
ending retained earnings.
Ending retained earnings (reported on the retained earnings statement) is also reported on the
balance sheet.
The ending amount of cash shown on the statement of cash flows must agree with the amount of
cash on the balance sheet
Preferred Stock
Preferred Stock---Preferred stock has contractual provisions that give it preference or priority
over common stock. Preferred stockholders have a priority in relation to:
(1) dividends
(2) assets in the event of liquidation.
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Preferred stockholders sometimes do not have voting rights.
Dividend Preferences---Preferred stockholders have the right to share in the distribution of
corporate income before common stockholders.
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If the dividend rate of preferred stock is $5 per share, common shareholders will not receive
any dividends in the current year until preferred stockholders have received $5 per share.
The first claim to dividends does not guarantee dividends.
Dividends depend on factors such as adequate retained earnings and availability of cash.
For preferred stock, the per share dividend amount is stated as a percentage of the stock or
as a specified amount.
Cumulative Dividend---Preferred stock contracts often contain a cumulative dividend feature.
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If preferred stock is cumulative, preferred stockholders must be paid both current-year
dividends and any unpaid prior-year dividends before common stockholders receive
dividends.
When preferred stock is cumulative, preferred dividends not declared in a given period are
called dividends in arrears.
CHAPTER 2:
Identify the Sections of a Classified Balance Sheet.
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Companies often group similar assets and similar liabilities together using standard
classifications and sections.
The groupings help users determine:
o (1) whether the company has enough assets to pay its debts
o (2) what claims by short-and long-term creditors exist on the company’s total
assets
 Current Assets
o Assets that are expected to be converted to cash or used up in the business within
one year or one operating cycle whichever is longer.
 Examples of current assets: cash, short-term investments (which include
shortterm U.S. government securities), receivables (accounts receivable,
notes receivable, and interest receivable), inventories, and prepaid
expenses (rent, supplies, insurance, and advertising).
o On the balance sheet, current assets are listed in the order in which they are
expected to be converted into cash (order of liquidity).
o Some companies use a period longer than one year to classify assets and liabilities
as current because they have an operating cycle longer than one year. The
operating cycle of a company is the average time required to go from cash to cash
in producing revenue-buy inventory, sell it, and collect the cash from the
customers.
Long-Term Investments
o Assets that can be converted into cash, but whose conversion is not expected
within one year.
o These include long-term assets not currently used in the company’s operations
(i.e., land, buildings, etc.) and investments in stocks and bonds of other
corporations.
Property, Plant, and Equipment
o Assets with relatively long useful lives.
o Assets currently used in operating the business.
o Sometimes called fixed assets or plant assets.
 Examples include land, buildings, machinery, equipment, and furniture
and fixtures.
 Record these assets at cost and depreciate them (except land) over their
useful lives. The full purchase price is not expensed in the year of
purchase because the assets will be used for more than one accounting
period.
o Depreciation is the practice of allocating the cost of assets to a number of years.
o Depreciation expense is the amount of the allocation for one accounting period.
o Accumulated depreciation is the total amount of depreciation that has been
expensed since the asset was placed in service.
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o Cost less accumulated depreciation is reported on the balance sheet.
Intangible Assets
o Noncurrent assets.
o Assets that have no physical substance.
o Examples are goodwill, patents, copyrights, and trademarks or trade names.
Current Liabilities
o Obligations that are to be paid within the coming year or operating cycle
whichever is longer.
o Common examples are notes payable, accounts payable, wages payable, bank
loans payable, interest payable, taxes payable, and current maturities of long-term
obligations.
o Within the current liabilities section, companies usually list notes payable first,
followed by accounts payable, and then the remaining items in the order of their
magnitude.
Long-Term Liabilities
o Obligations expected to be paid after one year.
o Liabilities in this category include bonds payable, mortgages payable, longterm
notes payable, lease liabilities, and pension liabilities.
o Many companies report long-term debt maturing after one year as a single amount
in the balance sheet and show the details of the debt in notes that accompany the
financial statements.
