Accounting Cycle, Generally Accepted Accounting Principles, and Financial Statements

Accounting cycle:the name given to the collective process of recording and processing the accounting events of a company. The series of steps begin when a transaction occurs and end with its inclusion in the financial statements. Steps:Collecting and analysis data from transactions and events; Putting transactions into the general journal; Posting entries to the general ledger; Preparing an unadjusted trial balance; Adjusting entries appropriately; Preparing an adjusting trial balance; Organizing the accounts into the financial statements; closing books; preparing a post-closing trial balance to check the accounts.

GAAP:The conventions, rules, and procedures necessary to define accepted accounting practice at a particular time; Developed to provide guidelines for financial accounting; Evolve as better methods emerge or as circumstances change

Four Major Financial Statements: Income Statement, Statement of Owner’s Equity, Balance Sheet, Statement of Cash Flows

Income Statement Summarizes revenues earned and expenses incurred over an accounting period; Dated “For the Month Ended …” or “For the Year Ended …”; Shows whether a company achieved its profitability goal; Often considered the most important financial report.

Statement of Owner’s Equity Shows changes in owner’s equity over an accounting period; Dated “For the Month Ended …” or “For the Year Ended…”; Uses net income figure from income statement; Owner’s Capital balance at the end of period used to prepare balance sheet.

Balance Sheet Shows the financial position of a business on a certain date; Often called the statement of financial position; Presents view of business as holder of assets that are equal to the claims against those assets; Claims consist of the company’s liabilities and the owner’s equity

Statement of Cash Flows Shows cash flows into and out of a business during an accounting period; Shows important investing and financing transactions of the period; Focuses on liquidity; Explains how the Cash account changed during the period

 

The Accounting Cycle is a series of steps which are repeated every reporting period. The process starts with making accounting entries for each transaction & goes through closing the books.

Accounting Cycle – Steps During the Accounting Period

These accounting cycle steps occur during the accounting period, as each transaction occurs:

1. Identify the transaction through an original source document (such as an invoice, receipt, cancelled check, time card, deposit slip, purchase order) which provides:

o Date,amount, description (account or business purpose), name & address of other party (if practical)

2. Analyze the transaction – determine which accounts are affected, how (increase or decrease), & how much

3. Make Journal entries – record the transaction in the journal as both a debit & a credit

4. Post to ledger – transfer the journal entries to ledger accounts

Accounting Cycle: Steps at the end of the accounting period

These accounting cycle steps occur at the end of the accounting period:

1.Trial Balance – this is a calculation to verify the sum of the debits equals the sum of the credits. If they don’t balance, you have to fix the unbalanced trial balance before you go on to the rest of the accounting cycle. (If they do balance you could still have a problem, but at least it balances!)

2.Adjusting entries – prepare & post accrued & deferred items to journals & ledger T-accounts

The following are the most common circumstances that require adjustments:

1. Accrued revenue (for example, interest earned but not yet received); 2. Accrued expense (wage cost incurred but not yet paid); 3. Unearned revenue (earning subscription revenue that had been collected in advance); 4. Prepaid expense (expiration of a prepaid insurance premium); 5. Depreciation (recognizing the cost of a machine as expense spread over its useful economic life); 6. Inv (recording the cost of goods sold on the basis of a period's purchases & the change between beginning & ending Inv balances); 7. Receivables (recognizing bad-debt expenses on the basis of expected uncollected amounts).

3.Adjusted trial balance – make sure the debits still equal the credits after making the period end adjustments

4.Financial Statements – prepare income statement, balance sheet, statement of retained earnings, & statement of cash flows (this can occur at other points in time with appropriate adjustments)

5.Closing entries – prepare & post closing entries to transfer the balances from temporary accounts (such as the revenue & expenses from the income statement to owner’s equity on the balance sheet).

6.After-Closing trial balance – final trial balance after the closing entries to make sure debits still equal credits.

GAAP

Accounting Entity: assumes that the business is separate from its owners or other businesses. Revenue & expense should be kept separate from personal expenses.

Going concern principle. Unless otherwise noted, financial statements are prepared under the assumption that the company will remain in business indefinitely. Therefore, assets do not need to be sold at fire-sale values, & debt does not need to be paid off before maturity. This principle results in the classification of assets & Liab as short-term (current) & long-term. Long-term assets are expected to be held for more than one year. Long-term Liabare not due for more than one year.

Principle of conservatism Relevance, reliability. Accountants must use their judgment to record transactions that require estimation. The № of years that equipment will remain productive & the portion of accounts receivable that will never be paid are examples of items that require estimation. In reporting financial data, accountants follow the principle of conservatism, which requires that the less optimistic estimate be chosen when two estimates are judged to be equally likely.

Monetary Unit principle: assumes a stable currency is going to be the unit of record. The FASB accepts the nominal value of the US Dollar as the monetary unit of record unadjusted for inflation.

Time period assumption. Most businesses exist for long periods of time, so artificial time periods must be used to report the results of business activity. Depending on the type of report, the time period may be a day, a month, a year, or another arbitrary period.

