Recording Business Transactions The Cash and Accrual Bases of Accounting Chapters 2 and 3

The Basic Accounting Equation Assets = Liabilities + Equity Accounting transaction  Any event that causes a change in the basic accounting equation Double-entry bookkeeping  Any transaction must affect at least two accounts if the equation is to remain in balance

The Cash Basis of Accounting Revenues are recorded when cash is received Expenses are recorded when cash is paid Transactions are only recorded if they increase or decrease cash Not acceptable for financial reporting purposes  Violates the matching concept

The Accrual Basis of Accounting Any transaction affecting the basic accounting equation is recorded Revenues are recorded when earned, expenses are recorded when incurred  Timing of the cash receipts or payments is not relevant Allows us to match expenses to the revenues they help produce

Adjusting Entries Adjustments must be made to record certain revenues and expenses in the proper periods Accruals  Revenue is earned, or expense is incurred, before the cash changes hands Interest, wages, taxes, utilities, etc.  Accrued revenues require the recording the revenue and a related asset (receivable)  Accrued expenses require the recording of the expense and a related liability (payable)

Adjusting Entries Deferrals  Cash changes hands before the revenue is earned or the expense incurred Depreciation, supplies, prepaid items, customer deposits, subscriptions, etc.  Deferred revenues Initial entry includes a receipt of cash and a liability Adjusting entry records the revenue and reduces the liability  Deferred expenses Initial entry includes an asset and a payment of cash Adjusting entry records the expense and reduces the asset

Financial Statement Formats Income statement  Single-step format All revenues are listed first, then all expenses Total revenue – total expenses = net income  Multi-step format Revenues and expenses are categorized as “operating” or “other” to emphasize the main activities of the business Provides more useful information than the single-step method

Financial Statement Formats Classified balance sheet  Categorizes assets and liabilities by their characteristics Current assets  Items expected to be consumed or converted into cash within one year or one operating cycle, whichever is longer  Cash, accounts receivable, inventory, short-term notes receivable, prepaid items, etc. Investments  Investments which are not considered current assets  Stocks, bonds, etc.

Financial Statement Formats Property, plant and equipment  Long-lived assets and the related accumulated depreciation  Land, buildings, equipment, vehicles, furniture, etc. Intangible assets  Assets with no physical substance  Copyrights, trademarks, patents, etc. Other assets  Assets which do not fit into one of the previous categories

Financial Statement Formats Current liabilities  Liabilities expected to be satisfied within one year or one operating cycle, whichever is longer, and will be satisfied with current assets  Accounts payable, wages payable, taxes payable, short- term notes payable, current maturities of long-term debt, unearned revenue, warranty liabilities, etc. Long-term liabilities  Liabilities which will not be satisfied within one year or an operating cycle, or will not be satisfied with current assets  Long-term debt, pension obligations, etc.

Financial Statement Formats Stockholders’ equity  Contributed capital  Capital stock and other amounts received from investors  Retained earnings  Treasury stock  Stock repurchased from investors  Negative stockholders’ equity item

Financial Statement Formats Statement of cash flows  Operating activities Direct method  Cash received from customers  Cash paid for operating activities Indirect method  Start with net income and adjust for changes in current assets and liabilities (accruals and deferrals)  Investing activities  Financing activities

Financial Statement Formats  Reconciliation of net income to cash flow from operating activities Required if direct method is used Net income is adjusted for the effects of accruals, deferrals and non-cash items  Begin with net income  Add back depreciation expense (and other non-cash expenses)  Subtract (add) increases (decreases) in current assets  Add (subtract) increases (decreases in current liabilities