Stockholders’ Equity: Stockholders’ equity consists of two parts:
o Common Stock - investments of assets into the business by the stockholders.
o Retained Earnings - income retained for use in the business.
Learning Objective 2 – Use Ratios to Evaluate a Company’s Profitability, Liquidity, and
Solvency.
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Ratio analysis expresses the relationship among selected items of financial statement
data.
o A ratio expresses the mathematical relationship between one quantity and another.
o Ratios shed light on company performance
 Intracompany comparisons – covers two years for the same company
 Industry-average comparisons – based on average ratios for particular
industries o Intercompany comparisons – based on comparisons with a
competitor in the same industry.
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Using the Income Statement--Creditors and investors are interested in evaluating
profitability. Profitability is frequently used as a test of management’s effectiveness. To
supplement an evaluation of the income statement, ratio analysis is used.
o Profitability ratios - measure the operating success of a company for a given
period of time.
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o Earnings per share
 Is a profitability ratio that measures the net income earned on each share
of common stock.
 Is computed by dividing (net income less preferred dividends) by the
average number of common shares outstanding during the year.
 By comparing earnings per share of a single company over time, one can
evaluate its relative earnings performance on a per share basis.
 Comparisons of earnings per share across companies are not meaningful
because of the wide variations in numbers of shares of outstanding stock
among companies.
Using A Classified Balance Sheet--An analysis of the relationship between a company’s
assets and liabilities can provide users with information about the firm’s liquidity and
solvency.
o Liquidity - The ability to pay obligations expected to come due within the next
year or operating cycle. Two measures of liquidity include:
o Working capital
 Measure of short-term ability to pay obligations
 Excess of current assets over current liabilities
 Positive working capital (Current Assets > Current Liabilities) indicates
the likelihood for paying liabilities is favorable.
 Negative working capital (Current Liabilities > Current Assets) indicates
that a company might not be able to pay short-term creditors and may be
forced into bankruptcy.
o Current ratio
 Measure of short-term ability to pay obligations
 Computed by dividing current assets by current liabilities
 More dependable indicator of liquidity than working capital
 Does not take into account the composition of current assets (like
slowmoving inventory versus cash)
Solvency - The ability of a company to pay interest as it comes due and to repay the
balance of debt due at its maturity.
Solvency ratios include:
o Debt to Assets Ratio
o Measures the percentage of assets financed by creditors
o The higher the percentage of debt financing, the riskier the company.
o Computed by dividing total debt (both current and long-term liabilities) by total
assets
In the statement of cash flows, cash provided by operating activities indicates the cashgenerating capability of the company. However, cash provided by operating activities
fails to take into account that a company must invest in new property, plant, and
equipment and at least maintain dividends at current levels to satisfy investors.
o Free cash flow indicates a company’s ability to generate cash from operations
that is sufficient to pay debts, acquire assets, and distribute dividends.
o It describes the cash remaining from operations after adjusting for capital
expenditures and dividends.
o It is computed by subtracting capital expenditures and cash dividends from cash
provided by operations.
Learning Objective 3 – Discuss Financial Reporting Concepts.
 Generally Accepted Accounting Principles (GAAP) are a set of rules and practices that
provide answers to the following questions.
o How does a company decide on the type of financial information to disclose?
o What format should a company use?
o How should a company measure assets, liabilities, revenues, and expenses?
 The Securities and Exchange Commission (SEC) is a U.S. government agency that
oversees U.S. financial markets and accounting standard-setting bodies.
 The primary accounting standard-setting body in the U. S. is the Financial Accounting
Standards Board FASB).
 The International Accounting Standards Board (IASB) sets standards called International
Financial Reporting Standards (IFRS) for many countries outside the U.S.
