Chapter One
Accounting
Foundations
Reliability of QUALCOMM
Financial Statements
• Auditor’s report,
company’s
adherence to GAAP,
and management’s
certification
• Why do investors
and analysts trust
QUALCOMM
numbers?
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Section A: The Four Financial
Statements
• Balance Sheet
• Income Statement
• Statement of Changes in
Stockholders’ Equity
• Statement of Cash Flows
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Balance Sheet
• Provides information about the
financial position of a company at
a specific point in time
Assets
Liabilities
Stockholders’
Equity
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Balance Sheet Elements
Assets:
Liabilities:
Probable future
economic
benefits
obtained or
controlled by a
firm as a result
of past
transactions or
events
Probable future
sacrifices of
economic benefits
arising from
present obligations
of a particular
entity to transfer
assets or perform
services to other
firms in the future
as a result of past
events
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Stockholders’
equity:
Residual interest
in the assets of a
firm that remains
after deducting its
liabilities (for a
corporation)
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Asset Section of the Balance
Sheet
• Current assets—
reasonably expected to
be realized in cash, sold,
or consumed during
normal operating cycle
or within one year
•
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Operating assets—will
last beyond one year;
tangible assets used to
create revenue from
operations
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Liability and Equity Section of
the Balance Sheet
• Noncurrent liabilities—
obligations that will take
more than one year to
satisfy
• Current liabilities—
expected to be liquidated
using current assets or
refinanced by other
current liabilities during
one cycle or one year
• Stockholders’ equity—commonly
made up of stock and retained
earnings, reduced by dividends
issued
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Concepts Underlying the
Balance Sheet
•
•
•
•
Economic Entity Assumption
Historical Cost Principle
Monetary Unit Assumption
Going Concern Assumption
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Economic Entity Assumption
• Accounting for a business should be kept
separate from the accounting for other
entities controlled by the owner or the
personal accounts of the owner
Company’s Accounting
Records
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Owner’s Personal
Accounting Records
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Historical Cost Principle
• Assets and liabilities are first recorded at
the value of what is given in exchange for
them—their original, or historical, cost
• When cash is not involved, the price is
based on the fair value of what is given or
what is received, whichever is more
clearly determinable
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Monetary Unit Assumption
• Currency is an appropriate unit of
measure for assessing the value of a firm
in financial reporting
• In most instances, the monetary unit is
considered to be stable
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Going Concern Assumption
• A firm will continue to operate indefinitely
(in the absence of evidence to the
contrary)
• Thus, the firm must depreciate long-term
assets, recognize revenue in the period
earned, and value assets based on their
expected future cash flows rather than
their liquidation values
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Income Statement
• Provides information about the
amount of net income earned by
a firm over a stated period of time
Income
and
Gains
Expenses
and
Losses
Net income or loss
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Income Statement Elements
• Revenues:
Inflows or
enhancements of the
assets of a firm or
settlements of its
liabilities from
delivering or producing
goods, rendering
services, or carrying
out other activities that
constitute the firm’s
central operations
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• Expenses:
Outflows or other using
up of assets or
incurrences of liabilities
from delivering or
producing goods,
rendering services, or
carrying out ongoing
central operations
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Income Statement Elements
• Gains:
Increases in equity
from peripheral or
incidental
transactions of a firm
and from other
transactions and
events affecting the
firm except those that
result from revenues
or investments by
owners
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• Losses:
Decreases in equity
from peripheral or
incidental
transactions of a firm
and from other
transactions and
events affecting the
firm except those that
result from expenses
or distributions to
owners
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Income Statement:
Cramer Corporation
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Critical Thinking
• Discussion: If financial statements were not
presented with commonly accepted elements,
what problems might arise for financial
statement users?
• Each financial statement contains certain key
elements that users of financial data expect to
find and analysts rely upon. Without these
elements, users would not be able to compare
like figures between companies and between
different fiscal periods for the same company.
