Financial Accounting DeMYSTiFieD


Simple enough for a beginner, but challenging enough for an advanced student, Financial Accounting DeMYSTiFieD is a shortcut to developing a working knowledge of accounting practices. The simple solution to complex accounting You don't need a genius IQ to ace your financial accounting curriculum. This fast and easy guide offers: Expert coverage of financial statements, cash and short-term investments, receivables, cash flows, liabilities Tips, techniques, and insights that drive home key financial accounting principles and theories Hundreds of worked-out examples, chapter-ending quizzes, and a final exam to reinforce learning and pinpoint weaknesses Specific recommendations if you're having difficulty with certain subtopics Simple enough for a beginner, but challenging enough for an advanced student, Financial Accounting DeMYSTiFieD is a shortcut to developing a working knowledge of accounting practices.

Analyzing and Recording Business Transactions. Preparation of the Worksheet Adjusting and Closing Entries. Chapter 6 Managing and Accounting for Cash and Investments. Opening the iTunes Store. If iTunes doesn't open, click the iTunes application icon in your Dock or on your Windows desktop. If Apple Books doesn't open, click the Books app in your Dock. Click I Have iTunes to open it now. View More by This Author. Description The simple solution to complex accounting You don't need a genius IQ to ace your financial accounting curriculum. Other Books in This Series. Extraordinary Items These items refer to a gain or loss from an event that is unusual in nature and infrequent in occurrence.

These losses would be written off on the income statement as an extraordinary item. A gain will add to the income statement's bottom line, and a loss will be subtracted from its bottom line. Earnings Per Share In addition to the items just mentioned, a company must report earnings per share and diluted earnings per share. Diluted earnings per share is a metric that takes earnings per share a step further. It assumes that any outstanding convertible securities can be converted to common stock, thereby diluting the value of the EPS.

This potential dilution is computed into the diluted earnings per share. Such outstanding securities could be convertible preferred shares, convertible debentures, stock options, and warrants. The balance sheet is a summary of the changes in assets, liabili- ties, and stockholders' equity during a period of time. Marketable securities are those short-term investments from extra cash that can be converted back to cash at a readily marketable price. Net book value refers to the market value of an asset less accu- mulated depreciation. The income statement reports the amount of revenues and gains less any expenses or losses for a company during a period of time.

The diluted earnings per share is included as an element on the balance sheet. List the statement in which each of the following would be included by entering BS for balance sheet, IS for income statement, or N for neither: Cost of goods sold D. Gain on sale of property G.

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Stockholders' investment contributed capital in company 7. Which of the following is not a characteristic of the balance sheet? The assets are usually listed in order of their liquidity. The balance sheet provides information that is useful for evaluating the profitability of the business during a period of time. The major elements of the balance sheet are assets, liabilities, and stockholders' equity. Retained earnings are one of the two elements in the Stockholders' Equity section. Which of the following is not usually classified as a current asset on the balance sheet?

Which of the following would most likely be included under Current Liabilities on the balance sheet? Current portion of interest on bonds payable B. Notes payable maturing in three years. Assets that a company expects to convert to cash within one year are called: Under which heading would patents and goodwill be classified on the balance sheet?

Property, Plant, and Equipment B. Stockholders' Equity 1 2. Which of the following would be classified under Stockholders' Equity on the balance sheet? Investment in bonds B. On the income statement a positive gross margin results from: Selling and administrative expenses that are less than sales. Cost of goods sold that is less than sales. Cost of goods sold that is less than net income. Cost of goods sold that is greater than selling and administrative expenses.

In the income statement Net Sales means: Sales discounts and returns and allowances have been deducted from gross sales. Purchase discounts have been deducted from gross sales. Freight on items sold has been deducted from sales. Bad-debt expense has been deducted from gross sales. Which of the following would not be included in a comprehensive income statement? Cost of goods sold The Accounting Process: There is no human being with green eyeshades laboriously recording transactions into the system with pen and ink and manually processing all of the data to complete preparation of the financial statements.

However, in order for the accountant to properly interact with the computer — that is, tell it what to do — he or she must understand how the com- puter program processes the transactions and prepares the statement. To do so, the accountant must manually work though the accounting process, step by step, to gain a full understanding of what happens inside the computer. That is the purpose of this and the next chapter. If you are not interested in the mechanics of accounting, you could perhaps skip this chapter; however, if you were to do so, you would have difficulty later in understanding and making necessary jour- nal entries.

