Financial accounting

Summary

Chapter 1: Accounting in action

1.1 Accounting Activities and users
LO: Identify the activities and user associated with accounting
Accounting consists of three basic activities:
1. Identifies the economic events relevant to its business
2. Records events in order to provide a history of its financial activities. Recording consists of
keeping a systematic, chronological diary of events measured in monetary units.
3. Communicates the collected information to interested users by means of accounting reports.
Most common reports are financial statements.
Reported financial information meaningful it is recorded in a standardized way. By presenting
recorded data in aggregate the accounting process simplifies a multitude of transactions and makes a
series of activities understandable and meaningful.

 Analysis involves a use of ratios, percentages, graphs etc. to highlight significant financial
trends.
 Interpretation involves explaining the uses, meaning, and limitations of reported data.
Bookkeeping usually involves only the recording of economic events, its just one part of the
accounting.
Who uses accounting data?
Internal users of accounting information are managers who plan, organize etc. They have to answer
important questions. Such as; Can Toyota afford to give its employees pay raises this year? To answer
these questions they need detailed information on a timely basis. Managerial accounting provides
internal reports to help users make decisions about their companies.
External users are individuals and organizations outside a company who want financial information
about the company.

 Investors (owners) use accounting information to decide whether to buy, hold or sell
ownership shares of a company.
 Creditors (banks, suppliers) use accounting information to evaluate the risks of granting credit
or lending money
Financial accounting provides economic and financial information for investors, creditors and other
external users. Need for this information varies.

 Taxing authorities, regulatory agencies, customers

and labour unions.
Data analytics
Data analytics involves analysing data, often employing both
software and statistics to draw inferences. See illustration for
4 types of data analytics.
1.2 The building blocks of accounting
LO: explain the building blocks of accounting ethics, principles and assumptions
Ethics in financial reporting
The standards of conduct by which actions are judged as right or wrong, honest or dishonest, fair and
not fair are ethics.
Steps in analysing ethics cases and situations:
1. Recognize an ethical situation and the ethical issues involved.
2. Identify and analyse the principal elements in the situation.
3. Identify the alternatives and weigh the impact of each alternative on various stakeholders.
Accounting standards
In order to ensure high-quality financial reporting, accountants present financial statements in
conformity with accounting standards that are issued by standard-setting bodies. 2 primary accounting
standard-setting bodies:

 International accounting standards board (IASB)

 Financial accounting standards board (FASB)
Measurement principles
Selection of which basis to use is generally determined by considering the qualitative characteristics of
useful information, including relevance and faithful representation. Relevance means that financial
information is capable of making a difference in a decision. Faithful representation means that the
numbers and descriptions match what really existed or happened they are factual.
Historical cost records and reports assets at their cost, when you buy it.
Current value basis records and reports assets and other accounts at current value. It is based on the
items fair value, value in use or current cost. In determining which measurements basis to use,
companies weigh the factual nature of historical cost figures vs the relevance of current value. Most
companies choose to use cost.
Assumptions
Two main assumptions:
Monetary unis assumption:

 Monetary unit assumption requires that companies include in the accounting record only
transactions data that can be expresses in money terms. This assumption enables accounting to
quantify economic events.
 This assumption prevents the inclusion of some relevant information in the accounting
records. Companies record only events that can be measured in money.
Economic entity assumption:

 Economic entity assumption requires that the activities of the entity be kept separate and
distinct from the activities of its owner and all other economic entities.
A business owned by one person is generally a proprietorship. The owner is often the manager of
the business and receives any profits, suffers any losses and is personally liable for all debts of the
business.
 A business owned by two or more persons associated as partners is a partnership. Each partner
generally has unlimited personal liability for the debts of the partnership. Partnerships are often
used to organize retail and service-type businesses, including professional practices.
A business organized as a separate legal entity under jurisdiction corporation law and having
ownership divided into transferable shares is a corporation. The holders od the shares enjoy
limited liability. Shareholders may transfer all or part of their ownership shares to other investors
at any time. Corporation enjoys an unlimited life.

1.3 The accounting equation

LO: State the accounting equation, and define its components
Two basic elements of a business:

 Assets are the resources a business owns. Claims of those to whom the company owes money
are liabilities.
 Claims of owners are called equity.
Assets = liabilities + equity  This relationship is the
basic accounting equation.
Liabilities appear before equity in the basic
accounting equation because they are paid first
is a business is liquidated.
Assets
Assets are resources a business owns. The common characteristic possessed by all assets is the
capacity to provide future services or benefits.
Liabilities
Liabilities are claims against assets existing debts and obligations. There are account payable, note
payable and also salaries and wages payable. All of these persons or entities to whom money is owned
are creditors. Creditors may legally force the liquidation of a business that does not pay its depts. In
that case, the law requires that creditor claims be paid before ownership claims.
Equity
The ownership claim on a company’s total assets is equity. Equity consists of

 Share capital-ordinary: term used to describe the amounts paid in by shareholders for the
ordinary shared they purchase.
 Retained earnings: is determined by three items
o Revenues: the gross increases in equity
resulting from business activities entered
into for the purpose of earing income.
Revenues usually result in an increase in an
asset.
o Expenses: are the cost of assets consumed or services used in the process of earing
revenue. They are decreased in equity that result from operating the business.
o Dividends: the distribution of cash and other assets to shareholder. Net income
represents an increase in net assets which is then available to distribute to
shareholders. Dividends are not expenses.
1.4 Analysing business transactions
LO: Analyse the effects of business transactions on the accounting equation
The system of collecting and processing transaction data and communicating financial information to
decision-makers is known as accounting information system. This system relies on a process referred
to as the accounting cycle.
Accounting transactions
Transactions: are a business economic events recorded by accountants.

