Accounting an Introduction 14th Ed

An introductory title for accounting students.

Chapter 1 - The world of accounting

Chapter 2 - The conceptual framework for financial reporting

Chapter 3 - The accounting equation

Chapter 4 - The accounting cycle: Transactions, source documents and journals

Chapter 5 - The accounting cycle: Ledgers and trial balance

Chapter 6 - The accounting cycle: Adjustments

Chapter 7 - Completion of the accounting cycle: Closing process and financial statements

Chapter 8 - Value-added tax (VAT)

Chapter 9 - Accounting systems

Chapter 10 - Cash and cash equivalents

Chapter 11 - Trade and other receivables

Chapter 12 - Inventories

Chapter 13 - Non-current assets: Tangible assets

Chapter 14 - Non-current assets: Intangible assets

Chapter 15 - Non-current and current liabilities

Chapter 16 - Presentation of financial statements

Chapter 17 - Statement of cash flows

Chapter 18 - Non-profit organisations

Chapter 19 - Partnerships

Chapter 20 - Companies

Chapter 21 - Analysis and interpretation of financial statements

Chapter 22 - Manufacturing entities

Chapter 23 - Cost-volume-profit (CVP) analysis

Chapter 24 - Labour

Chapter 25 - Financial planning and management

Additional:

 Inventory and Cost of Goods Sold

 Stockholders’ Equity

Understanding the accounting cycle

Assume that, on August 1st, Reliable spends RA2,000 on tires. Cash isn’t
paid immediately, and the vendor gives Reliable an invoice.

How that event is tracked through a business is known as the accounting

cycle. Here’s an overview, which we’ll breakdown:
 1. Source document
A source document is generated when an event happens in your business.

In this case, Reliable receives a RA2,000 invoice from the tire vendor and
a shipping receipt. When tires are received at the warehouse, a Reliable
employee reviews the shipment, to confirm that the entire order was sent.
The data on the shipping receipt matches the invoice.
2. Financial impact
Next, Steve (the accountant) must decide how the event impacts the
accounting records. He decides to record an increase in Inventory- Tires
account, and an increase in the Accounts Payable account.
3. Journal entry
A journal is a record of each transaction that occurs, listed in
chronological order. Journal entries are individual activities
(transactions) within the journal, typically posted accountants.

Steve records the transaction using this journal: The Inventory- Tires and
Accounts Payable balances are both increased by RA2,000, and the
journal entry is dated August 1st. The entry includes a brief explanation:
“To purchase tires on credit.”
4. General ledger
A company’s general ledger is a record of every transaction posted to the
accounting records throughout its lifetime. Steve frequently reviews
general ledger to verify that he’s posted transactions correctly.
5. Trial balance
Reliable’s trial balance is a listing of each account used to post
transactions and the current account balance.

This document provides a quick snapshot of Reliable’s current financial

condition.

Steve can scan the list of accounts and balances to decide if the
accounting data looks reasonable. If he wants more detail, the general
ledger is the place to go.
6. Financial statements
The trial balance is used to generate the financial statements, including
the balance sheet and income statement (or profit and loss statement).
Steve produces financial statements at the end of the month, and the
cycle starts over next month. Reliable Auto Repair also needs a clearly
defined system to record transactions.

Debit and credit rules

These rules help you post journal entries that keep the balance sheet
equation in balance:

 Debit entries: Debit entries are posted on the left side of each
journal entry. Asset and expense accounts are increased with a
debit entry, with some exceptions.
 Credit entries: Credit entries are posted on the right side of each
journal entry. Liability and revenue accounts are increased with a
credit entry, with some exceptions.
 Totals: The total dollar amount of debits must always equal credits.
Fortunately, accounting software requires each journal entry to post
an equal dollar amount of debits and credits. The number of debit
and credit entries, however, may be different.
 One of each: Every journal entry has at least one debit and
one credit entry.

Accrual method of accounting

The accrual method of accounting requires a business to post revenue

when it is earned, and expenses when they are incurred. This method
applies the matching principle, which matches revenue with the expenses
that relate to producing the revenue.

The accrual basis presents a more accurate picture of net income, and
this method ignores the timing of cash inflows and outflows.

So, before you can use a trial balance to produce the financial
statements, you need to pump the brakes.

All of your transactions should apply the accrual method and not
the cash method of accounting.

What’s the difference?

Accrual method vs. cash method
The differences between the accrual method and the cash method relate
to the timing of revenue and expenses. Net income using the accrual
method will be different than net income generated using the cash
method.

To explain, let’s go back to the tire purchase.