Matching principle. Expenses have to be matched with revenues as long as it is reasonable to do so. Expenses are recognized not when the work is performed, or when a product is produced, but when the work or the product actually makes its contribution to revenue. Only if no connection with revenue can be established, cost may be charged as expenses to the current period (e.g. office salaries & other administrative expenses). This principle allows greater evaluation of actual profitability & performance (shows how much was spent to earn revenue). Depreciation & Cost of Goods Sold are good examples of application of this principle.

Full Disclosure principle. Amount & kinds of info disclosed should be decided based on trade-off analysis as a larger amount of info costs more to prepare & use. Info disclosed should be enough to make a judgment while keeping costs reasonable. Infois presented in the main body of financial statements, in the notes or as supplementary information

Accrual basis accounting. In most cases, GAAP requires the use of accrual basis accounting rather than cash basis accounting. Accrual basis accounting, which adheres to the revenue recognition, matching, & cost principles discussed below, captures the financial aspects of each economic event in the accounting period in which it occurs, regardless of when the cash changes hands. Under cash basis accounting, revenues are recognized only when the company receives cash or its equivalent, & expenses are recognized only when the company pays with cash or its equivalent.

Historical cost princi ple. Assets are recorded at cost, which equals the value exchanged at the time of their acquisition. In the United States, even if assets such as l& or buildings appreciate in value over time, they are not revalued for financial reporting purposes.

Revenue recognition principle. Revenue is earned & recognized upon product delivery or service completion, without regard to the timing of cash flow. requires companies to record when revenue is (1) realized or realizable & (2) earned, not when cash is received. This way of accounting is called accrual basis accounting.

Consistency principle: It means that the company uses the same accounting principles & methods from year to year.

 

67. Merchandising operations & inventories

Merchandising Businesses - earn income by buying and selling products or merchandise

It can be wholesalers or retailers. Use the same basic accounting methods as service companies

The process is more complex than for service companies because of the buying and selling of goods. The goods on hand for sale to customers are called merchandise inventory

Operating cycle - series of transactions that include the

– Purchase of merchandise inventory for cash or on credit

– Payment for purchases made on credit

– Sales of merchandise inventory for cash or on credit

– Collection of cash from credit sales

The Financing Period - The time period from the purchase of inventory until it is ultimately sold and collected less the amount of time creditors give the company to pay for the inventory. Also called the cash gap. This is the period of time the company will be without cash from a particular series of transactions. The company will need to have funds available or borrow from the bank. This is why cash flow management is important

Choice of Inventory System. There are two basic systems:

– Perpetual inventory system

– Periodic inventory system

Management must choose the system or combination of systems that is best for achieving the company’s goals:

The perpetual inventory system keeps continuous records of quantity and, usually, the cost of individual items as they are bought and sold. The periodic inventory system determines inventory on hand only by a physical count taken at the end of the period. No detail records of the actual inventory on hand are maintained during the accounting period.

Trade Discount. A reduction from list or catalogue prices given by wholesalers and manufacturers. Usually 30 percent or more

Sales Discounts. Discounts given by seller to a buyer for early payment of the buyer’s account

Sales discounts taken are debited to the Sales Discounts account.

Purchases Discounts. Discounts taken by the buyer for the early payment on merchandise

Purchases discounts taken are credited to the Purchases Discounts account

Buyer pays shipping costs, called freight-in

Title of merchandise passes from seller to buyer at the point merchandise is shipped

Seller pays shipping costs, called freight-out

Title of merchandise passes from seller to buyer when the merchandise reaches its destination

The Purchases Returns and Allowances account is a contra-purchases account, it carries a normal credit balance. It is deducted from purchases on the income statement

The Sales Returns and Allowances account is a contra-revenue account. It carries a normal debit balance. It is deducted from sales on the income statement.

Inventories. Is considered to be a current asset. Items, normally sold within a year or a company’s operating cycle.

Manufacturing Businesses:Inventory consists of:

• Raw materials or goods used in making of products

• Work in process or partially completed products

• Finished goods ready for sale

Merchandising Businesses:Inventory consists of goods held for sale in regular course of business

Inventory Decisions:

ü Inventory processing systems

ü Costing methods

ü Valuation methods

Result in different amounts of reported net income, taxes paid, and cash flows

When keeping large quantity: Costs of handling and storage are high but customers will be satisfied with quick order fulfillment and large selections.

When keeping low quantity: Lower storage costs but it may result in lost sales or dissatisfied customers.

Days’ Inventory on Hand = Number of Days in a Year / Inventory Turnover - indicates the average number of days required to sell the inventory on hand.

Supply Chain Management: Computerized system that a company uses to order and track inventory and just-in-time operating environment helps reduce inventory levels by coordinating orders and shipments of products so that they arrive “just in time” for customer orders

Inventory Cost includes: Invoice price less purchases discounts Freight-in, including insurance in transit

Applicable taxes and tariffs

Ownership of goods in transit is determined by the terms of the shipping agreement: FOB destination or FOB shipping point

Lower-of-Cost-or-Market Rule: When the replacement cost of inventory falls below historical cost, the inventory is written down to the lower value and a loss is recorded.