Therefore, it is strongly suggested that you do read this chapter. The Double-Entry Accounting System The double-entry accounting system is based on the dual entity concept dis- cussed in Chapter 2, which states that a business transaction must be recorded in at least two different accounts of the financial accounting system. A double entry is really an internal control to assure that the two or more affected accounts are always changed as required by the transaction and that the accounts are always in balance.

But how does this work? Up to this point, when a transac- tion occurred, we simply stated how much each of the affected accounts was increased or decreased. However, the procedure is a little more complex than this. Actually, the double-entry accounting system uses debits and credits to effect changes in the accounts.

Thus, an understanding of debits and credits work is essential, as we will be using them throughout the remainder of this book. But first, a basic familiarity with the components of the accounting sys- tem is in order: The General Ledger The general ledger is a collection of accounts that form the major accounting records of a business that uses the double-entry accounting system.

It is some- times referred to as a chart of accounts, as each account is numbered in the sequence in which it occurs on the financial statements. Assets are listed in order of liquidity, and liabilities are listed in order of when they are due to be liqui- dated the nearest to be liquidated is listed first]. All balance sheet accounts are permanent accounts, because they are not closed out at the end of an account- ing period. All revenue, expenses, and dividend accounts are temporary accounts, because they are closed to retained earnings at the end of the period.

In other words, in a double-entry system, debit simply means the left side of an account and credit means the right side of the account: Accounts Receivable Debit Credit While the account is often referred to and shaped like a T, it frequently has different formats. For example, an alternative format of accounts receivable would look like the one in Exhibit 4. This format has the advantage of containing a lot of information and allows for a running balance.

Based on the double-entry book- keeping system, the left side of the account must equal the right side of each account. Further, the total of all the accounts on the left side of the accounting equation must equal the total of all the accounts on the right side. To record changes to an account based on a business transaction, one must debit or credit that account. If the account is on the left side of the accounting equation i. If the account is on the right side of the accounting equation i. What about revenue, expense, and dividend accounts? This topic will be discussed in more detail in Chapter 5.

That is, revenue accounts act like retained earnings for the rules of debits and credits: Likewise, because expenses offset revenues, an increase to an expense account or a dividend account requires a debit, and a decrease requires a credit. The rules of debits and credits are summarized in Exhibit 4. The following are two transactions to illustrate the rules of debits and credits and how they are entered into the accounts.

The trans- actions would be posted to the account as shown below: Cash Common Stock , , Note that the accounting equation is in balance: The transaction would be posted to the accounts as shown below with the resulting balance. Cash Equipment Common Stock , Bal. The normal balances in Exhibit 4. All transactions that are not entered into special journals are entered into the general journal. In the previous exam- ple of the rules of debits and credits, we entered transactions directly into each account, because doing so provided a clear illustration of how debits and credits operate.

In actuality, however, all transactions first are entered into a journal. Why is a journal needed in addition to an account? A journal is needed because it enters transactions into the system in chronological order and the journal allows for an explanation of the transaction just below the entry. The former is a significant advantage. If an accountant were looking for a particular transaction, he or she would have difficulty finding it among all the transactions in the many accounts maintained by a large company. He or she would find it much more easily in the journal, especially if the date were known.

Illustrative entries are included in Exhibit 4. The Date column in Exhibit 4. Debit Credit Account Title column. All debit entries for a particular transaction are recorded first in the Debit column, then the credit entries for that transaction follows immediately after the debit entries. In other words, the account s that is cred- ited is always listed after the last debit entry, in case of multiple debit entries, and indented.

See transaction number two in the illustration below. The account number is the number of the account as specified in the chart of accounts. The dollar sign is never used in journals, accounts, trial balances, and worksheets. More Information about Journals and Accounts: Posting In accounting terminology when a business transaction is entered into a journal, it is journalized.

When the entry is transferred to an individual account, it is posted. Remember that in a computerized environment the computer does all of this after the data is entered. Journalize the above transactions into the general journal. The following is an explanation of the analysis of each entry: The Cash account is debited because a debit increases an asset account. The Office Furniture and Computer Equipment accounts are debited because a debit increases an asset account.

The Accounts Payable account is credited since a credit increases a liability account. Note that the two debit entries are listed first. The Accounts Receivable account is debited because a debit increases an asset account. The Prepaid Rent account is an asset account because the rent was paid in advance and has not been used up. The Cash account is credited because a credit decreases an asset account. The next step is to post the transactions into the relevant accounts. The alternative account format is used for this purpose.

The postings are made in Exhibits 4. It is assumed that the journalizing of the transac- tions was on page 1.