 The Public Company Accounting oversight Board (PCAOB) determines auditing
standards and reviews the performance of auditing firms.
o Qualities of Useful Information--To be useful, information should possess two
fundamental qualities: relevance and faithful representation.
o Relevance - if information has the ability to make a difference in a decision
scenario, it is relevant. Accounting information is considered relevant if it
provides information that
 has predictive value--helps provide accurate expectations about the future
o has confirmatory value – confirms or corrects prior expectations.
 an item is material when its size makes it likely to influence the decision
of an investor or a creditor.
o Faithful Representation - information accurately depicts what really happened. To
provide a faithful representation, information must be:
 complete—nothing important has been omitted
 neutral—is not biased toward one position or another
 free from error
o Enhancing Qualities
 Comparability—when different companies use the same accounting
principles. To make a comparison, companies must disclose the
accounting methods used.
 Consistency—when a company uses the same accounting principles and
methods from year to year
 Verifiable—information that is proven to be free from error.
 Timely—information that is available to decision makers before it loses its
capacity to influence decisions.
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Understandability—information presented in a clear fashion so that users
can interpret it and comprehend its meaning.
o Assumptions and Principles in Financial Reporting--To develop accounting
standards, the FASB relies on the following key assumptions and principles:
o Monetary Unit Assumption--States that only transactions expressed in money are
included in accounting records.
o Economic Entity Assumption
 Every economic entity can be separately identified and accounted for.
 Economic events can be identified with a particular unit of accountability.
o Periodicity Assumption - allows the business to be divided into artificial time
periods that are useful for reporting.
o Going Concern Assumption--Assumes the business will remain in operation for
the foreseeable future
Principles in Financial Reporting
o Measurement Principles--GAAP generally uses one of two measurement
principles: the cost principle or the fair value principle
 Historical Cost Principle – requires assets to be recorded at original cost
because that amount is verifiable.
 Fair value Principle – requires that assets and liabilities should be reported
at fair value (the price received to sell an asset or settle a liability).
Full Disclosure Principle – requires that all circumstances and events that would make a
difference to financial statement users should be disclosed.
Cost Constraint--Determining whether the cost that companies will incur to provide the
information will outweigh the benefit that financial statement users will gain from having
the information available.
IFRS A Look at IFRS
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Learning Objective 4 – Compare the classified balance sheet under GAAP and IFRS. The
classified balance sheet, although generally required internationally, contains certain
variations in format when reporting under IFRS.
KEY POINTS Similarities
o IFRS generally requires a classified statement of financial position similar to the
classified balance sheet under GAAP.
o IFRS follows the same guidelines as this textbook for distinguishing between
current and noncurrent assets and liabilities. Differences
o IFRS recommends but does not require the use of the title “statement of financial
position” rather than balance sheet.
o The format of statement of financial position information is often presented
differently under IFRS. Although no specific format is required, most companies
that follow IFRS present statement of financial position information in this order:
 Noncurrent assets
 Current assets
 Equity o Noncurrent liabilities
 Current liabilities
o Under IFRS, current assets are usually listed in the reverse order of liquidity. For
example, under GAAP cash is listed first, but under IFRS it is listed last.
o IFRS has many differences in terminology from what are shown in your textbook.
For example, in the sample statement of financial position illustrated on the next
page, notice in the investment category that stock is called shares.
 Both GAAP and IFRS are increasing the use of fair value to report assets. However, at
this point IFRS has adopted it more broadly. As examples, under IFRS companies can
apply fair value to property, plant, and equipment; natural resources; and in some cases
intangible assets.
Chapter 3 Outline
Learning Objective 1
Analyze the Effect of Business Transactions on the Basic Accounting Equation
o The basic accounting equation;
 Assets = Liabilities + Stockholders’ Equity.
Accounting Information System
 collects and processes transactions
 communicates financial information to decision makers.
 Factors that shape the Accounting Information System include:
o nature of the company’s business
o types of transactions
o company size
o the volume of data
o information demands of management and others.