 External transactions: involve economic events between the company and some outside
enterprise.
 Internal transactions: are economic events that occur entirely within one company.
Each transaction must have a dual effect on the accounting equation.
Transaction analysis
1. Each transaction must be analysed in terms of its effects on:
a. The 3 components of the basic accounting equation
b. Specific sides of the equation must always be equal
2. The two sides of the equation must always be equal
3. The Share Capital-ordinary and retrained earnings columns indicate the causes of each change
in the shareholders claim on assets.

1.5 Financial statements

LO: describe the five financial statements and how they are prepared
Income statement
An income statement presents the revenues and expenses and resulting net income or net loss for a
specific period of time.

 The income statement lists revenues first, followed by expenses

 Then, the statement shows net income
 When revenues exceed expenses, net income results. When expenses exceed revenues a net
loss results
Income statements does not include investment and dividend transactions between the shareholders
and the business in measuring net income.
Retained earnings statement
A retained earnings statement summarizes the changes in retained earnings for a specific period of
time.

 The first line of the statements shows the beginning retained earnings amount, followed by net
income and dividends.
 The retained earnings ending balance is the final amount on the statement
 The information provided by this statement indicated the reason why retained earnings
increased or decreased during the period.
Statement of financial position
A statement of financial position reports the assets, liabilities and equity of a company at a specific
date.

 Statement of financial position lists assets at the top followed by equity and then liabilities
 Total assets must equal total equity and liabilities.
Statement of cash flows
A statement of cash flows summarizes information about the cash inflows and outflows for a specific
period of time.

 Reporting the sources, users and change in cash is useful because investors, creditors and
others want to know what is happening to a company’s most liquid resource. Answers these
questions:
o Where did cash come from during the period?
o What was cash used for during the period?
o What was the change in de cash balance during the period?

Comprehensive income statement

A comprehensive income statement presents other comprehensive income items that are not included
in the determination of net income.

 Comprehensive income items are not part of net income but are considered important enough
to be reported separately

Appendix 1
LO: explain the career opportunities in accounting
Public accounting
Individuals in public accounting offer expert services to the general public. It involves auditing: an
independent accountant or a certified public accountant examines company financial statements and
provides an opinion as to how accurately the financial statements presents the company’s results and
financial position in accordance with international financial reporting standards.
Taxation: work includes tax advice and planning, preparing tax returns. At last there is also
management consulting.
Private accounting
In private accounting you would be involved in activities such as cost accounting, budgeting etc.
Forensic accounting
Forensic accounting uses accounting to conduct investigations into theft and fraud.
Chapter 2: The recording process
2.1 Accounts, Debits and Credits
LO: Describe how accounts, debits and credits are used to record business transactions.
The accounting
An account is an individual accounting record of increases and decreases in a specific asset, liability
or equity item. Account consists of three parts:
1. A title
2. A left or debit side
3. A right or credit side
The format of an account resembles the letter T, so we refer to it as a T-account.
Debits and credits
Debit indicated the left side of an account, and credit indicated the right side. When comparing the
totals of the two sides, an account shows a debit balance if the total of the debit amount exceeds the
credits. And the same for the credit balance.

 Each transaction must affect two or more accounts to keep the basic accounting equation in
balance.
 The equality of debits and credits provides the basis for the double-entry system of recording
transactions.
 Increases and decreases in liabilities have to be recorded opposite from increases and
decreases in assets.
The normal balance of an account is on the side where an increase in the account is recorded.
Companies uses share capital-ordinary in exchange for the owners investment paid in the company.

 Credits increase the share capital-ordinary account and debit decreases it.
Retained earnings = net income that is kept retained in the business.

 Retained earnings represents the portion of equity that the company has accumulated through
the profitable operation of the business.
 Credits increase the retained earnings account, and debits decrease it.
A dividend is a company’s distribution to its shareholders.

 Dividends reduce tythe shareholders claims on retained earnings.

 Debits increase the dividends account, and credits decrease it.
Revenues and expenses have the purpose of benefiting the shareholders.

 When a company recognizes revenues, equity increases. Therefore the effect of debits and
credits on revenue accounts is the same as their effect on retained earnings.
 Expenses decrease equity.
2.2 The journal
LO: Indicate how a journal is used in the recording process.
Basic steps for the recording process:
1. Analyse transactions
2. Enter transaction in journal
3. Transfer journal information to ledger accounts (posting)
The journal
The journal is referred to as the book of original entry. For each transaction, the journal shows the
debit and credit effects on specific accounts. The journal makes several significant contributions to the
recording process:
1. It discloses in one place the complete effects of a transaction
2. It provides a chronological record of transactions
3. It helps to prevent or locate errors because the debit and credit amounts for each entry can be
easily compared.
Entering truncation data in a journal is known as journalizing. It is important to use correct and
specific account titles in journalizing.
Some accounts only involve two accounts, one debit and one credit, this is a simple entry. An account
that requires three or more accounts is a compound entry.

