Generally Accepted Accounting Principles Financial accounting practice is governed by concepts and rules known as generally accepted accounting principles (GAAP). Relevant Information Affects the decision of its users. Financial accounting in governed by a set of rules we call Generally Accepted Accounting Principles, or GAAP for short. Generally accepted accounting principles identify three major characteristics of information. First, the information must be relevant. Relevant information impacts the decision of the informed user for financial information. Second, the information must be reliable. Finally, the information must be comparable. Comparability helps us compare financial information from one period with that of the next period. Reliable Information Is trusted by users. Comparable Information Used in comparisons across years & companies. 1-1

Principles and Assumptions of Accounting Measurement principle (also called cost principle) means that accounting information is based on actual cost. Going-concern assumption means that accounting information reflects a presumption the business will continue operating. Revenue recognition principle provides guidance on when a company must recognize revenue. Monetary unit assumption means we can express transactions in money. Matching principle (expense recognition) prescribes that a company must record its expenses incurred to generate the revenue. Time period assumption presumes that the life of a company can be divided into time periods, such as months and years. Here are some key principles and assumptions of accounting. Accounting Principles The measurement principle (also called the cost principle) tells us that accounting information is based upon actual costs incurred. We refer to this cost as historical cost. The revenue recognition principle provides guidance on when a company must recognize revenue. The matching principle (expense recognition) prescribes that a company must record its expenses incurred to generate the revenues. The principle of full disclosure requires a company to report the details behind financial statements that would impact users’ decisions. Accounting Assumptions The going-concern principle states that, in the absence of information to the contrary, the business entity is assumed to continue operations into the foreseeable future. The monetary unit principle means we can express transactions in monetary terms. The time period assumption presumes that the life of a company can be divided into time periods, such as months and years. A business entity means that a business is accounted for separately from its owner or other business entities. Full disclosure principle requires a company to report the details behind financial statements that would impact users’ decisions. Business entity assumption means that a business is accounted for separately from its owner or other business entities. 1-2

= + Accounting Equation Liabilities Equity Assets Liabilities + Equity The basic accounting equation states that assets are equal to liabilities plus equity of a company. The equation makes sense because in a general way it states that assets must be equal to the claims against those assets. If you have an asset we can have two broad categories of claims against that asset. First, we may have claims by creditors for liabilities. Finally, after all creditor claims are satisfied, the residual owners, and stockholders, have a claim on those assets. Liabilities + Equity Assets 1-3

Resources owned or controlled by a company Assets Cash Accounts Receivable Notes Receivable Resources owned or controlled by a company Vehicles Land Assets may be viewed as resources owned or controlled by a company. They include such items as cash, accounts receivable (amounts owed to the company by customers), land, building and equipment, and supplies. Buildings Store Supplies Equipment 1-4

Creditors’ claims on assets Liabilities Accounts Payable Notes Payable Creditors’ claims on assets Liabilities represent the claims of creditors on the entity’s assets. Liabilities include accounts payable (amounts we owe to creditors for assets purchased on account), notes payable, taxes payable, and wages payable (amounts we owe to our employees at the end of the accounting period). Wages Payable Taxes Payable 1-5

Equity Owner’s claim on assets Retained Earnings Contributed Capital The equities of an entity include investments by owners, contributed capital, and payments to those owners (dividends). Retained earnings represents all of the accumulated earnings of a corporation that have not been distributed to shareholders. Dividends 1-6

Expanded Accounting Equation Liabilities Equity Assets = + Liabilities Equity Assets = + Revenues Expenses Contributed Capital Dividends _ + Here is a breakdown of the equity section of the of the accounting equation to show the mathematical signs we will be using to keep track of investments by owners, common stock, payments to owners (dividends), revenues and expenses. Notice that revenues increase equity and expenses reduce equity. Retained Earnings 1-7

Transaction Analysis Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. Internal transactions are exchanges within any entity; they can also affect the accounting equation. Events refer to happenings that affect an entity’s accounting equation and can be reliably measured. Transaction analysis is defined as the process used to analyze transactions and events. Business activities can be described in terms of transactions and events. External transactions are exchanges of value between two entities, which yield changes in the accounting equation. Internal transactions are exchanges within any entity; they can also affect the accounting equation. Events refer to happenings that affect an entity’s accounting equation and can be reliably measured. Transaction analysis is defined as the process used to analyze transactions and events. 1-8

