Chapter 3 Lecture and Notes

Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements

The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting, including generally accepted accounting principles (GAAP), for both public- and private-sector businesses in the United States.

• GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements.
  • US accounting rules are called US GAAP.
  • International accounting rules are called International Financial Reporting Standards (IFRS).
  • Some companies that operate on a global scale may be able to report their financial statements using IFRS.

Publicly traded companies (those that offer their shares for sale on exchanges in the United States) have the reporting of their financial operations regulated by the Securities and Exchange Commission (SEC).

The Conceptual Framework

The conceptual framework is a set of concepts that guide financial reporting. These concepts help ensure information is comparable and reliable to stakeholders.

• Revenue recognition principle: directs a company to recognize revenue in the period in which it is earned; is earned when a product or service has been provided
• Expense recognition (matching) principle: states that we must match expenses with associated revenues in the period in which the revenues were earned
• Cost principle: states that virtually everything the company owns or controls (assets) must be recorded at its value at the date of acquisition
• Full disclosure principle: states that a business must report any business activities that could affect what is reported on the financial statements
• Separate entity concept: prescribes that a business may only report activities on financial statements that are specifically related to company operations, not those activities that affect the owner personally
• Conservatism: states if there is uncertainty in a potential financial estimate, a company should err on the side of caution and report the most conservative amount
• Monetary measurement concept: must be a monetary unitby which to value the transaction
• Going concern assumption: assumes a business will continue to operate in the foreseeable future
• Time period assumption: states a company can present useful information in shorter time periods, such as years, quarters, or months

Accounting Equation

Assets = Liabilities + Owner's Equity

Double-Entry Bookkeeping

The basic components of even the simplest accounting system are accounts and a general ledger.

• An account is a record showing increases and decreases to assets, liabilities, and equity; each of these categories includes many individual accounts.
• A general ledger is a comprehensive listing of all of a company’s accounts with their individual balances.

Recording transactions in the general ledger utilizes a double-entry accounting system:

• Each time we record a transaction, we must record a change in at least two different accounts. Having two or more accounts change will allow us to keep the accounting equation in balance.
• Not only will at least two accounts change, but there must also be at least one debit and one credit side impacted.
• The sum of the debits must equal the sum of the credits for each transaction.

Debits and Credits

• A debit(DR) records financial information on the left side of each account. A credit(CR) records financial information on the right side of an account. One side of each account will increase and the other side will decrease. The ending account balance is found by calculating the difference between debits and credits for each account.
• This graphic representation of a general ledger account is known as a T-account:

Depending on the account type, the sides that increase and decrease will vary.

The normal balance is the expected balance each account type maintains, which is the side that increases.

Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions

Various Asset Accounts

• Cash: includes paper currency as well as coins, checks, bank accounts, and money orders
• Accounts receivable: money that is owed to the company, usually from a customer
• Inventory: goods available for sale; are an asset until they are sold
• Supplies: (office supplies) include pens, paper, and pencils; considered assets until an employee uses them, at which time they have lost their economic value and their cost is now an expense to the business
• Prepaid expenses: items paid for in advance of their use, such as rent and insurance; considered assets until used
• Notes receivable: similar to accounts receivable, is money owed to the company by a customer or other entity, but includes interest and specific time payment terms
• Equipment: includes desks, chairs, and computers; has a long-term value and is considered a long-term asset, meaning it can be used for more than one accounting period; will lose value over time in a process called depreciation
• Buildings, machinery, and land: all considered long-term assets; building and machinery depreciate; land is not depreciated

Various Liability Accounts

• Accounts payable: recognizes that the company owes money and has not paid
• Notes payable: similar to accounts payable in that the company owes money and has not yet paid, but the terms are usually longer, are typically more formal (written agreements), and include interest
• Unearned revenue: represents a customer’s advanced payment for a product or service that has yet to be provided by the company; the company cannot record revenue yet, and must record a liability, as the company is liable to the customer to either complete the service (or deliver the goods) or return the customer’s money.

Equity Account Components

Stockholders’ equity is the owner’s (stockholders’) investments in the business and earnings.

• Two components of stockholders’ equity:
• Contributed capital: amounts paid into the business for an ownership interest (stock); business uses that money to grow and develop the business
• Retained earnings: income that has been earned by the business that has been paid out in the form of dividends to the owners (stockholders)

Define and Describe the Initial Steps in the Accounting Cycle

The first four steps of the accounting cycle are

Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements

The first step in the accounting cycle is to identify and analyze transactions.

Each original source must be evaluated for financial implications. Meaning, will the information contained on this original source affect the financial statements? If the answer is yes, the company will then analyze the information for how it affects the financial statements.

One task is to determine the value of the transaction; sometimes this is obvious, and others times it is less clear.

Recording Transactions: Understanding Impact on the Accounting Equation

Use Journal Entries to Record Transactions and Post to T-Accounts

Accountants use special forms called journals to keep track of their business transactions. A journal is the first place information is entered into the accounting system. 

• Formatting when recording journal entries:
• Include a date of when the transaction occurred.
• The debit account title(s) always come first and on the left.
• The credit account title(s) always come after all debit titles are entered, and on the right.
• The titles of the credit accounts will be indented below the debit accounts.
• You will have at least one debit (possibly more).
• You will always have at least one credit (possibly more).
• The dollar value of the debits must equal the dollar value of the credits or else the equation will go out of balance.
• You will write a short description after each journal entry.
• Skip a space after the description before starting the next journal entry.

Prepare a Trial Balance

The trial balance is prepared from the general ledger. Each account balance is listed by title and with its current balance in the appropriate debit or credit column. The total of all the amounts in the debit column should equal the total amount in the credit column.

Limitations to the Trial Balance

Trial balance may balance even when:

1.A transaction is not journalized.

2.A correct journal entry is not posted.

3.A journal entry is posted twice.

4.Incorrect accounts are used in journalizing or posting.

5.Offsetting errors are made in recording the amount of a transaction.

• The Financial Accounting Standards Board (FASB) is an independent, nonprofit organization that sets the standards for financial accounting and reporting standards for both public- and private-sector businesses in the United States, including generally accepted accounting principles (GAAP).
• GAAP are the concepts, standards, and rules that guide the preparation and presentation of financial statements.
• The Securities and Exchange Commission (SEC) is an independent federal agency that is charged with protecting the interests of investors, regulating stock markets, and ensuring companies adhere to GAAP requirements.
• The FASB uses a conceptual framework, which is a set of concepts that guide financial reporting.
• The expanded accounting equation breaks down the equity portion of the accounting equation into more detail to show common stock, dividends, revenue, and expenses individually.
• The chart of accounts is a numbering system that lists all of a company’s accounts in the order in which they appear on the financial statements, beginning with the balance sheet accounts and then the income statement accounts.
• Step 1 in the accounting cycle: Identifying and analyzing transactions requires a company to take information from an original source, identify its purpose as a financial transaction, and connect that information to an accounting equation.
• Step 2 in the accounting cycle: Recording transactions to a journal takes financial information identified in the transaction and copies that information, using the accounting equation, into a journal. The journal is a record of all transactions.
• Step 3 in the accounting cycle: Posting journal information to a ledger takes all information transferred to the journal and posts it to a general ledger. The general ledger in an accumulation of all accounts a company maintains and their balances.