Accounting Basics - Lecture Note

BASICS OF ACCOUNTING ACCOUNTING According to Accounting Standards Council (ASC) “Accounting is a service activity. Its function is to provide qualitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions.” According to American Institute of Certified Public Accountant (AICPA) “Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are in part of at least of a financial character and interpreting the results thereof.” According to American Accounting Association (AAA) “Accounting is the process of identifying, measuring and communicating economic information to permit informed judgement and decision by users of the information.” Service Business BUSINESS Merchandising Business Manufacturing Business ROLE OF ACCOUNTING IN BUSINESS: Accounting is the “language of business”. It is the means by which business information is communicated to shareholders. Accounting is an information system that provides reports to users about economic performance and condition of a business. ACCOUNTING PROCESS 1. Documenting Transactions 2. Journalizing 3. Posting to Ledger 4. Preparation of Unadjusted Trial Balance 5. Journalizing and posting of Adjusting journal entries 6. Preparation of Adjusted Trial Balance 7. Preparation of Financial Statements 8. Journalizing and Posting of Closing entries 9. Preparation of Post Closing Trial Balance 10. Journalizing and Posting of Reversing entries NOTE: “Posting is under the Recording Phase and the only step included in Classifying Phase.” RECORDING PHASE SUMMARIZING PHASE USERS OF ACCOUNTING 1. Internal Users (for management purposes) 2. External Users (main users of Financial Statement) (e.g creditors and investors) ACCOUNTABLE EVENTS Documenting Transactions NON-ACCOUNTABLE EVENTS Only those that affects the elements of the financial statements are recognized or journalized. Non-accountable events are not recognized but disclosed in the notes to Financial Statements. Journalizing Double-entry accounting system The sum of the debits is always equal to the sum of the credits for each journal entry. The equality of debits and credits for each transaction is built into the accounting equation (Asset = Liabilities + Equity). Because of this double equality, this system of recording transactions is called the double-entry accounting system. General Journal Special Sales Journal Cash Receipt Journal Purchase Journal Cash Disbursement THE ELEMENTS OF FINANCIAL STATEMENT The international Accounting Standards Board (IASB) has published its revised ‘Conceptual Framework for Financial Reporting’. Included are revised definitions of an asset and a liability as well as new guidance on measurement and derecognition, presentation and disclosure. BALANCE SHEET ASSET A present economic resource controlled by the entity as a result of past events. An economic right that has the potential to produce economic benefits. LIABILITY A present obligation of the entity to transfer an economic resource as a result of past events. EQUITY The residual interest in the assets of the entity after deducting all its liabilities. INCOME STATEMENT INCOME Increases in assets or decreases in liabilities that result in increase in equity, other than those relating to contributions from holders of equity claims. EXPENSES Decreases in assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to holders of equity claims. The expression “economic resource” instead of simply “resource” stresses that IASB no longer thinks of assets as physical objects but as sets of rights. The definitions of assets and liabilities also no longer refer to expected” inflows or outflows. Instead, the definition of an economic resource refers to the potential of an asset / liability to produce / to require a transfer of economic benefits. How do you Journalize transactions? TRANSACTIONS: o On January 4 ABC Company purchased office equipment on account from XYZ Company for Php 90,000. o On January 16 ABC Company paid 50% of purchased equipment. The January 4 transaction above can be journalized as follows: Using the T-account, this journal entry can be shown as Office Equipment is an asset of the company therefore its normal balance should be on the Debit side (Left side) Accounts Payable is a liability of the company therefore its normal balance should be on the Credit Side (Right side) The January 4 transaction above can be journalized as follows: Using the T-account, this journal entry can be shown as Paying the Office Equipment means reducing the liability account. To reduce the liability account, we should debit the amount because liability account’s normal balance is Credit side. Cash is an asset account therefore the normal balance is Debit. Since cash will depart from the company, the asset account should be reduced. Reducing asset account means we credit the amount. Posting to ledger A transaction is first recorded in a journal. Periodically, the journal entries are transferred to the accounts in the ledger. TRIVIA! In 1494, Luca Pacioli, a Franciscan monk, invented the double entry accounting system that is still used today. The process of transferring the debits and credits from the journal entries to the accounts is called “Posting”. General Ledger Subsidiary Ledger Also known as: JOURNAL Book of Original Entry LEDGER Book of Final Entry The ledger is a history of transactions by account. It