 Most businesses use computerized accounting systems, sometimes referred to as
electronic data processing (EDP) systems.
Accounting Transactions
 economic events that require recording in the financial statements
 occur when assets, liabilities, or stockholders’ equity items change as a result of some
economic event
Analyzing Transactions
 Transaction analysis the process of identifying the specific effects of economic events
on the accounting equation
 The accounting equation must always balance
 Each transaction has a dual effect on the equation
1. On October 1, cash of $10,000 is invested in the business by investors, in exchange for
$10,000 of Sierra Corporation common stock. Both Cash (an asset) and Common Stock
(a component of stockholders’ equity) increase by $10,000.
2. On October 1, Sierra issued a 3-month, 12%, $5,000 note payable to Castle Bank. This
transaction results in an equal increase in assets and liabilities: Cash (an asset) increases
$5,000 and Notes Payable (a liability) increases $5,000.
3. On October 2, Sierra purchased equipment by paying $5,000 cash to Superior Equipment
Sales Co. An equal increase and decrease in Sierra’s assets occur. Cash decreases by
$5,000 and Equipment increases by $5,000.
4. On October 2, Sierra received a $1,200 cash advance from R. Knox, a client, for guide
services for multi-day trips that are expected to be completed in the future. Both Cash and
Unearned Service Revenue (a liability) increase by $1,200
5. On October 3, Sierra received $10,000 cash from Copa Company for guide services
performed for a corporate event. Sierra received an asset (cash) in exchange for services
(revenue). Revenue increases stockholders’ equity. Both assets and stockholders’ equity
would increase. Cash is increased $10,000 and Service Revenue is increased $10,000
6. On October 3, Sierra paid its office rent for the month of October in cash, $900. Both
Cash and stockholders equity (Rent Expense) decrease. Expenses decrease stockholders’
equity.
7. On October 4, Sierra paid $600 for a one-year insurance policy that will expire next year
on September 30. Cash decreases and another asset Prepaid Insurance increases.
8. On October 5, Sierra purchased supplies on account from Aero Supply for $2,500. Both
Supplies and Accounts Payable (a liability) increase by $2,500.
9. Hired four new employees. This is not a business transaction.
10. On October 20, Sierra paid a $500 dividend. Both Cash and Stockholders’ Equity
(Dividends) decrease by $500.
11. Employees have worked 2 weeks, earning $4,000 in salaries, which were paid on October
26. Both Cash and stockholders’ equity (Salaries Expense) decrease.
Summary of Transactions
 Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders’
equity.
 The two sides of the equation must always be equal.
 The cause of each change in stockholders’ equity must be indicated.
Learning Objective 3.2
Explain How Accounts, Debits, and Credits Are Used to Record Business Transactions
Account - an individual accounting record of increases and decreases in a specific asset,
liability, or stockholders’ equity item.
 An account consists of three parts:
o (1) the title of the account
o (2) a left or debit side
o (3) a right or a credit side.
 In its simplest form it is referred to as a T account because the alignment of the parts of
the account resembles the letter T.
Debits and Credits
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debit means left
credit means right.
They DO NOT mean increase or decrease
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Debit is abbreviated Dr. and credit is abbreviated Cr.
The act of entering an amount of the left side of an account is called debiting.
Making an entry on the right side is called crediting.
When the totals of the two sides are compared, an account will have a debit balance if
the left side (dr. side) is greater. Conversely, the account will have a credit balance if the
right side (cr. side) is greater.
Debit and Credit Procedures
Each transaction must affect two or more accounts to keep the basic accounting equation in
balance.
 Under the double-entry system the equality of debits and credits keeps the equation
balanced.
 the two-sided effect of each transaction is recorded in appropriate accounts
 This helps to ensure the accuracy of the recorded amounts and helps to detect errors.
Dr./Cr. Procedures for Assets and Liabilities
o Debits increase assets and decrease liabilities.
o Credits decrease assets and increase liabilities.