Debit Credit Balance Jan. A trial balance that balances means that the total of all debit account balances equals the total of all credit account balances. The point of original entry into the accounting system is the general ledger. A law firm receives an advance fee from a client. The firm's accoun- tant would debit Cash and credit Earned Fees. According to the rules of debits and credits, expense accounts are debited to increase the account balances. The normal balance in the Accumulated Depreciation account would be a debit balance.

Financial Accounting DeMYSTiFieD

A prepaid expense is an expense that has been: Paid and incurred B. Incurred before it has been paid C. Paid before it has been incurred D. None of the above 7. Accounts that normally have credit balances are: Assets, Liabilities, and Shareholders' Equity B. Liabilities, Shareholders' Equity, and Revenues C. Liabilities, Shareholders' Equity, and Dividends D. Accumulated Depreciation, Liabilities, and Dividends 8. Which of the following statements is true? The journal is part of the general ledger. The specialized journals are part of the chart of accounts.

Each account in the general journal has a page number. All transactions journalized in the general journal are then posted to an account in the general ledger. Which of the following accounts normally has a debit balance? Which of the following entries would the accountant make? An advertising firm paid cash for a one-year building lease in advance. The correct journal entries would be: Debit Prepaid Leases, and credit Cash.

Debit Lease Expense, and credit Cash. Debit Prepaid Leases, and credit Accounts Payable. Debit Building, and credit Cash. The board of directors declared a dividend and paid it immediately to all stock- holders. The correct entries would be: Debit Dividend Expenses, and credit Cash. Debit Dividends, and credit Cash. Debit Dividends, and credit Dividends Payable. Which of the following statements is correct?

All accounts in the general ledger are numbered. When transactions are posted to an account, the journal page number is included. The general journal is often called the book of original entry. All of the above After a transaction is analyzed, the next likely step is: Posting to an account in the general ledger B. Enter it into a worksheet C. Journalizing into the general journal D. An Internet company receives a cash payment for future ads to be included on its Web site. Debit Cash, and credit Ad Revenue. Debit Cash, and credit Retained Earnings. This page intentionally left blank The Accounting Process: The latter steps are actually part of what is called the accounting cycle.

The accounting cycle is a series of steps that the accountant goes through from the point that a business transaction occurs until the financial statements are prepared. A summary of these steps are listed below: Identify a business transaction, which is found on a source docu- ment, such as an invoice. All transactions entered into the accounting system must have a supporting source document. Analyze the transaction; that is, determine what amounts are to be journalized, which accounts are affected, and whether the accounts are to be debited or credited.

Journalize the transaction by recording it into the appropriate journal as a debit and credit. Post the journal entries to the appropriate accounts in the general ledger. Prepare a trail balance and a worksheet at the end of a period in which statements are to be prepared.

Verify that the sum of debits equals the sum of credits. Make adjusting entries to all appropriate accrual and deferred accounts onto the worksheet. These entries are then journalized and posted to the accounts. Prepare and make closing entries to all temporary revenue and expenses accounts. Prepare an adjusted trial balance after the closing entries are made to determine if all debits and credits balance.

Prepare the financial statements. Steps 1 through 4 were covered in the last chapter. We now turn to step 5, the preparation of a trial balance and the worksheet. First, the accountant prepares a worksheet, which includes a trial balance of all the accounts in the accounting system. A trial balance is simply a listing of the cur- rent balances of all accounts in the general ledger. A major purpose of the trial balance is to check that the total of all debits equals the total of all credits.

The trial balance is entered directly on the worksheet. The worksheet see Exhibit 5. It starts with the unadjusted trial balance taken from the general ledger being placed in columns two and three see Exhibit 5. Any required adjustments to entries for the appropriate accounts are entered into the next two columns. What Are Adjusting Entries?

Adjusting entries are made at the end of the accounting period in order to allo- cate revenue and expenses to the proper accounting period using the revenue recognition and matching principles see Chapter 2. As mentioned, most com- panies use the accrual basis of accounting, which means that all revenue is rec- ognized when it is earned regardless of when the cash is received. This is based on the realization principle. Likewise, all expenses are recognized when they are incurred in generating the revenue earned.

This is based on the matching prin- ciple. This gives rise to accruals and deferrals that were discussed in Chapter 2. At the end of the accounting period, the accruals and deferrals must be adjusted as needed and entered on the worksheet. Some accountants may insert an addi- tional set of columns after the adjustments columns and include the adjusted trial balances to check that debits equal credits prior to entering the balances into the appropriate financial statement column.