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Concepts Underlying the
Income Statement
Periodicity Assumption
Accrual Accounting
Revenue Recognition Principle
Matching Principle
Conservatism
Full Disclosure
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Periodicity Assumption
• A firm’s activities should be measured in
terms of arbitrary time periods even
though the firm’s life is considered to be
indefinite
• The firm’s operating cycle may differ from
these arbitrary time periods
• Periodic financial statements are
published
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Accrual Accounting
• Practice of recording transactions in the
period in which they occur rather than in
the period in which cash or other form of
payment is received
• Differs from cash basis of accounting in
which revenues are recorded when cash
is received and expenses are recorded
when cash is paid
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Revenue Recognition
Principle
• Governs when revenue should be
recognized and recorded in records
• Record revenue when the amount and
timing of revenue are reasonably
determinable AND when the earnings
process is complete or virtually complete
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Matching Principle
• Expenses should be reported in the same
accounting period as the revenues to
which they are related
• Supports accrual accounting and the
practice of depreciation, in which the cost
of an asset is allocated over its useful life
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Conservatism
• Guides the valuation of assets and
liabilities and influences the recognition of
revenues and expenses, gains and losses
• Dictates that accountants should select
accounting methods that are least likely to
overstate net income and the financial
position of the firm
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Full Disclosure
• Requires that financial statements and
related notes include any information that
is significant or material enough to change
the decisions of financial statement users
• Details of complicated transactions, such
as leases, interest swaps, and stock
options, are usually disclosed in the notes
to the financial statements
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Statement of Changes in
Stockholders’ Equity
• Summarizes the adjustments to
stockholders’ equity accounts over an
accounting period
Capital Stock Accounts
Paid-in Capital Accounts
Retained Earnings
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Statement of Changes in
Stockholders’ Equity
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Statement of Cash Flows
• Shows the amount of cash collected and
paid out by a firm over an accounting
period
Cash Flows from Operating Activities
Cash Flows from Investing Activities
Cash Flows from Financing Activities
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Statement of Cash Flows
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Check Your Understanding
Q Which financial statement provides
information about the financial position of
a firm at a specific point in time?
A
The balance sheet
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Check Your Understanding
Q What are the primary elements found on
the income statement?
A Revenues, expenses, gains, and losses
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Check Your Understanding
Q What three categories of cash flows are
found on the statement of cash flows?
A
Cash flows from investing, financing and
operating activities
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Check Your Understanding
• The balance sheet is supported by the
assumption that a firm will continue to
operate indefinitely. What is the name of
this assumption?
A
Going Concern Assumption
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Section B: Double-Entry Accounting
System and the Accounting Cycle
• Every transaction has a dual effect on the
accounting equation
ACCOUNTING EQUATION
Assets =
Liabilities +
Stockholders’ Equity
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Rules for Debiting and Crediting
Accounts
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The Accounting Cycle
Step 1: Identify and
gather information
about transactions
and economic events
Step 7: Record and
post closing entries and
prepare a post-closing
trial balance
Step 2: Analyze and
record each transaction
Step 3: Post journal
entries to the general
ledger
Step 6: Prepare the
financial statements
Step 4: Prepare an
unadjusted trial balance
Step 5: Record and post
the adjusting journal
entries and prepare an
adjusted trial balance
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Step 1: Identify and Gather
Transaction Information
• Use source documents like invoices,
purchase orders, sales invoices, and
register printouts for external transactions
• Use source documents like memos or
depreciation schedules for internal
transactions
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Step 2: Analyze Transactions
and Record in a Journal
• Determine the dollar amounts and accounts
involved.
• To journalize the transaction, enter the date of the
transaction and the debited account title and
amount. On the next line, indent and enter the
credited account title and amount. On the third line,
enter the description of the transaction.
Date
Account Title & Post Ref
Explanation
Debit
July 1
Land
$300,000
Cash
Credit
$300,000
To record the purchase of land for cash
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Analyzing and Recording:
Sample Transaction 1
• On September 1, 2006, Nancy and John
form a corporation, Kettle and Wolf, Inc.,
by filing with the State of Illinois. They
each invest $5,000 in the business in
exchange for common stock.
2006
Sept. 1
Cash
$10,000
Common Stock
$10,000
To record the issuance of common stock
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Analyzing and Recording:
Sample Transaction 2
• On September 1, Kettle and Wolf sign a
note at the local bank for $3,000 due in
two years at 12 percent annual interest.
2006
Sept. 1
Cash
Long-Term Notes Payable
$3,000
$3,000
To record the issuance of a long-term note payable
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Analyzing and Recording:
Sample Transaction 3
• On September 1, Kettle and Wolf sell 800
newsletters for $3 each as one-month
subscriptions.