Dr./Cr. Procedures for Stockholders’ Equity
o Debits Decrease Common Stock, Retained Earnings, and Revenue, but
Increase Dividends and Expenses.
o Credits Increase Common Stock, Retained Earnings, and Revenue, but
decrease Dividends and Expenses.
The normal balance of an account is on its increase side
o The normal balance for Assets, Dividends, and Expenses is a debit balance
o The normal balance for Liabilities, Common Stock, and is a credit balance.
Stockholders’ Equity Relationships
o Common stock and retained earnings: in the stockholders’ section of the balance
sheet.
o Dividends: on the retained earnings statement.
o Revenues and expenses: on the income statement.
On October 1, cash of $10,000 is invested in the business by investors, in exchange for $10,000
of Sierra Corporation common stock. Both Cash and Common Stock would increase by $10,000.
Try not to memorize the rules of debit and credit. Rather understand the process.
Think of the balance sheet equation:
Assets = Liabilities + Stockholders’ Equity
A debit, or a left hand entry, increases accounts on the left of the equation.
A credit, or a right hand entry, increases accounts on the right of the equation.
Now think of the elements in Stockholders’ Equity. Three of these elements:
o Common Stock,
o Retained Earnings, and
o Revenue
All above Increase stockholders’ equity.
Therefore these three accounts—Common Stock, Retained Earnings, and Revenue are increased
by credit entries and decreased by debit entries.
The fourth and fifth elements—Expenses and Dividends, decrease stockholders’ equity.
Therefore Expenses and Dividends are increased by debit entries and decreased by credit entries.
Learning Objective 3.3
Indicate How a Journal is Used in the Recording Process
Steps in the Recording Process--The basic steps in the accounting process are used by most
businesses in the recording process. The steps are:
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Analyze each transaction in terms of its effect on the accounts. A source document, such
as a sales slip, a check, a bill, or a cash register tape provides evidence of the
transaction.
Enter the transaction information in a journal.
Transfer the journal information to the appropriate accounts in the ledger (book of
accounts).
The Journal--Transactions are initially recorded in chronological order in
journals before they are transferred to the accounts.
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The journal shows the debit and credit effects on specific accounts for each
transaction.
Companies may use various types of journals, but every company has the most basic
form of journal, a general journal.
Entering transaction data in the journal is known as journalizing.
The journal makes three significant contributions to the recording process:
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The journal discloses in one place the complete effect of a transaction.
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The journal provides a chronological record of transactions.
○ The journal helps prevent or locate errors because the debit and credit amounts for
each entry can be readily compared.
Learning Objective 3.4
Explain How a Ledger and Posting Help in the Recording Process
The Ledger--The entire group of accounts maintained by a company is referred to as the ledger.
 The general ledger contains all of the asset, liability and stockholders’ equity
accounts.
 Information in the ledger provides management with the balances in various accounts.
Chart of accounts Is a list of the accounts used by a company. They are typically listed in the
following order: assets, liabilities, stockholders’ equity, revenues, and expenses.
Posting--the process of transferring journal entries to the ledger accounts.
 Posting accumulates the effects of journal transactions in the individual ledger
accounts. It involves these steps.
o In the ledger, enter in the appropriate columns of the debited account(s) the date
and debit amount shown in the journal.
o In the ledger, enter in the appropriate columns of the credited account(s) the date
and credit amount shown in the journal.
GENERAL JOURNAL
Ledger
Learning Objective 5 - Prepare a Trial Balance
The trial balance--list accounts and their balances on a specific date. The primary purpose of
the trial balance is to prove the mathematical equality of debits and credits after posting.
A trial balance
 uncovers errors in journalizing and posting.
 is useful in the preparation of financial statements.
 is limited in that it will balance but not uncover errors when:
o A transaction is not journalized.
o A correct journal entry is not posted.
o A journal entry is posted twice,
o Incorrect accounts are used in journalizing or posting, or
o Offsetting errors are made in recording the amount of a transaction.