2.3 The ledger and posting

LO: Explain how a ledger and posting help in the recording process.
The ledger
The entire group of accounts maintained by a company is a ledger.

 Provides the balance in each of the accounts as well as keeps track of changes in these
balances.
 Companies may use various kind of ledgers, but
every company has a general ledger.
o General ledger = contains all the assets,
liability and equity accounts.
Besides the T-account there is also a three-column form of
account. It has three money columns, debit credit and balance.
Posting
The procedure of transfering journal entries to the ledger accounts is called posting.
1. In the ledger, in the appropriate columns of the accounts debited, enter the date, journal page,
and debit amount shown in journal
2. In the reference column of the journal, write the account number to which the debit amount
was posted
3. In the ledger, in the appropriate columns of the accounts credited, enter the date, journal page,
and credit amount shown in the journal.
 4. In the reference column of the journal, write the account number to which the credit amount
was posted.
Posting should be performed in chornological order. The reference column in the ledger account
indicates the journal page from which the transaction was posted.
Chart of accounts
Most companies have a chart of accounts. This chart lists the accounts and the account numbers that
identify their location in the ledger. The numbering system that identifies the accounts usually starts
with the statement of financial osistion accounts and follows with the income statements accounts.

2.4 The trial balance

LO: Perepre a trial balance.
A trial balance is a list of accounts and their balances at a given time.

 Companies usually perpare a trial balance at the end of an accounting period.

 They list accounts in order in which they appear in the ledger.
 Debit balances appear in the left column and credit balances in the right column. The total
must be equal.
The trial balance proves the mathematical equality of debits and credits after posting. A trial balamce
may also uncover error in journalizing and posting. And a trial balance is usfull in the preperation of
financial statements. Steps for preparing a trial balance:
1. List the account titles and their balances in the appropriate debit or credit column
2. Totel the debit and credit column
3. Verify the equality of the two columns.
Limitations of a trial balance
The trial balance may balance even when:

 A transaction is not journalized

 A correct journal entry is not posted
 A journal entry is posted twice
 Incorrect accounts are used in journalizing or posting
 Offsetting errors are made in recording the amount of a transaction
A trial balance does not prove that the company has recored all transactions or that the ledger is
correct.
Locating errors
Errors generally result from mathematical mistakes, incorrect postings, or transcribing data incorrectly.
Currency signs and underlining
Currency signs do not appear in journals or ledger. A currency sign is showns only for the first item in
the column and for the total of that column. A single line is placed under the column of figures to be
added or substracted. And the total amounts are double-underlined to indiacte they are final sums.
Chapter 3: Adjusting the accounts
3.1 Accrual-basic accounting and sdjusting entries
LO: Explain the accrual basis of accounting and the reasons for adjusting entries.
Accountants divide the economic life of a business into artificial time periods. This convenient
assumption is reffered to as the time period assumption.
Fiscal and calendar years
Accounting time periods are generaly a month, a quarter, or a year. Monethly and quarterly time
periods are called interim periods. An accounting time period that is one year in length is a fisical
year. Many business use the calendar year as their accounting period.
Accrual vs cash-basis accounting
Everything in this chapter is accrual-basis accounting.
Under accrual bais, companies record transactions that change a company’s financial statements in the
period in which the events occur. An alternative to accrual basis ts the cash basis. Under cash-basis
accounting, companies record revenue at the time they receive cash. They record an expense at the
time they pay out cash.
Accrual basis accounting is in accordance with International Financial Reproting Standards (IFRS).
Recognizing revenues and expenses
When a company agrees to perform a service or sell a product to a customer, it has a performance
oblihation.

 The revenue recognition priciple requirs that companies recognnize revenue in the accounting
period in which the performance obigation is satisfied.
Five step revenue recognition process
1. Identify the contract with customers
2. Indetify the separate performance obligation in the contract
3. Deterine the transaction price
4. Allocate the transaction price to the separate performance obligations
5. Recognize revenue when each performance obligation is satisfied
Accountants follow a simple rule in recognizing expenses: ‘let the expenses follow the revnues’.

 Critical issue in expense recognition is when the expense makes it contribution to revenue.
 The practise of expense recogniton is referred to as the expense recognition priciple. It
requires that companies recognize expenses in the period in which they make efforts.
The need for adjusting entries
Adjusting entries ensure that the revenue recognistion and expense recognition principles are followed.
Adjusting entries are necessary because the tiral balance may not contain up to date and complete data.
This is true for several reasons:

 Some events are not recorded on a daily because it is not efficiant to do so.
 Some costs are not recorded during the accounting period because these costs expire with the
passage of time rather than as a rsult if recurring daily transactions.
 Some items mat be unrecorded.
Types of adjusting entries.
Adjusting entries are classified as either deferrals or accruals.
Deferrals:
1. Prepaid expenses: expenses paid in cash before they are used or consumed.
2. Unearned revenues: cash received before services are performed.
Accurals:
1. Accrued revenues: revenues for services performed but not yet received in cash or recorded.
2. Accrued expenses: expenses incurred but not yet received cash or recorded.