is where the end balance of each account. Income statement accounts are Nominal Accounts which means they are temporary accounts. On the other hand, Balance Sheet accounts are Real Accounts which means the accounts are carried over to the next period. Represents the record-keeping system for a company’s financial data, with debit and credit account records validated by a trial balance. an accounting record that contains detailed information about a specific subset of General ledger. The subsidiary ledger shows detail for part of the accounting records such as property and equipment, prepaid expense etc. • A journal can be thought of as being similar to an individual’s diary of significant day-to-day life events. • Every transaction affects at least two accounts. • The left side of all accounts is the debit side, and the right side is the credit side. Posting to Ledger Ledger accumulates all the effects of the transactions during a period in specific accounts. In other words, we combine the effects of transactions affecting the accounts. JANUARY 4 TRANSACTION TRANSACTIONS: o On January 4 ABC Company purchased office equipment on account from XYZ Company for Php 90,000. o On January 16 ABC Company paid 50% of purchased equipment. Posting to Ledger: When posting to the ledger, we are creating the end balances of the accounts. The beginning balance of Office Equipment is 90,000. There are no other transactions that increases or decreases the Office equipment thus the ending balance of Office Equipment is also 90,000. JANUARY 16 TRANSACTION Accounts payable beginning balance is 90,000, however, on January 16, ABC company paid 50% of 90,000. Therefore, Accounts payable is reduced by 45,000 by debiting it. THE END BALANCES OF THE ACCOUNTS THEREFORE ARE: Office Equipment 90,000 Accounts Payable 45,000 Cash (45,000) “Ledger accumulates all the effects of the transactions during a period in specific accounts.” Preparation of Unadjusted Trial Balance Posting to Ledger means accumulating all the effects of transactions in a specific account. In other words, we get the ending balances of each account. After we get the ending balances of each account, we will then prepare the Unadjusted Trial Balance, which includes the ending balances of each the accounts. How can you be sure that you have not made an error in posting the debits and credits to the ledger? One way is to determine the equality of the debits and credits in the ledger. This equality should be proved at the end of each accounting period. Such a proof, called a TRIAL BALANCE. The trial balance does not provide complete proof of the accuracy of the ledger. It indicates only that the debits and the credits are equal. If a transaction is not recorded or omitted, it is possible that the Trial Balance Debit and Credit will still be equal. EXAMPLE OF UNADJUSTED TRIAL BALANCE: Adjusting Journal Entries Whenever accountants prepare Financial Statements, they use the accounting period concept to determine in which period the revenues and expenses should be reported. Accountants use the Accrual basis of accounting based on GAAP which means Revenues are reported in the period in which they are earned (cash may or may not be received during this period). When using the accrual basis of accounting, some accounts in the ledger require updating of balances. For example, Prepaid Expense, which we do not journalize on a dayper-day basis because it would be inefficient and require too many entries. It would be better if we debit the total amount of asset and at the end of period, we credit the expired portion to reduce the amount of asset and make it up to date. In accrual basis, expenses are reported in the same period as the revenues to which they relate. By matching revenues and expenses, net income or loss for the period will be properly reported in the income statement. ACCOUNTING PERIOD ASSUMPTION states that businesses should report their financial position, results of operations, and cash flows at regular intervals. These intervals are typically monthly, quarterly, or yearly. ACCOUNTING PERIOD ASSUMPTION Record revenue when a sales transaction occurs. Record expenses when a transaction for the purchase of goods or services occurs. Therefore, recognize revenue and matching expense when they are generated, not when money actually received or given. Prepaid Expense An expense that is paid for in advance. All adjusting entries affect at least one income statement account and one balance sheet account. Thus, an adjusting entry will always involve revenue or an expense account and an asset or a liability account. ADJUSTING ENTRIES Under the cash basis of accounting, accounts do not require adjusting. This is because transactions are recorded only when cash is received or paid. Matching concept is not used under the cash basis. The cash basis concept states that revenues and expenses are reported in the income statement in the period in which cash is received or paid. Therefore, when an entity uses Accrual basis of accounting, the entity is required to do adjustment through the adjusting entries. PREPAID EXPENSE BAD DEBT EXPENSE Bad Debt Expense Allowance for Bad Debts Debit XX ASSET METHOD Credit XX Expense Account Payable Account ORIGINAL JOURNAL ENTRY: Credit XX Receivable Account Income Account Credit XX Insurance Expense Cash Debit XX Credit XX