Keeping An Eye On Cash—The Statement of cash flows categorizes the inflows and outflows
of cash during in a given period into three types of activities.
 Operating activities are the types of activities the company performs to generate profits.
These can include cash received or spent to directly support the company’s operations,
like cash used to pay an accounts payable or cash spent to purchase inventories.
 Investing activities include the purchase or sale of long-lived assets used in operating the
business, or the purchase or sale of investment securities (like stocks and bonds of other
companies).
 Financing activities include borrowing money, issuing shares of stock and paying
dividends.
IFRS
Learning Objective 6 – Compare the procedures for the recording process under GAAP
and IFRS.
International companies use the same set of procedures and records to keep track of transaction
data. Thus, the material in Chapter 3 dealing with the account, general rules of debit and credit,
and steps in the recording process—the journal, ledger, and chart of accounts—is the same under
both GAAP and IFRS.
KEY POINTS
Following are the key similarities and differences between GAAP and IFRS as related to the
recording process.
 Similarities
o Transaction analysis is the same under IFRS and GAAP.
o Both the IASB and FASB go beyond the basic definitions provided in this
textbook for the key elements of financial statements, that is, assets, liabilities,
equity, revenues, and expenses. The implications of the expanded definitions are
discussed in more advanced accounting courses.
o As shown in the textbook, dollars signs are typically used only in the trial balance
and the financial statements. The same practice is followed under IFRS, using the
currency of the country that the reporting company is headquartered.
o A trial balance under IFRS follows the same format as shown in the textbook.
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Differences
o IFRS relies less on historical cost and more on fair value than do FASB standards.
o Internal controls are a system of checks and balances designed to prevent and
detect fraud and errors. While most public U.S. companies have these systems in
place, many non-U.S. companies have never completely documented the controls
nor had an independent auditor attest to their effectiveness.
LOOKING TO THE FUTURE
The basic recording process shown in this textbook is followed by companies across the globe. It
is unlikely to change in the future. The definitional structure of assets, liabilities, equity,
revenues, and expenses may change over time as the IASB and FASB evaluate their overall
conceptual framework for establishing accounting standard.
Chapter 4 Outline
Learning Objective 1
Explain the Accrual Basis of Accounting and the Reasons for Adjusting Entries
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Determining the amount of revenues and expenses to report in a given accounting period
can be difficult.
 Accounting divides the economic life of a business into artificial time periods. This is the
periodicity assumption.
 Many transactions affect more than one of these periods. Determining the amount of
revenues and expenses to report in a given accounting period can be difficult.
o Proper reporting requires an understanding of the nature of the company’s
business.
o Two principles are used as guidelines: o Revenue recognition principle o
Expense recognition principle
The revenue recognition principle requires that revenue be recognized in the accounting
period in which the performance obligation is satisfied. When a company agrees to perform a
service or sell a product to a customer, it has created a performance obligation.
A service company recognizes (records) revenue when the services are performed.
The expense recognition principle requires that efforts (expenses) be matched with
accomplishments (revenues).
The critical issue is determining when the expense makes its contribution to revenue.
Expenses need to be matched with the revenue in the period when the company makes efforts
to generate those revenues.
 Accrual-basis accounting means that transactions that change a firm’s financial statements
are recorded in the periods in which the events occur, even if cash was not exchanged.
 With cash basis accounting, revenue is recognized (recorded) when cash is received.
Expenses are recognized (recorded) only when cash is paid.
 Accrual basis accounting requires accountants to adhere to the revenue recognition principle
and the expense recognition principle.
 Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting
Principles (GAAP), whereas accrual basis accounting does.
o Accrual basis accounting provides an objective measurement of net income.
 Adjusting entries are needed to ensure that the revenue recognition and expense recognition
principles are followed.