3.2 Adjusting entries for deferrals

LO: Prepare adjsuting entries for deferrals
Prepaid expenses
When companies record payments of expenses that will benefit more than one accounting period, they
record an asset called prepaid expenses or prepayments. When expenses are prepaid, an asset account
is increases to whom the service or benefit that the company will receive in the future.

 Prepaid expenses are costs that expire either with the passage of time or through use.
 The expiration of these costs does not recquire daily entries.
Prior to adjustment, assets ate overstated and expennses are understated. Therefore an adjusting entry
for prepaid expenses results in an increase to an expense account and a decrease to an asset account.
The purchase of supplies results in an increase to an asset account. Companies recoginze supplies
expense at the end of the accounting period.
Companies purchase insurance to protect themselfves from losses. Insurance must be paid in advance.
The cost of insurance paid in advance is recorded as an increase in the asset account Prepaid
Insurance. At the financial statement date, companies increase insurance expense and decrease prepaid
insurance for the cost of insurance that has expired during the period.
A company typicaly owns a variety of assets that have long lives. The period of service is reffered to
as the useful life of the asset. Because it is expected to be of service for many years, it is recorded an
an asset on the date it is acquired.

 Deprecaition is the process of allocating the cost of an asset to expense over its useful life.
The acquisition of long-lived assets is essentially a long-term pre-payment for the use of an asset. An
adjusting entry for depreciation is needed to recognize the cost that has been used during the period
and to report the unused cost at the end of the period.

 Depreciation is an allocation concept not a valuation concept

 Depreciation allocates an assets cost to the periods in which it is used
 Depreciation does not attempt to report the actual change in the value of the asset
Accumulated depreciation is called a contra asset account. Such an account is offset against an asset
account on the statement of financial posistion. This account keeps track of the total amount of
depreciation expense taken over the of the asset.
Book value is the difference between the cost of any depreciable asset and its related accumulated
depreciation. The book value and the current value of the asset are generally 2 different values. The
purpose of depreciation is not valuation nut a means of cost allocation.
Unearned revenues
When companies receive cash before services are performed, they recored a liability by increasing o
liability account called unearned revenues. A company now has a performance obligation to transfer a
service to one of its customers.

 Unearned revenues are the opposite of prepaid expenses.

3.3 Adjusting Entries for accruals

LO: Prepare adjusting entries for accruals.
Accrued revenues
Revenues for services performed but not yet recorded at the statement date are accrued
revenues.Accrued revenues may accumulate with the passing of time, as in the case of interest
revenue. The company recordes the collection of the receivables by a debit (increase) to cash and a
credit (decrease) to accounts receivable.
Accrued expenses
Expenses incurred but not yet paid or recorded at the statement date are called accrued expenses.
Interets, taxes and salaries are common examples of these expenses.

 Companies make asjustments for accrued expenses to record the obligations that exist at the
statement of financial posistion date and to recognize the expenses that apply to the current
accounting period.
Accrued interest: the amount of the interest recorded is
determined by 3 factors:
1. The face value of the note
2. The interest rate, which is always expressed as an
annual rate
3. The length of time the note is outstanding

3.4 Adjusted trial balance and financial statements

LO: Describe the nature and purpose of an adjusting trial balance.
After a company has journalized ans posted all adjusting entries, it prepared another trial balance from
the ledger accounts. This trial balance is called an adjusted trial balance. The adjusted trial balance
shows the balannces of all accounts, including those adjusted, at the end of the accounting period. The
purpose is to prove the equality of the total debit balances and the total credit balances in the ledger
after adjustments.
Appendix 3B financial reporting concepts
LO: Prepare adjusting entries for the alternative treatment of deferrals
Qualities of useful information
The IASB developed a conceptual framework for financial reporting. The framework begins by stating
that the primary objective of financial reporting is to provide financial information that is useful to
investors and creditors for making decisions about providing capital.
Enhancing qualities:

 Comparability: results when different companies use the same accounting pricinples.
 Consistency: means that a company uses the same accounting principles and methods from
year to year.
 Informationis verifiable if indipendent observers, using the same methods obtain similar
results.
 For accounting information to have relevance it must be timely.
 Information has the quality of understandability if it is presented in a clearand concise
fashion, so that reasonably informed users of that information can interpret it and comprehend
its meaning.
Assumptions in financial reporting
Monetary unit assumption required that only those things that can be expressed in money are included
in the accounting records.
Ecnomic entity assumption states that every economic entity can be separately identified and
accounted for.
Time period assumption states that the life of a business can be divided into artificial time periods and
that useful reports covering those periods can be prepared for the business.
Going concern assumption states that the business will remain in operation for the foreseeable future.
Principles in financial reporting
The historical cost basis dictates that companies record and contine to report assets at their cost. The
current value basis indicates that assets and liabilities should be reported at current value. In
determing which measurment basis to use, the factual nature of cost figures are weighed vs the
relevance of current value.
Revenue recognition principle required that companies recognize revenue in the accounting period
which the performance obligation is satisfied.
Expense recognition principle dictates that companies recognize expense in the period in which they
make effort to generate revnue.
Full disclosure priciple requirs that companies disclose all circumstantces and events that would make
a difference to financial statements users.
Cost constraint
Providing information is costly. In deciding wheter companies should be requierd to provide a certain
type of information, accounting standard-setters conside the cost constraint. It weighs the cost that
companies will incur to provide information against the benefit that financial statement users will gain
from having the information available.
Chapter 4: completing the accounting cycle
4.1 The worksheet
LO: prepare a worksheet
A worksheet is a multiple-column form used in the adjustment process and in preparing financial
statements. It is not a permanent accounting record.
Steps in preparing a worksheet
1. Prepare a trial balance on the worksheet
a. Enter all ledger accounts with balances in the account titles coumn and then enter
debit and credit amounts from the ledger in the trial balance columns.
2. Enter the adjustments in the adjustments columns
a. Companies do not journalize the adjustments until after they complete the worksheet
and prepare the financial statement.
3. Enter adjusted balances in the adjusted trial balance columns.
a. For each account, the amount in the adjusred trial balance columns is the balance that
will appear in the ledger after journalizing and posting the adjusting entries.
4. Extend asjusted trial balance amounts to appropriate financial statement columns.
a. Every adjusted trial balance amount must be extended to one of the four statement
columns.
5. Total the statement columns, compute the net income, and complete the worksheet.
a. The debit amount balances the income statement columns, the credit amount balances
the statement of financial position columns.
b. If total credits exceed total debits, the result is net income.
Preparing financial statements from a worksheet
The amount of share capital-ordinary on the worksheet does not change from the beginning to the end
of the period unless the company issues additional ordinary shares.
Completed worksheet is not a substitute for formal financial statements.
Preparing adjusting entries from a worksheet
A worksheet is not a journal and it cannot be used as a basis for posting to ledger accounts.