Transaction Analysis J. Scott invests $20,000 cash to start the business in return for stock. Here we show the increase in the asset account, cash, and the increase in the equity account, common stock, by twenty thousand dollars. Our basic accounting equation is in balance. Assets have a total balance of twenty thousand dollars and liabilities plus equity have a total balance of twenty thousand dollars. Let’s move on to another transaction. 1-9

Purchased supplies paying $1,000 cash. Transaction Analysis Purchased supplies paying $1,000 cash. We can see the decrease in cash and the increase in supplies. The total assets are still equal to twenty thousand dollars but are divided between cash and supplies. There is no change on the liabilities plus equity section of our books. 1-10

Purchased equipment for $15,000 cash. Transaction Analysis Purchased equipment for $15,000 cash. Cash is reduced by fifteen thousand dollars and equipment is increased by fifteen thousand dollars. The balance in our cash account is now four thousand dollars. We have a current balance in supplies of one thousand dollars, and equipment of fifteen thousand dollars. The three asset accounts total twenty thousand dollars. Once again, there has been no change in the liabilities plus equity side of the equation. 1-11

Transaction Analysis Purchased Supplies of $200 and Equipment of $1,000 on account. You can see the balance in the cash, supplies and equipment accounts. The total on the asset side of the equation is twenty one thousand, two hundred dollars. We acquired the assets without paying cash. If you use a credit card to purchase gas for your car, you receive an asset, gas, and incur an account payable to the credit card company. The balance in the liabilities accounts is now twelve hundred dollars, and the common stock account balance is still twenty thousand dollars. 1-12

Borrowed $4,000 from 1st American Bank. Transaction Analysis Borrowed $4,000 from 1st American Bank. The asset account, cash, increased by four thousand dollars and the liability account, notes payable increased by four thousand dollars. The asset side of the equation now has a balance of twenty five thousand, two hundred dollars. The liabilities plus equity side of the equation has the same total balance, so our books are in balance. 1-13

Transaction Analysis The balances so far appear below. Note that the Balance Sheet Equation is still in balance. Notice that the sum of all assets is equal to the sum of liabilities and equity. The accounting equation is in balance as required. 1-14

Transaction Analysis Now, let’s look at transactions involving revenue, expenses and dividends. To this point, we have not looked at transactions involving revenues, expenses, and dividends. In the next few slides we will address these accounts. 1-15

Transaction Analysis Provided consulting services receiving $3,000 cash. You see that our cash account increases by three thousand dollars, to a current balance of eleven thousand dollars. Total assets amount to twenty eight thousand, two hundred dollars. The revenue account also increased by three thousand dollars. Recall that from our expanded accounting equation that revenues increase equity and expenses decrease equity. The total of our liabilities plus equity is now twenty eight thousand, two hundred dollars. 1-16

Remember that expenses decrease equity. Transaction Analysis Paid salaries of $800 to employees. Let’s think about what happens when the firm pays their employees eight hundred dollars for work performed. What will be the effect on the accounting equation? How did you do? You got the decrease in the cash account, but did you remember to show the increase in expenses as a decrease in total equity. Our expanded equation is getting to look more and more complicated. Don’t worry, practice will help you fully understand the recording of these and similar transactions. Our books are still in balance. Remember that expenses decrease equity. 1-17

Transaction Analysis Dividends of $500 are paid to shareholders. Did you get this transaction recorded properly? We hope so. The asset account, cash, decreased by five hundred dollars and the equity account, Dividends increased by five hundred dollars. The dividend account reduces the total equity of the company in the same way expenses decrease equity. The final balances show that total assets are equal to twenty six thousand, nine hundred dollars. The total of the liabilities plus the equity has the same balance. Let’s use the information we developed to this point to prepare our basic accounting reports. Remember that dividends decrease equity. 1-18

Financial Statements Let’s prepare the Financial Statements reflecting the transactions we have recorded. Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows There are four fundamental financial statements used in accounting. The income statement shows our revenues and expenses. The statement of owner’s equity shows the change in the owners’ equity during the current period. The balance sheet is a listing of all asset, liability, and equity account balances. The statement of cash flows shows where the company obtained its cash and how it spent its cash. The first financial statement that we will prepare is the income statement. Let’s get started. 1-19

Net income is the difference between Revenues and Expenses. Income Statement Net income is the difference between Revenues and Expenses. Net income is defined as the difference between revenues and expenses. If expenses exceed revenues, we have a net loss rather than net income. Financial statements have a three line title with the company name, the name of the statement, and the period covered by the report. In our case, we had total revenues of three thousand dollars and total expenses of eight hundred dollars, so net income for the month ended December 31, 2011, was two thousand, two hundred dollars. After completing the income statement, we may prepare the statement of retained earnings. The income statement describes a company’s revenues and expenses along with the resulting net income or loss over a period of time due to earnings activities. 1-20