Assume that Reliable pays the invoice for the tires on September 15th.
Here’s the journal entry:

September 15th

Debit #5000 Accounts Payable: RA2,000

Credit #1000 Cash: RA2,000

(To pay invoice for tires purchased on 8/1)

The entry reduces Accounts Payable (a liability account) and the Cash
account.

The tires purchased on August 1st are sold on October 5th for RA2,600 in
cash. Here’s how the accounting works, using both methods:
Accrual method
The accrual method required two journal entries on October 5th. One
increases expenses, and the other increases revenue:

October 5th

Debit #6000 Cost of Sales: RA2,000

Credit #3100 Inventory- Tires: RA2,000

(To record a reduction in inventory and to post cost of sales expense)

October 5th

Debit #1000 Cash: RA2,600

Credit #7000 Sales: RA2,600

(To record cash received for tires sold)

The cost of the tires is moved out of inventory and into an expense
account, Cost of Sales.

At the same time, Reliable collected RA2,600 in the Cash account and
recognized a sale (a revenue account).

Here’s the key point: The revenue and expenses are both posted in
October. The difference between revenue and expenses is a RA600 profit
in October.

The cash method does not match revenue with expenses.

Cash method
What if you used your checkbook activity to post revenue and expenses?

When a client pays you cash, you increase revenue. Expenses are posted
when you pay cash.

Sure, it’s simple, but it doesn’t match the revenue you earned with the
related expenses. You really don’t know what your profit is on a particular
transaction.

Confused? Here’s the cash method of accounting, using the tire purchase
and sale.

When Reliable pays cash for the tires, the company recognizes an
expense (Cost of Sales):

September 15th

Debit #6000 Cost of Sales: RA2,000

Credit #1000 Cash: RA2,000

(To pay cash and record an expense for tires purchased)

The client pays in cash on October 5th, and Reliable posts this entry:

October 5th

Debit #1000 Cash: RA2,600

Credit #7000 Sales: RA2,600

(To record cash received for tires sold)

The October 5th entry using the cash method is the same as the accrual
method. That’s not always the case, however.

If the customer bought the tires on October 5th on credit, the accrual
method would still post revenue on October 5th. The sale is completed
when the customer receives the tires, so revenue should be posted.

Reliable would increase Accounts Receivable and Sales on October 5th.

Assuming that the customer paid on November 3rd, Reliable would reduce
Accounts Receivable and increase Cash on November 3rd.

Income statement

Did I make any money last month? Check the income statement.

The income statement reports on revenue, expenses, and net income

(profit) or loss for a specified period. The statement is based on the
income statement formula:

Revenue – expenses = net income (loss)

Here is Reliable’s income statement for the month ending October 31st:
Download this template—and two more basics of accounting
spreadsheets—here

If you want a better look under the hood, use a multi-step income
statement.

Multi-step income statement

A multi-step income statement separates income into operating and non-

operating categories, and this information helps you understand what
activities are driving profitability.

Start at the top of the income statement.

As you can see, most of the business activity flows through gross profit:

RA520,000 sales – RA420,000 cost of sales = RA100,000 gross profit

The materials, parts, and labor costs Julie incurs to make repairs are
posted to Cost of Sales.
These costs are directly related to production. The more repairs Reliable
performs, the more is spent on material, parts, and labor.

Reliable incurs other expenses to operate the business, including home

office salaries, insurance premiums, and a building lease. Operating
expenses are subtracted from gross profit to calculate net income:

RA100,000 gross profit – RA90,000 operating expenses = RA10,000 net

income

Reliable must be able to produce the vast majority of net income from
vehicle repairs because the repair business is sustainable. Accountants
refer to consistent, sustainable net income as operating income.

Non-operating income is not consistent or predictable.

No company can survive over the long-term by relying on non-operating

income to produce profits. If Reliable sells a piece of equipment for a
gain, the gain is considered non-operating income. Reliable is in the
business of fixings cars- not selling equipment.

This income statement example doesn’t include any non-operating

income.

Net income is connected to the balance sheet, as you’ll see below.

Balance sheet

The balance sheet is a snapshot of a company’s financial position at a

specific date. It reflects the company’s assets, liabilities, and equity
balances.

Here are the components that make up a balance sheet:

 Assets: What your business owns. Assets are resources used to

produce revenue.
 Liabilities: Amounts your business must pay other parties. Liabilities
include accounts payable and long-term debt.
 Equity: Equity is the difference between assets and liabilities, and
you can think of equity as the true value of your business.

The components are connected by a formula.