4.2 Closing the books

LO: Perpare closing entries and a post-closing trial balance.
In closing the books, the company distinguishes between temporary and permanent accounts.

 Temporary accounts: relate only to a given accounting

period. They include all income statement accounts and
the dividends account. The company closes all
temporary accounts at the end of the period.
 Permanent accounts: relate to one or more future
accounting period. They consist of all statement of
financial position accounts, including equity accounts.
Permanent accounts are not closed from period to
period.
Preparing closing entries
At the end of an accounting period, the company transfers temporary account balances to the
permanent equity account, retained earnings.

 Closing entries: the transfer of net income and dividends to retained earnings. They also
produce a zero balance in each temporary account. This step is requires in the accounting
cycle.
Companies close the revenue and expense accounts to another account: income summary. Than they
transfer the resulting net income or net loss from this account to retained earnings.
Closing entries that are quick:

 Debit each revenue accounts for its balance, and credit income summary for total revenues.
 Debit income summary for total expenses, and credit each expense account for its balance.
 Debit income summary and credit retained earnings for the amount of net income
 Debit retained earnings for the valance in the dividends account, and credit dividends for the
same amount.
Dividends are not an expense, and they are not a factor in determining net income. So you don’t close
dividends through the income summary account.
Preparing a post-closing trial balance
Post-closing trial balance: lists permanent accounts and their balances after the journalizing an
posting of closing entries. The purpose is to prove the equality of the permanent account balances
carried forward into the next accounting period. This account will contain only permanent accounts.

4.3 The accounting cycle and correcting entries

LO: Explain the steps in the accounting cycle and how to prepare correcting entries.
Reversing entry: is the exact opposite of the adjusting entry made in the previous period. Use if
reversing entries is an optional book-keeping procedure.
Correcting entries
Correcting entries only happen when mistakes are made.
The accounting cycle
1. Analyze business transactions
2. Journalize the transactions
3. Post to the ledger accounts
4. Prepare a trial balance
5. Journalize and post adjusting entries
6. Prepare an adjusted trial balance
7. Prepare financial statements
8. Journalize and post-closing entries
9. Prepare a post-closing balance
4.4 classified statement of financial position
LO: Identify the sections of a classified statement of financial position.
A classified statement of financial position groups together similar assets and similar liabilities, using
a number of standard classifications and sections.

 Assets: intangible assets, property, plant and equipment, Long-term investments and current
assets
 Equity and liabilities: equity, non-current liabilities and current liabilities.
Intangible assets
Many companies have long-lived assets that do not have physical substance yet often are very
valuable, these are intangible assets.

 Goodwill is one significant intangible asset.

Property, plant and equipment
Property, plant and equipment: are assets with relatively long useful live that a company is currently
using in operating the business. Depreciation is the practice of allocating the cost of assets to a number
of years.

 The accumulated depreciation shows the total amount of deprecitation that the company has
expensed so far is the asset’s life.
Long-term investments
Long term investments are usually:

 Investments in shares and bonds of other companies that are normally held for many years
 Non-current assets such as land or buildings that a company is not currently using in operating
activities.
 Long-term notes receivable .
Current assets
Current assets include cash, investments held for trading purposes and assets that a company expects
to convert to cash or use up within one year or its operating cycle.

 The operating cycle of a company is the averaged time that it takes to purchase inventory, sell
it on account, and then collect cash from customers.
On the statement of financial position, companies usually list these items in the reverse order in which
they expect to convert them into cash.
Equity
The content of equity varies with the form of business organization.

 Proprietorship: one capital account

 Partnership: capital account for each partner
 Corporation: divide equity into two accounts Share capital-ordinary and retained earnings.
o They record shareholders investments in the company by debiting an asset account
and crediting the share-capital-ordinary account.
Non-current liabilities
Non-current liabilities are obligations that a company expects to pay after one year.