The totals in the income state- ment and balance sheet accounts are the preliminary financial statements. The worksheet is an informal document that is not considered a permanent part of the accounting records but nevertheless is a very useful tool for preparing the financial statements.

All adjustments in the adjustments columns must be journalized to become part of the accounting records. As stated earlier, a com- puter program will prepare the worksheet internally and the accountant then decides which accounts require adjustments and makes the input entries. Then the computer program prepares the financial statements. What Are Closing Entries? Closing entries are journal entries necessary to close out the temporary Revenue, Expense, and Dividend accounts to Retained Earnings, which is a permanent account.

The final step is to close out all of the temporary revenue and expenses accounts to an account labeled Income Summary, and this account is then closed out to Retained Earnings. All of these entries must be journalized. At this point some companies may prepare a post-closing trial balance. The fol- lowing are transactions that occurred during the first month of its operation. At the end of the month, management directed that financial statements be pre- pared so that they could assess how well the company had performed in its first month of operation. It was assumed that they would be used up within one month; therefore, they were immediately written off as an expense.

The paper was used up in January. The payroll is made on the fifteenth of the month and on the first day of the following month. Following the steps in the accounting cycle, prepare the financial statements required by management. The transactions are analyzed and recorded in the journal see Exhibit 5. They are recorded in sequence by date. The journal entries are posted in journal sequence into the follow- ing ledger accounts. All transactions were on page 1 of the general journal see Exhibits 5. The accounts are in account sequence.

Prepare the worksheet Exhibit 5. See step 6 for explanations of adjustments. Note that no revenue was recognized since both subscription and adver- tising will not be recognized until February, when the first issue is mailed to subscribers. Note that the accumulated depreciation is a credit balance account and is called an asset offset or contra-asset account. It will be deducted from the original cost of the asset on the balance sheet to give a net book value of the asset.

Assume that all of the above journal entries were posted to the relevant accounts.

11 - Accounting for Natural Resources

Making closing entries requires the temporary revenue and expenses accounts to be closed to an account called Income Summary which is another temporary account]. To close the expense accounts a debit balance account], simply credit each account by the amount of the final balance and debit the Income Sum- mary account.

To close revenue accounts a credit balance account], do the opposite. After all of the revenue and expense accounts have been closed to the Income Summary account, the Income Summary account is closed to Retained Earnings. The result of the process is that all of the temporary accounts have a zero balance. Net income in the previous example, a net loss] has been closed to Retained Earnings.

In our example, assume that the balances in the temporary accounts are the amounts shown in the Income Statement columns of the worksheet. The following are the closing entries for Glitzy Magazine Company at the end of January 31, 2xxx. In actuality, the books would not be closed until the end of the year. However, we are closing the books for illustration purposes. It is assumed that the previous credit entries were made to the appropriate expense accounts and the related debit entries were made to the account shown in Exhibit 5.

A debit balance in what is normally a credit balance account may seem unusual. However, since this is a start-up company, it is not uncommon for such a com- pany to have a negative debit] balance in Retained Earnings for several years until the company reaches profitability. Prepare a post-closing trial balance. Some companies will complete this step, others will not, as the work- sheet in effect has the post-closing trial balances. The one exception is the Retained Earnings account, which can be determined after the Income Summary is closed.

For purposes of this illustration this step is skipped. The income statement for Glitzy Magazine Company is shown in Exhibit 5. However, in larger companies where there are thousands of transactions such an approach would be very inefficient. If there were only one sale per month to each of these customers, the number of individual transactions journalized in the general journal and posted to the accounts receivable account would be voluminous.

To streamline the accounting process, all companies use specialized special journals to record repetitive transactions. The most common of these journals are sales journals, purchases journals, cash receipts journals, and cash disbursement journals. All other transactions that do not fit in or relate to these special journals are recorded in the general journal. In addition to specialized journals, businesses use subsidiary accounts that are tied to an overall control account in the general ledger. For example, each business would want a record of, and track the history of, individual customer sales.

Therefore, companies will have — in addition to the Accounts Receivable Control account — a subsidiary account for each customer. The total of all subsidiary customer accounts must equal the Accounts Receivable Control account total. Other control subsidiary account relationships exist in the accounting system. To summarize the journal and ledger accounts relationships: With modern computer technology, all of these recordings can be done on a daily basis or even on a real-time basis. The four major journals are discussed in the following sections.

Sales Journal The simplest form of a sales journal would look like that in Exhibit 5. The total of the last column would also be posted to the sales account periodically. In larger companies, more information would be entered into the sales jour- nal. Electronic Sales The individual customer transactions would be posted to the subsidiary cus- tomer accounts daily. The total of the Accounts Receivable column and the Sales columns would be posted periodically but at least by the end of an accounting period. Further, a company would break out the number of sales columns necessary to provide sales information needed.