Balance Sheet The Balance Sheet describes a company’s financial position at a point in time. The balance sheet is an inventory of assets, liabilities and equity at the end of the month. Our total assets are equal to twenty six thousand, nine hundred dollars. This includes cash of ninety seven hundred dollars, supplies of twelve hundred dollars, and equipment of sixteen thousand dollars. Liabilities include accounts payable of twelve hundred dollars and notes payable of four thousand dollars. The common stock account has a balance of twenty thousand dollars and we just calculated the ending balance in retained earnings of seventeen hundred dollars. You can see that the books are in balance because total assets are equal to total liabilities plus equity. Creditors have claims against our assets of five thousand, two hundred dollars. The owner has claims to assets of twenty one thousand, seven hundred dollars. 1-21

Tool to analyze and determine the balance in a given account T-Account Tool to analyze and determine the balance in a given account Account Name (Left Side) Debit (Right Side) Credit

Rules of Debit and Credit Liabilities Equity = + Debit Credit - + Debit Credit Assets + -

Rules of Debit and Credit Owner’s Equity Debit Credit Owner’s Withdrawals Debit Credit + - - + Owner’s Capital Debit Credit - + Expenses Debit Credit + - Revenues - + Debit Credit

Expanding the Rules of Debit and Credit Owner’s Equity Owner’s Capital _ Owner’s Withdrawals _ + Revenues Expenses Debit Credit Debit Credit Debit Credit Debit Credit + - + - - + - +

Remember: Just ask ALICE! The middle three are increased with credits The first and the last are increased with a debit Debit Credit + A = Assets - L = Liabilities I = Income* C = Capital E = Expenses * Really, this is revenues, but “r” just doesn’t fit in!

Journalizing Transactions Identify accounts affected and its type Determine whether each account is increased or decreased. Apply the rules of debit and credit Record transaction in journal. Debit side of entry is entered first Total debit $ must = Total credit $

General Journal Transaction Date Accounts Affected Journal Page 1 Date Description Debit Credit Jul 1 Cash 45,000 Lange, Capital Investment from owner Optional: Explanation of transaction Dollar amount of debits and credits

General Journal Debits are ALWAYS entered 1st. Credits are INDENTED and listed after the debit accounts or accounts. Do not use dollar signs. SKIP A LINE between each entry

Exercise 2-19 Accounts Payable Cash Aug 2 200 Aug 1 60,000 Accounts Receivable Aug 17 2,100 Service Revenue Aug 6 3,000 Bal. 12,400 Building Aug 4 50, 000 R. Woodward, Capital Aug 1 60,000 Rent Expense Salary Expense Aug 2 200 Supplies Aug 2 200 Accounts Payable Bal. 100 Aug 17 2,100 Aug 23 1,200 Aug 23 1,200 Aug 31 1,200 Aug 31 500 Bal. 900 Bal. 5,100 Exercise 2-19 Take the difference between total debits and total credits to determine the balance in each account. If debits are greater than credits, the account has a debit balance and vice versa

Revenue Principle When is revenue recognized (entered into the accounting records) ? When it is earned Not necessarily when cash is received How much revenue is recognized? Cash value of item transferred to customer

The Matching Principle Measure all expenses incurred during the accounting period When are expenses recognized? Match the expenses against the revenues earned during the period

Adjusting Entries At the end of an accounting period, ask yourself these questions: Have I recorded all revenues earned during this accounting period? Have I recognized all expenses incurred during this accounting period? If “No”, prepare an adjusting entry

Adjusting Entries Prepared at end of an accounting period Recorded to bring an asset or liability account balance to its proper amount Recognize all revenues when earned Recognize all expenses incurred 12 12

Adjusting Prepaid Expenses Resources paid for prior to receiving the actual benefits 14 14

Adjusting for Depreciation Depreciation - process of allocating the cost of a plant asset to expense over its expected useful life Straight-Line Depreciation Expense = Asset Cost Useful Life Long term plant assets except for land are depreciated 19 19

Depreciation Depreciation, for accounting purposes, has NOTHING to do with market value, resale value or insurance value of an asset. It is a way to allocate the cost of the asset to each period that asset helps earn revenue Accumulated Depreciation A contra asset account … it is the amount of depreciation on that asset taken to date,

Tips An adjusting entry will NEVER involve a debit or credit to Cash. Each adjusting entry will affect at least one balance sheet account and one income statement account