 Exp: bonds payable, mortgages payable, long-term notes payable, lease liabilities and pension
liabilities.
Current liabilities
Current liabilities include liabilities related to the operations of the business as well as liabilities
related to the financing of the business.
Relationship between current assets and current liabilities is important for the company’s liquidity.

 Liquidity: its ability to pay obligations expected to be due within the next year.

Chapter 5: Accounting for merchandise operations

5.1 Merchandising operations and inventory systems
LO: Describe merchandising operations and inventory systems
Merchandising companies that purchase and sell directly to consumers are called retailers, and
merchandising companies that sell to retailers are called wholesalers.
The primary source of revenue for these companies is the sale of
merchandise, also called sales revenue/sales. Two categories of
expenses
1. Cost of goods sold is the total cost of merchandise sold
during the period. This expense is directly related to the
revenue recognized from the scale of goods.
2. Operating expenses are incurred in the process if earning
sales revenue.
Operating cycles
Image shows that a service company has a much small cycle than a mershadnising firm.
Flow of costs
Beginning inventory + cost of goods purchased = cost of goods available for sale.
As goods are sold, they are assigned to cost of goods sold. Those goods that are not sold by the end of
the accounting perod represent ending inventory.
Prepatual system:

 Prepetual inventory system: companies keep detailed records of the cost of each inventory
purchase and sale. A company determines the cost of goods sold each time a sale occurs.
 System is often used when companies that sell merchandise with high values.
 Provides better control over inventories than a periodic system.
Periodic system:

 Periodic inventoy system: companies do not keep detailed inventory records of the goods on
hand throughout the period, instead they determine the cost of goods sold only at the end of
the accounting period.
 Determine the cost of goods sold:
1. Determine the cost of goods on hand at the beginning of the accounting period.
2. Add to it the cost of goods purchased
3. Substract the cost of goods on hand as determined by the physical inventory count at the
end of the accounting period.

5.2 Recording purchases under a perpetual system

LO: Record purchases under a perpetual inventory system
A purchase invoice should support each credit purchase, it indicated the total purchase price and other
relevant information.
Freight-costs
Freight terms are agreed to by the buyer and seller. They indicate who is responsible for paying the
freight charges (shipping cost) and who is responsible for the risk of loss or damage to the
merchandise during transport.
Freight terms are expressed as either FOB shipping point or Fob destination. FOB means free on board
until the point of ownership is transferred.

 FOB shipping point: means that ownership of goods passes to the buyer when the public
carrier accepts the goods from the seller.
o The buyer is responsible for the freight costs from the shipping point to the buyers
destination.
o These costs are considered part of the cost of purchasing inventory.
 So debits (increases) the inventory account
o Inventory cost should include all costs to acquire the inventory, including freight
necessary to deliver the goods to the buyer.
 FOB destination: means that ownership of the goods remains with the seller until the goods
reach the buyer.
o The seller is responsible for delivering the goods to the destination.
o They are included in the sellers inventory until they are delivered.

Purchase returns and allowances

The purchaser may return the goods to the seller for credit is it was paid by credit and same for cash,
this is called purchase return.
Purchaser mat also choose to keep the merchandise is the seller is willing to grant an
allowance(deduction) from the purchase price, this is called a purchase allowance.
Purchase discounts
The credit terms of purchase on account may permit the buyer to claim a cash discount for prompt
payment. The buyer calls this cash discount a purchase discount.
Credit terms specify the amount of the cash discount and time period in which it is offered.

 2/10 means that the buyer may take a 2% cash discount on the invoice price less any returns or
allowances, if payment is made within 10 days.
 n/30 means the invoice price – any returns or allowances is due in 30 days from now.
When a buyer pays an invoice within the discount period, the amount of the discount decreases
inventory because companies record inventory cost, and by paying within the discount period, the
buyer has reduced its cost.
Passing up the discount may be viewed as paying interest for use of the money.

5.3 Recording sales under a perpetual system

LO: Record sales under a perpetual inventory system
A business document should support every sales transaction, to provide written evidence of the sale.
Cash register documents provide evidence of cash sales.
A sales invoice provides support for a credit sale.
Seller makes 2 entries for each sale:
1. To record the sale, seller increases cash(debit) and also increases sales revenue (credit).
2. To record the cost of the merchandise sold, the seller increases (debit) cost of goods sold, and
also decreases inventory for the cost of those goods.
Sales returns and allowances
Sales returns and allowances: transactions where the seller either accepts goods back from the buyer
or grants a reduction in the purchase price.
Seller grants buyer an allowance by reducing the purchase price:

 The seller debits sales returns and allowances and credits accounts receivable for the amount
of the allowance.
 An allowance has no impact on inventory or cost of goods sold.
Sales returns and allowances is a contra revenue account to sales revenue. That means that it is offset
against a revenue account on the income statement.
Sales discounts
The seller may offer the customer a cash discount called by the seller a sales discount. The seller
increases (debits) the sales discounts account for discounts that are taken. This is also a contra revenue
account.

5.4 The accounting cycle for a merchandising company

LO: Apply the steps in the accounting cycle to a merchandising company.
Merchandiser using a perpetual inventory will require one additional adjustment to make records agree
with the actual inventory on hand.
  At the end of each period a merchandiser will do a physical count of the goods.
 The companies unadjusted balance in inventory usually does not agree with the actual amount
of inventory on hand.
 Company needs to adjust the perpetual records to make the recorded inventory amount agree
with the inventory on hand.