Assets = liabilities + owner’s equity

Here is Reliable’s balance sheet as of October 31, 20X9:

Download this template—and two more basics of accounting

spreadsheets—here

Not all assets are created equal.

Each asset account is defined as current or non-current.

Current assets include cash and assets that will be converted into cash
within 12 months. Non-current assets will not be converted into cash
within 12 months. The same categories apply to liabilities, as explained
below.

Current assets

 Cash: The total amount of money on hand.

 Accounts receivable: The amount that your customers owe you after
buying your goods or services on credit.
 Inventory: Items purchased for resale to customers.
 Prepaid expenses: Expenses you’ve paid in advance, such as six
months of insurance premiums.
  Investments: Money-market account balances, stocks, and bonds.
Some investments may be categorized as long term, but most are
short-term assets.
 Notes Receivable: Amounts you are owed that will be paid within 12
months.

These are the most frequently used current asset accounts.

If you’re wondering if a particular asset is a current asset, consider how

quickly the asset can be converted into cash. If the conversion will
happen within a year, it’s a current asset.

Your business has other resources are used over the long term.

Non-current assets

 Fixed assets: Fixed assets include vehicles, equipment, and

buildings used to produce revenue. These assets decrease in value
over time. For that reason, depreciation expense is posted to record
the decline in value of fixed assets.
 Intangible assets: Assets that have no physical manifestation, such
as goodwill, patents, copyrights, and trademarks fall into this
category.

If you’re able to use an asset over multiple years, odds are that it’s a long-
term asset.

Creditors have a claim on some of your company assets. If you don’t pay a
creditor, the firm can sue you and ask a court to award the firm some of
your assets.

These claims are called liabilities.

Liabilities

 Current liabilities: These are amounts due to be paid within a year,

such as accounts payable (amounts you owe suppliers), payroll
liabilities, and amounts due on short-term business loans, such as a
line of credit.
 Long-term liabilities: Amounts that are due to be paid in a year or
more, including long-term loans, mortgage payments, and future
employee benefits. These liabilities are non-current, but the
category is often defined as “long-term” in the balance sheet.
If you sold all of your company assets and used the proceeds to pay off all
liabilities, any remaining cash would be considered your equity balance.

Equity

Reliable has two components of equity—owner’s equity and retained

earnings. More on that below.

Equity may include …

 Opening balance equity: The owner’s initial investment in the

company. If an owner contributes RA50,000 in cash and RA10,000 in
equipment, the opening equity balance is RA60,000.
 Capital stock: The dollar amount of common and preferred stock a
company issues to shareholders. Issuing stock increases the equity
balance. Julie is the sole owner of Reliable, and the equity section
does not have any stock-related categories.
 Net income: Total revenue less expenses, for a month or year. Net
income is calculated in the income statement, and the balance
increases equity.

Retained earnings are the last component of equity.

This balance is defined as total company earnings (net income) since

inception, less all dividends paid to owners since inception. Firms can
choose to retain earnings for use in the business or pay a portion (or all)
of the earnings as a dividend.

Dividends reduce the equity balance.

The opening balance in equity, net income, and issuing stock all increase
the equity balance. If your firm pays a dividend to owners or generates a
net loss, equity is decreased.

Connection to income statement

Reliable’s balance sheet includes a RA25,000 in owner’s equity. The

balance represents cash or other assets contributed by Julie, the sole
owner of the business.
The retained earnings balance is RA10,000, and that amount equals the
RA10,000 in net income for 20X9. Let’s assume no beginning balance in
retained earnings, and that Julie decides to leave the entire RA10,000 in
net income in the retained earnings balance.

Cash is the biggest issue facing many companies, so let’s not forget
about cash inflows and outflows.

Statement of cash flows

The statement of cash flows reports cash inflows and outflows for
operating, financing, and investing activities.

Cash flows are reported for specific time frames, such as a month or year.
Here is Reliable’s statement of cash flows for the accounting period
ending 10/31/X9:

Download all three accounting templates (spreadsheets) here

Cash flows are assigned to one of three categories:

 Cash flows from operations: Operations refer to the day-to-day

activities of managing a business. Reliable has cash inflows for
 customer payments, and cash outflows to purchase parts, and to
fund payroll.
 Cash flows from investing: If a business purchases or sells an asset
for cash, the impact is posted here. In 20X9, Reliable purchased
RA10,000 in equipment for cash.
 Cash flows from financing: When a company raises money from
investors, borrows funds, or pays on a loan, the cash transactions
are classified as financing activities. Julie’s firm paid RA15,000 for
loans in 20X9.

The RA40,000 ending balance in cash equals the 10/31/X9 cash balance in
the balance sheet.