ADJUSTING JOURNAL ENTRY: Debit XX Insurance Expense Prepaid Insurance Credit XX Prepaid Insurance Insurance Expense Debit XX Credit XX Credit XX INCOME METHOD LIABILITY METHOD ORIGINAL JOURNAL ENTRY: Cash Unearned Income DEPRECIATION EXPENSE Depreciation Expense Accumulated Depreciation Credit UNEARNED INCOME XX Debit XX Debit XX Prepaid Insurance Cash ACCRUED INCOME Debit XX ORIGINAL JOURNAL ENTRY: ADJUSTING JOURNAL ENTRY: ACCRUED EXPENSE Debit XX EXPENSE METHOD ORIGINAL JOURNAL ENTRY: Debit XX Credit XX ADJUSTING JOURNAL ENTRY: Unearned Income Income account Cash Income account Debit XX Credit XX ADJUSTING JOURNAL ENTRY: Debit XX Credit XX Income account Liability account Debit XX Credit XX Preparation of Adjusted Trial Balance After posting the adjusting entries, the total debit balance and total credit balance should be equal as verified by an adjusted trial balance then the accountant proceeds to the preparation of Financial Statements. Preparation of Financial Statements Statement of Financial Position Statement of Financial Performance FINANCIAL STATEMENTS NOTE! Statement of Financial Position is also the Balance Sheet. On the other hand, Statement of Financial Performance is also the Income Statement Statement of Cash Flows Statement of Owner’s Equity Notes to Financial Statements Statement of Financial Position Statement of Financial Position is also known as the Balance Sheet. Under the Balance Sheet, it has the elements of Asset, Liability and Equity. Under the Accounting equation, Assets should be equal to the sum of Liabilities and Owner’s Equity. Like the example, the Total Assets is 45,000 and the Total Liabilities and Equity should also be 45,000. Notice that the Statement of Financial Position title date is “As of” because Balance sheet accounts are permanent accounts wherein Asset, Liabilities and Equity accumulates (carried over to next period). Users of Financial Statements use the Statement of Financial Position to make judgement about a company’s valuation and creditworthiness, allowing the intended users to make useful decisions. Statement of Financial Performance Statement of Financial Performance is also known as the Income Statement. Under the Balance Sheet, it has the elements of Income and Expenses. Like the example, the Income (Service Fee) is 263,000 and the Total Expenses is 207,650. The 55,550 excess of the revenue over the expenses is called Net income. Suppose Total Expenses is greater than the Income, the excess is called Net loss. Notice that the Statement of Financial Performance title date is “For the Year Ended” because Income Statement accounts are temporary accounts (also known as temporary accounts) wherein Income and Expense accounts are closed at the end of the period using the Closing Journal Entries. Users of Financial Performance identifies how well a company generates revenues and manages its assets, liabilities, and financial interests of shareholders. Statement of Owner’s Equity The Statement of Owner’s Equity should be prepared before the Statement of Financial Position because the amount of Owner’s Equity is reported in the Balance Sheet. On the other hand, Statement of Owner’s Equity should be prepared after the Statement of Financial Performance because we need the amount of Net Income or Net Loss that is also reported in the Statement of Owner’s Equity. (Look at the Net income presented in Statement of Financial Position above). Statement of Cash Flow Statement of Cash flows consists of 1. Cash flows from Operating Activities 2. Cash flows from Investing Activities 3. Cash flows from Financing Activities The cash flow statement measures the performance of a company over a period of time. It is a financial statement that shows how changes in balance sheet accounts and income affect cash. (Look at the Cash account in the Statement of Financial Position above, it is also 26,525 derived from the Statement of Cash Flows CLOSING ENTRIES Closing entries are journal entries that is made at the end of the accounting period. Account balances of temporary account should be transferred to a Real (Permanent) Account. Closing entries is done to make the balances of Revenue and Expenses zero for the year-end, therefor the Revenue and Expenses’ beginning balance next year is zero. In other words, the amount of Net income or Net loss is transferred to the Equity section of the Statement of Financial Position. How to Close the Temporary accounts? Why is there a need to close the amounts of Revenues and Expenses to zero at year-end? The purpose of Statement of Financial Position is to keep track how well the company generates revenue and manages the assets during the year. We need to close it at the end of the current year so that we can track again the performance of the company next year by reviewing the Revenues and Expense of that year. Using the account title “Income Summary” we can close the Revenue and Expenses. CLOSING THE REVENUE ACCOUNTS CLOSING THE EXPENSE ACCOUNTS Note that the normal balance of Revenue is Credit, to reduce its amount means we must Debit it and then Credit Income Summary account. Note that the normal balance of Expenses is Debit, to reduce its amount means we must Credit it and then Debit Income summary account. INITIAL ENTRIES REVENUE CLOSING ENTRIES REVENUE EXPENSES EXPENSES TRANSFERRING TEMPORARY ACCOUNT TO PERMANENT ACCOUNT