5.5 financial statements for a merchandiser

LO: Prepare financial statements for a merchandising company
Income statement
The income statement is a primary source of information for evaluating a company’s performance.
The income statement begins by presenting sales revenue. It then deducts contra revenue accounts to
arrive at net sales.

 Sales revenue – sales returns and allowances – sales discounts = net sales.
Gross profit: companies deduct cost of goods sold from sales revenue

 Net sales – cost of goods sold = gross profit

 Gross profit rate: gross profit/net sales x 100
o Is generally more useful than gross profit amount
o Tells how much of each euro of sales goes to gross profit
 Gross profit represents the merchandising profit of a company.
Operating expenses: next component in the income statement of a merchandising company. They are
expenses incurred in the process of earning sales revenue.

 Add all expenses, exp: freight-in, salaries expenses etc.

 Presentation by nature: provides very detailed information with numerous line items, that
reveal the nature of cost incurred by the company.
 Presentation by function: aggregates costs into groupings based on the primary functional
activities in which the company engages.
Merchandising companies report other income and expense in the income statement immediately after
the company’s primary operating activities.
In some instances the unrealized gains or losses that result from adjusting recorded amounts to current
value are included in net income. However in other cases, these unrealized gains and losses are not
included in net income.

 These excluded items are reported as part of mor inclusive earnings measure, comprehensive
income.
o Exp: adjustments to pension plan assets, gains and losses on foreign currency
translation etc.
 Comprehensive income is presented in a separate comprehensive income statement.
Appendix 5B: periodic inventory system
LO: record purchases and sales under a periodic inventory system
Determining cost of goods sold under a periodic system
Company using periodic system does not determine cost of goods sold until the end of the period. At
the end of the period the company performs a count to determine the ending balance of inventory. If
then calculates cost of goods sold by subtracting ending inventory from the cost of goods available for
sale.

 Beginning inventory + cost of goods purchases = cost of goods available for sale – ending
inventory = cost of goods sold
Recording merchandise transactions
In periodic inventory system companies record revenues from the sale of merchandise when sales are
made the companies do not attempt on the date of sale to record the cost of the merchandise sold.
Recording purchases of merchandise
Purchases is a temporary account whose normal balance is a debit.
When the purchaser directly incurs the freight costs, it debits the account freight-in. Normal balance is
a debit. Freight-in is part of cost of goods purchased.
Purchase returns and allowances is a temporary account whose normal balance is a credit.
Journalizing and posting closing entries
All accounts that affect the determination of net income are closed to income summary. To close the
merchandise inventory in a periodic inventory system:
1. The beginning inventory balance is debited to income summary and credited to inventory.
2. The ending inventory balance is debited to inventory and credited to income summary.

Chapter 6: inventories
6.1 Classifying and determining inventory
LO: Discuss how to classify and determine inventory.
Classifying inventory
In a merchandising company inventory consists of many different items. These items have 2 common
characteristics, 1. They are owned by the company, 2. They are in a form ready for sale to customers in
the ordinary course of business.
In a manufacturing company some inventory may not yet be ready for sale. As a result they classify
inventory in 3 categories:

 Finished goods inventory: manufactured items that are completed and ready for sale.
 Work in process: portion of manufactured inventory that has been placed into the production
process but is not yet complete.
 Raw materials: the basic goods that will be used in production but have not yet been placed in
production.
By observing the levels and changes in the levels of these three inventory types, financial statements
users can gain insight into management’s production plans. Many companies have significantly
lowered inventory levels and costs using just-in-time inventory methods.

 = companies manufacture or purchase goods only when needed.

Determining inventory quantities
If using a perpetual system, companies take a physical inventory for following reasons:
1. To check the accuracy of their perpetual inventory records.
2. To determine the amount of inventory lost due to wasted raw materials, shopliftings etc.
Companies using a periodic inventory system take a physical inventory for 2 reasons:
1. To determine the inventory on hand at the statement of financial position date
2. To determine the cost of goods sold for the period.
Determining inventory quantities involves 2 steps:
1. Taking physical inventory: involves actually counting, weighing or measuring each kind of
inventory on hand.
2. Determining ownership of goods
a. A complication in determining ownership is goods in transit at the end of the period.
They should be included in the inventory of the company that has legal title to the
goods.
i. When the terms are FOB (free on board) shipping point, ownership of the
goods passes to the buyer when the public carrier accepts the goods from the
seller.
ii. When the terms are FOB destination, ownership of the goods remains with
the seller until the goods reach the buyer.
b. Sometimes it is common to hold the goods of other parties and try to sell the goods for
them for a fee, but without taking ownership of the goods = consigned goods.

6.2 Inventory methods and financial effects

LO: Apply inventory cost flow methods and discuss their financial effects.
Inventory is an accounted for at cost. Costs include all expenditures necessary to acquire goods and
place them in a condition ready for sale. After a company has determined the quantity of units of
inventory, it applies unit costs to the quantities to compute the total cost of the inventory and cost of
goods sold.
Specific identification
If it can positively identify which particular units it sold and which are still in ending inventory it can
use the specific identification method.