2006
Sept. 1
Cash
Subscription Revenue
$2,400
$2,400
To record the sale of 800 one-month subscriptions
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Step 3: Post Journal
Entries to the Ledger
2006
Sept. 1
Cash
$10,000
Common Stock
$10,000
To record the issuance of common stock
Posting to T-accounts (for illustrative purposes):
Cash
Common Stock
9/1
10,000
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10,000
9/1
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Post Journal Entries
to the Ledger
2006
Sept. 1
Cash
Long-Term Notes Payable
$3,000
$3,000
To record the issuance of a long-term note payable
Posting to T-accounts (for illustrative purposes):
Long-Term Notes Payable
Cash
9/1 10,000
9/1 3,000
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3,000
9/1
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Post Journal Entries
to the Ledger
2006
Sept. 1
Cash
Subscription Revenue
$2,400
$2,400
To record the sale of 800 one-month subscriptions
Posting to T-accounts (for illustrative purposes):
Cash
9/1 10,000
9/1 3,000
9/1 2,400
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Subscription Revenue
2,400
9/1
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Step 4: Prepare an Unadjusted
Trial Balance
• After all transactions are recorded in the
journal and posted to the ledger, prepare
the unadjusted trial balance
• Compares total debit and credit balances
in the ledger to verify that they are correct
before preparing the adjusting entries
[Insert Illustration 1.13, Unadjusted Trial Balance]
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Step 5: Record and Post Adjusting Entries
and Prepare Adjusted Trial Balance
• Prepare adjusting entries to record the
financial effects of transactions or events that
cover more than one period and to make
estimates and other changes necessary to
bring the accounts to their true balances
Deferrals:
Accruals:
• Recognized when • Recognized when
cash is exchanged
an economic event
before an economic
occurs before cash
event occurs
is exchanged
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Accrual Entries
• Accrue revenue to
ensure that all
revenues for that
period are recorded
in the period, even
though related cash
may not yet be
received
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• Accrue expenses to
ensure that all
expenses incurred
during period are
recorded even though
they have not yet
been paid
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Deferral Entries
• Defer revenue when
a firm receives cash
or assets prior to
earning the revenue
associated with the
transaction
• Examples: Advance
deposits or
professional services
retainers
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• Defer expenses
when cash has been
paid before the
related expense has
been incurred
• Examples: Supplies
and prepaid
expenses
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Other Adjusting Entries
• Adjust accounts to their true balances due
to estimates of future events that affect
the current period’s financial statements
• Estimates that may need review and
adjustment include bad debt expense,
warranty expense, pension costs, and
postretirement benefits
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Adjusting Entry: Illustration
• On September 31, Kettle and Wolf should
recognize one month of accrued interest
on the $3,000 long-term note payable at
12 percent.
2006
Sept. 31
Interest Expense
30
Interest Payable
30
To record interest expense for the current period
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Step 6: Prepare Financial
Statements
• Income Statement
• Statement of Changes in Stockholders’
Equity
• Balance Sheet
• Statement of Cash Flows
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Step 7: Prepare and Post Closing Entries
and Prepare Post-Closing Trial Balance
1. Close all revenue accounts to Income
Summary.
2. Close all expense accounts to Income
Summary.
3. Close Income Summary to Retained Earnings.
4. Close the Dividends account to Retained
Earnings.
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Sample Closing Entries
for Kettle and Wolf
Subscription Revenue
3,400
Income Summary
3,400
To close Revenue account to Income Summary
Income Summary
855
Salaries Expense
400
Interest Expense
30
Depreciation Expense
125
Supplies Expense
100
Website Expense
200
To close expense accounts to Income Summary
Income Summary
2,545
Retained Earnings
2,545
To close Income Summary to Retained Earnings
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Prepare Post-Closing
Trial Balance
• Post-closing trial balance should contain
only permanent accounts (all temporary
accounts have been closed)
• Final check to ensure that total debits
equal total credits
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Check Your Understanding
Q Under the rules of debit and credit in a
double-entry accounting system, describe
the change represented by a debit to an
asset account, to a liability account, and to
a stockholders’ equity account.
A Debit to an asset account represents an
increase; a debit to a liability account or to
a stockholders’ equity account represents
a decrease.
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Check Your Understanding
Q Why are adjusting entries needed?
A Adjusting entries record the financial
effects of transactions and events that
cover more than one accounting period
and to make the estimates and other
changes necessary to bring the accounts
to their actual balances.
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Check Your Understanding
Q List the four basic closing entries required
at the end of an accounting period.
A Close all revenue accounts to Income
Summary. Close all expense accounts to
Income Summary. Close the Income
Summary account to Retained Earnings.
Close the Dividends account to Retained
Earnings
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