 The trial balance may not contain up-to-date and complete data for several reasons:
o Some events are not recorded daily because it is not efficient to do so.
o Some costs are not recorded during the accounting period because these costs
expire with the passage of time rather than as a result of recurring daily
transactions.
o Some items may be unrecorded.
 Adjusting entries are required every time a company prepares financial statements.
o Every adjusting entry will include one income statement account and one balance
sheet account.
 Adjusting entries can be classified as either deferrals or accruals. Each of these classes has
two subcategories.
 Deferrals can be prepaid expenses or unearned revenues.
 Accruals are either accrued revenues or accrued expenses.
Learning Objective 2 - Prepare Adjusting Entries for Deferrals
Deferrals fall into two categories—prepaid expenses and unearned revenues.
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Prepaid expenses - expenses paid in cash and recorded as assets until they are used or
consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent and
insurance) or through use (i. e. supplies).
Unearned revenues – cash received and recorded as liabilities before the services are
performed.
An adjusting entry for prepaid expenses will result in an increase (a debit) to an expense
account and a decrease (a credit) to an asset account.
 An adjusting entry for unearned revenues will result in a decrease (a debit) to a
liability account and an increase (a credit) to a revenue account.
 An adjusting entry for deferrals (prepaid expenses or unearned revenues) will
decrease a balance sheet account and increase an income statement account.
Learning Objective 3 - Prepare Adjusting Entries for Accruals
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Accruals fall into two categories—accrued revenues and accrued expenses.
Accrued revenues - revenues for services performed but not yet received in cash or recorded
at the statement date.
o an adjusting entry for accrued revenues will result in an increase (a debit) in an asset
account and an increase (a credit) to a revenue account.
Accrued expenses - expenses incurred but not yet paid in cash or recorded at the statement
date. an adjusting entry for accrued expenses results in an increase (a debit) to an expense
account and an increase (a credit) to a liability account.
o an adjusting entry for accruals (accrued revenues or accrued expenses) increases both
a balance sheet and an income statement account.
Summery of basic relationships
Objective 4 – Prepare an Adjusted Trial and Closing Entries
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The adjusted trial balance is prepared after all adjusting entries have been journalized and
posted. The adjusted trial balance shows the balances of all accounts, including those that
have been adjusted, at the end of the accounting period.
The purpose of the adjusted trial balance is to prove the equality of the total debit
balances and total credit balances in the ledger after all adjustments.
Financial statements are prepared from the adjusted trial balance.
Quality of Earnings
Earnings management is the planned timing of revenues, expenses, gains, and losses to
smooth out bumps in net income.
The quality of earnings is greatly affected when a company manages earnings up or down
to meet some targeted earnings number.
A company that has a high quality of earnings provides full and transparent information
that will not confuse or mislead users of the financial statements.
A company with questionable quality of earnings may mislead investors and creditors,
who believe they are relying on relevant and reliable information.
Companies manage earnings in a variety of ways:
Use of one-time items to prop up earnings numbers (i.e. nonrecurring gains).
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Inflate revenue numbers in the short-run (to the detriment of the long-run).
o Improper adjusting entries
Closing entries transfer net income (or net loss) and dividends to Retained Earnings.
o This causes the ending balance of Retained Earnings (amount shown on the
Balance Sheet) to agree with the balance shown on the Retained Earnings
Statement.
o Close the revenue accounts to the Income Summary account.
o Close the expense accounts to the Income Summary account.
o Close the Income Summary account to Retained Earnings.
o Close Dividends to Retained Earnings.
Closing entries produce a zero balance in each temporary account (revenues, expenses,
and dividends)
o These accounts are then ready to accumulate data for the next accounting period.
o Permanent accounts (assets, liabilities, common stock and retained earnings) are
not closed.