 It requires that companies keep records of the original cost of each individual inventory item.
 Most companies make assumptions called, cost flow assumptions, about which units were
sold.
Cost flow assumptions
These assumptions differ from specific identification in that they assume flows of costs that may be
unrelated to the physical flow of goods.
There is no accounting requirement that the cost flow assumption be consistent with the physical
movement of the goods.
Cost of goods sold = (beginning inventory + purchases) – ending inventory
There are 2 flows of goods:

 First in, first out (FIFO) assumes that the earliest goods purchased are the first to be sold.
o Under FIFO the costs of the earliest goods purchased are the first to be recognized in
determining cost of goods sold. The costs of the oldest units are recognized first.
o Under FIFO companies obtain the cost of the ending inventory by taking the unit cost
of the most recent purchase and working backward until all units of inventory have
been costed.
 Average-cost: allocated the cost of goods available for sale on the basis of the weighted-
average unit cost incurred.
o Weighted-average unit cost: average cost that is weighted by the number of units
purchased at each unit cost.
 Weighted-average unit cost = cost of goods available for sale/total units
available for sale
o This method assumes that goods are similar in nature.

Financial statements and tax effects of cost flow methods

Reasons companies adopt different inventory cost flow methods:

 Income statement effects: In period of inflation, FIFO produces a higher net income because
the lower unit costs of the first units purchased are matched against revenues.
o In periods of rising prices, FIFO reports a higher net income than average cost.
o If prices are falling, the results from the use of FIFO and average-cost are reversed.
FIFO will report the lower net income and average-cost the higher.
 Statement of financial position effects
 Tax effects

Using inventory cost flow methods consistently

A companies should use a method consistently from one accounting period to another, this is called
consistency concept. It enhances the comparability of financial statements over successive time
periods.

6.3 Effects on inventory errors

LO: Indicate the effects of inventory errors on the financial statements.
Income statement effects
Cost of goods sold = (beginning inventory +
purchases) – ending inventory
If beginning inventory is understated, cost of goods
sold will be understated. If ending in inventory is
understated, cost of goods sold will be overstated. An error in the ending inventory will have a reverse
effect on net income of the next accounting period.
Statements of financial positions effects
Companies can determine the effect of ending inventory errors on the statement of financial position
by using the basic accounting equation: assets = liabilities + equity.
Inventory turnover: measures the number of times on average the inventory is sold during the period.
Its purpose is to measure the liquidity of the inventory.

 Inventory turnover: cost of goods sold / average inventory

 A variant of the inventory turnover is days in inventory: measures the average number of days
inventory is held.
6.4 Inventory statement presentation and analysis
LO: Explain the statement presentation and analysis of inventory
In a multiple step income statement, cost of goods sold is subtracted from net sales. There should also
be disclosure of:

 The major inventory classifications

 The basis of accounting
 The cost method
Lower of cost or net realizable value
Lower of cost or net realizable value (LCNRV): is an example of the accounting concept of prudence
which means that the best choice among accounting alternatives is the method that is least likely to
overstate assets and net income.

 Under LCNRV basis, net realizable value refers to the net amount that a company expects to
realize

Appendix 6A: Inventory cost flow methods in perpetual inventory system

LO: Apply the inventory cost flow methods to perpetual inventory records
FIFO
Under perpetual FIFO, the company charges to cost of goods sold the cost of the earliest goods on
hand prior to each sale. The results under FIFO in a perpetual system are the same as in a periodic
system.
Average costs
The average cost method in a perpetual inventory system is called the moving-average method. Under
this method, the company computes a new average after each purchase by dividing the cost of goods
available by the units on hand.

Appendix 6B: Estimating inventories

LO: Describe the two methods of estimating inventories
Two circumstances explain why companies sometimes estimate inventories:

 A casualty such as fire, flood or earthquake may make it impossible to take a physical
inventory.
 Managers may want monthly or quarterly financial statements, but a physical inventory is
taken only annually.
Gross profit method
The gross profit method estimates the cost of ending inventory by applying a gross profit rate to net
sales.

 Step 1: Estimated cost of goods sold = net sales – estimated gross profit
 Step 2: Estimated cost of ending inventory = cost of goods available for sale – estimated cost
of goods sold.
The gross profit method is based on the assumption that the gross profit rate will remain constant. But
it may not remain constant due to a change in merchandising policies or in market conditions. In such
cases the company should adjust the rate to reflect current operating conditions.
Retail inventory method
Retail inventory method: a company’s records must show both the cost and retail value of the goods
available for sale.

 Step 1: ending inventory retail

 Step 2: Cost-to-retail ratio
 Step 3: Estimated cost of ending inventory
Disadvantage of retail method is that it is an averaging technique. It may produce an incorrect
inventory valuation if the mix of the ending inventory is not representative of the mix in the goods
available for sale.
This method is permitted for financial statement purposes.

Appendix 6C: LIFO inventory method

LO: Apply the LIFO inventory closing method
LIFO assumes that the latest goods purchases are the first to be sold. It seldom coincides with the
actual physical flow of inventory. Under this method the costs of the latest goods purchased are the
first to be recognized in determining cost of goods sold.
Under LIFO companies obtain the cost of the ending inventory by taking the unit cost of the earliest
goods available for sale and working forward until all units of inventory have been costed.
All goods purchase during the period are assumed to be available for the first sale, regardless of the
date of purchase.