Finally, the totals of all of the credit columns must equal the total of the Accounts Receivable debit. Purchases Journal All credit purchases are recorded in the purchases journal. Cash purchases would be recorded in the cash disbursements journal below. Purchases on the subsidiary ledger would be done daily. Totals of each debit account column and the totals of the Accounts Payable column would be posted periodically but at least by the end of the accounting period. Cash Receipts Journal Only cash receipts would be recorded in the cash receipts journal.

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Sales The totals of each column would be posted to the respective general ledger accounts periodically. Addi- tional columns could be added to the cash receipts journal as needed. Cash Disbursements Journal Cash payments would be recorded in the cash disbursements journal, includ- ing cash purchases.

Individual accounts that had cash purchases would be listed in column four e. Credit purchases would be recorded in the purchases journal, discussed previously. The total of the Accounts Payable, Pur- chases Discounts, and Cash accounts would be recorded in the ledger accounts periodically.

In addition, individual vendor accounts in the accounts payable subsidiary ledger would be posted daily. Accountants prepare an unadjusted trial balance at the end of an accounting period, which is useful in preparing financial statements. Dollar signs are entered in the journal when transactions are journalized.

The first step in the accounting cycle is to record a transaction in the general ledger. A trial balance is simply a listing of the current balances of all accounts in the general ledger. A deferred income account would never require an adjustment at the end of the accounting period. The purpose of the closing process in the accounting cycle is to: Close out the permanent account balances B. Record the necessary end of the accounting year adjusting entries C. Close the revenue and expense accounts to the Income Summary account D. None of the above Use the following information for questions 7 through 9: The board of directors declares a dividend on December 1, which is payable on February I.

The company closes its books on December What would be the entries on December 1, assuming that the company uses a dividend account?

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A debit to Dividends and a credit to Dividends Payable C. A debit to Dividends and a credit to Accounts Payable D. None of the above 8. On December 31 what would be the closing entry? A debit to Retained Earnings and a credit to Dividends B. A debit to Dividends Payable and a credit to Dividends C. A debit to Income Summary and a credit to Dividends D.

On February 1 what would be the entry when the dividends are paid? A debit to Dividends Payable and a credit to Dividends B. A debit to Retained Earnings and a credit to Cash C. A debit to Retained Earnings and a credit to Dividends D. A debit to Dividends Payable and a credit to cash What would be the adjusting entry on December 31, the end of the accounting period?

The term of the rental contract is one year. What would be the entry on December 1? What closing entry would be made? There is no closing entry, since Notes Receivable is a permanent account. None of the above 1 3. Which of the following accounts would most likely not require an adjusting entry at the end of the accounting period? Unearned Rental Income D.

Subscriptions Received in Advance The Accumulated Depreciation account is: An asset account B. An expense account C. A stockholders' equity account D. The entry to close this account would be: Cash is the most liquid asset and is generally defined as those unrestricted items that are acceptable to a bank for deposit. Specifically, cash includes such items as these: As such, the company will invest this excess in very short-term securities in order to earn interest.

These holdings are called cash equivalents. Cash equivalents are generally defined as liquid assets that are read- ily convertible into cash and will mature in a relatively short period of time not to exceed 90 days from the date of acquisition. Cash equivalents should have a low risk of loss of value. They include such items as these: Short- term investments are generally investments in securities maturing in excess of 90 days but within one year.

Cash and cash equivalents specifically exclude any funds on hand or on deposit that have restrictions, such as compensating balances funds held as collateral on a loan and sinking funds held to pay bond debts. Valuing and Reporting of Cash and Cash Equivalents Since cash equivalents can be converted to cash immediately, they are reported at the face value of the instruments involved. Both cash and cash equivalents are normally bundled and reported as one figure on the Current Asset section of the balance sheet. Further, the individual types of cash equivalents are not broken out but may be explained in a footnote, if material.

Doing so requires the accountant to provide cash budgets, accurately account for cash and cash equivalents, and report cash flows to relevant company managers in a timely manner. It also requires the accoun- tant to establish adequate controls to protect cash and prevent fraud and theft. The latter is discussed in the next section. To summarize, here are the steps in good cash management: Prepare a cash budget to evaluate cash needs. Preparation of cash budgets will be covered in Chapter Cash budgets should be used to determine the right level of cash to have on hand.

Excess cash should be invested temporarily in short-term investment.