Introduction to Financial Accounting

Journal Entries

Note that journal entries are only recorded when the revenue is recognized (XXX).

Debits and Credits

In general assets and expense accounts are increased through debits and decreased through credits. On the other hand, liabilities, stockholders equity, and revenues are decreased through debits and increased through credits.

Adjusting Entries

There are number of adjusting entries that have to be recorded every financial year (or quarter). These include:

1. Deferred Expenses (these are assets that have been used up such as prepaid rent and prepaid insurance)
2. Deferred Revenues (these are liabilities that have been taken care of such as delivery of goods)
3. Accrued Expenses (these are liabilities that have increased such as income tax payable)
4. Accrued Revenue (these are assets that have been increased but not recorded such as interest receivable on a loan or rent receivable on a property that the company is leasing out)
5. Depreciation and amortization

Types of Financial Statements

Balance Sheet

Measures finances of a company at a given point in time and is based on the equation that

Assets = Liabilities + Equity

where stockholders equity is defined as:

Prior Retained Earnings + Revenues - Expenses -Dividends

Income Statement

This statement shows the revenue and expenses of a company over a period of time.

Statement of Equity

This statement shows how the stockholder equity changes over a period of time.

Statement of Cash Flows

This statement shows the net cash flows due to the following activities:

1. operating expenses
2. investments
3. financing activities

Revenue/Expense Timing

Percentage of Completion Method

Over a long term project that takes multiple years to complete, companies often use the percentage of completion method. One must determine what percentage of expenses are incurred during a given period. During this period, the amount of revenue recognized will be the percentage of expenses incurred multiplied by the total revenue expected to be generated by the entire project.

Completed Contract Method

If it is hard or impossible to determine the exact amount of contract, or the amount of the expenses incurred, then none of the revenue is recognized until the contract is complete.

(Non) Operating Income

Expense and revenue items can either be categorized as operating or non-operating. Operating income includes cost of goods sold and selling, general, and administrative expenses. Dividends and interest are generally not considered operating expenses/income. GAAP does not have rules to classify expense/revenue as operating or not.

Account Types

Assets

Definition

An asset is a resource that is expected to generate future benefit.

Recognition

An asset is recognized only when:

1. it is acquired in a past transaction
2. The value of future benefits can be measured with reasonable degree of certainty

Measurement Method

There are three ways to measure an asset:

1. The fair market value
2. The historical value of the asset
3. The least of cost and market value

Inventory

Inventory starts in the work in process account. After it is finished being produced, the inventory is moved to the finished goods account. Finally, after the goods are sold, the inventory is moved into the COGS account (Cost of Goods Sold).

Inventory accounts include direct labor, direct materials, and manufacturing overhead.

There are two systems of counting inventory:

1. Perpetual System
2. Periodic System

When you write down inventory there are two ways to do this:

1. if the fair market value is less than cost, then inventory is written down to its fair market value (the fair market value of the good is the lower of the replacement cost and the sales price less selling cost)

There are two ways in which inventory can be written down:

1. Direct write-off method. At the time the company identifies the loss, ... In the direct write off method, inventory is debited and COGS is credited.
2. Allowance method. At the time the company anticipates the loss in value, ... The allowance account is called ... If the allowance method is used, the inventory number on a company balance sheet is the net inventory (meaning that the inventory is the gross inventory minus the write-off allowance.)

Prepaid Rent

Prepaid rent includes rent that has been paid for future months.

Accounts Receivable

Accounts receivable has a number of sub accounts:

Other

The other sub account in accounts receivable can include exchange rates that change and M&A activity that might lead to the acquisition of accounts receivable.

These can be written off in two ways:

1. Set up an allowance for doubtful accounts. This is a sister account that keeps account of estimate of the accounts that will not be received. If this type of account is used, then there needs to be an item on the balance sheet called net accounts receivable, which includes the accounts receivable minues the allowance for doubtful accounts. Note that the expense does not happen when the default on the payment happens by the customer; the expense account (bad debt expense) is changed when the allowance for doubtful accounts is incremented. This makes sure that the expense happens in the same period in which the expense actually happens rather than in the following year. Note: if the amount of doubtful accounts is not calculated properly, bad debt expense will have to be adjusted at the end of the year. (Bad debt expense is only adjusted at the end of the year, even if there is a surprise payment in the middle of a year.) There is a question about how the allowance for doubtful accounts is created. It can be done in two ways:
   1. First, one could use just a straight percentage of the accounts receivable and add that to the doubtful accounts
   2. Second, one could use different percentages of the accounts receivable depending on how long the value has been on receivable account.
2. Direct right off method.

Investments

This includes things like the purchase of shares in other companies

Land

This includes the the purchase price of the land.

Liabilities

In order for something to be considered a liability, good/services have to be rendered to the company without the company having yet paid for them.

Unearned Revenue / Advances from Customers

Unearned revenue is money paid to a company but goods or services have not yet been provided for this money. As the goods and services are provided to the customers, the unearned revenue is subtracted from the liabilities and increased to the earned capital on the balance sheet.

Possible: bundles sales in which the product's revenue is earned while the revenue from the services sold with the product are not earned.

Accounts Payable

Accounts payable are usually from supplies/inventory that are received but have not yet been paid for.

Income Tax Payable

This is the amount of tax that is owned to the IRS based on estimates that has not been paid yet.

Salaries Payable

Salaries payable is the amount of money that is owed to employees for the time that they have worked but not been paid for it.

Warranties Payable

Generally, warranties are estimated as a percentage of sales. So if $1,000,000 of goods are sold, and it is estimated that it costs 10% of the cost of goods to service warranties, then the liability would be $100,000.

Notes Payable

This is the amount of principle outstanding from loans taken out.

Revenue

Money incoming to a firm is considered revenue if:

1. it is earned (the seller has done everything required of them in the sales agreement and/or if there are goods involved, the title of the goods have passed over) AND
2. it is realized. Realized means that
   1. there is a sales agreement
   2. delivery of services or goods delivered
   3. the seller's price can be determined
   4. it is possible to collect the payment form the goods/services

Possible issues: returns, installment sales (in which case the the revenue is only recognized then cash is paid; expenses are COGS are adjusted in proportion to the installment paid)

Shareholder Equity

Common Stock/Par

This is the par value of the stock.

Additional Paid in Capital

This is the amount paid for the stock in excess of the par value.

Retained Earnings

This account is debited when there are dividends paid out.