After the closing entries have been journalized and posted, a post-closing trial balance is
prepared.
o The post-closing trial balance shows the balances of all of the permanent
accounts.
o The permanent account balances are carried forward to the next accounting
period.
o All of the temporary accounts have a zero balance
 The required steps in the accounting cycle.
o Analyze business transactions.
o Journalize the transactions.
o Post to ledger accounts.
o Prepare a trial balance.
o Journalize and post adjusting entries—deferrals and accruals.
o Prepare an adjusted trial balance.
o Prepare financial statements:
 Income statement o Retained earnings statement
 Balance sheet
 Journalize and post closing entries.
 Prepare a post-closing trial balance.
Net income is based on accrual basis accounting and is accomplished through the
adjusting entry process.
Cash provided by operating activities is determined by comparing cash received from
operating activities to cash expenditures from operating activities.
Cash provided by operating activities is essentially net income determined under the
cash-basis of accounting.
Learning Objective 5 – Describe the Purpose and the Basic Form of a Worksheet
The worksheet is a multiple-column form that may be used in the adjustment process and in
preparing financial statements. Today most accountants use computer spreadsheets.
A worksheet is not a permanent accounting record.
IFRS
*Learning Objective 6 - Compare the procedures for adjusting entries under GAAP and IFRS. It
is often difficult for companies to determine in what time period they should report particular
revenues and expenses. Both the IASB and FASB are working on a joint project to develop a
common conceptual framework that will enable companies to better use the same principles to
record transactions consistently over time.
 KEY POINTS
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Similarities
o In this chapter, you learned accrual-basis accounting applied under GAAP.
Companies applying IFRS also use accrual-basis accounting to ensure that they
record transactions that change a company’s financial statements in the period in
which events occur.
o Similar to GAAP, cash-basis accounting is not in accordance with IFRS.
o IFRS also divides the economic life of companies into artificial time periods.
Under both GAAP and IFRS, this is referred to as the periodicity assumption.
o The general revenue recognition principle required by GAAP that is used in this
textbook is similar to that used under IFRS.
o Revenue recognition fraud is a major issue in U.S. financial reporting. The same
situation occurs in other countries, as evidenced by revenue recognition
breakdowns at Dutch software company Baan NV, Japanese electronics giant
NEC, and Dutch grocer Ahold NV.
Differences
o Under IFRS, revaluation (using fair value) of items such as land and buildings is
permitted. IFRS allows depreciation based on revaluation of assets, which is not
permitted under GAAP.
o The terminology used for revenues and gains, and expenses and losses, differs
somewhat between IFRS and GAAP. For example, income under IFRS includes
both revenues, which arise in the normal course of operating activities, and gains,
which arise from activities outside of the normal sales of goods and services. The
term income is not used this way under GAAP. Instead, under GAAP income
refers to the net difference between revenues and expenses.
o Under IFRS, expenses includes both those costs incurred in the normal course of
operations as well as losses that are not part of normal operations. This is in
contrast to GAAP, which defines each separately.
LOOKING TO THE FUTURE The IASB and FASB are now involved in a joint project on
revenue recognition. The purpose of this project is to develop comprehensive guidance on when
to recognize revenue. Presently, the Boards are considering an approach that focuses on changes
in assets and liabilities (rather than on earned and realized) as the basis for revenue recognition.
It is hoped that this approach will lead to more consistent accounting in this area.
Problem 3-5A
Ayala Architects incorporated as licensed architects on April 1, 2017. During the first month
of the operation of the business, these events and transactions occurred:
Apr. Stockholders invested $18,000 cash in exchange for common stock of the
1 corporation.
1 Hired a secretary-receptionist at a salary of $375 per week, payable monthly.
2 Paid office rent for the month $900.
3 Purchased architectural supplies on account from Burmingham Company
$1,300.
10 Completed blueprints on a carport and billed client $1,900 for services.
11 Received $700 cash advance from M. Jason to design a new home.
20 Received $2,800 cash for services completed and delivered to S. Melvin.
30 Paid secretary-receptionist for the month $1,500.
30 Paid $300 to Burmingham Company for accounts payable due.