PROFESSOR S CLASS NOTES UNIT 3 COB 241 Sections 13, 14, 15 September 5, 2018

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1 PROFESSOR S CLASS NOTES UNIT 3 COB 241 Sections 13, 14, 15 September 5, 2018 Administrative Items: Free Tutoring Schedule: Monday & Tuesdays, 1:00 to 3:00 pm, ZSH 321 Paid Tutoring: By appointment, contact list distributed in class Brief Reminder of Major Topics which must be completely mastered: (covered in class Sep 3) Entity Principle: The organization keeps its records separately from the owners records. Definition of Accounting: Accounting is the process of recording and tracking where the entity s financial resources came from, where they are, and where they went, and preparing reports (for insiders and outsiders) which provide useful information for decisionmaking.. Accountant s other Responsibilities: Tax preparation/guidance, data analysis/interpretation, budgeting, auditing Accounting Types: Financial vs. Managerial accounting. Financial Accounting MUST follow GAAP. GAAP, published by FASB: Generally-Accepted Accounting Principles, Financial Accounting Standards Board The Master Accounting Equation: Assets = Liabilities + Equity Assets: Anything the organization has ownership rights to, or rights to collect, prepaids, etc. Liabilities: Anything the organization has a legal obligation to pay, perform, or return. Equity: The portion of the business s total assets which are not obligated to be paid back (or returned) to a debtholder Four Primary Financial Statements: Income statement, Balance Sheet, Changes in Equity, cash Flows Components of Owner s Equity: Contributed Capital, Components of : Net Income less Distributions Components of Net Income: Revenue less Expenses, plus Gains less Losses Demonstration using Rustic Camp Sites (RCS) from the textbook TODAY S MATERIAL The Period Principle: Accounting records are always kept for a period of time. Typically this is either one year, or one quarter, or commonly, one month. Closing: at the end of the period The books are closed and financial statements prepared. The term Closing means performing the following tasks: (a) Making adjusting entries (one of the main topics of today s class) (b) Determining the balance in each account after making adjusting entries. (c) Netting Revenue against Expenses (and gains and losses, if any) to (d) Determine the period s Net Income. (e) Moving all account balances from Revenue, Expense, (& gains/losses) and Distributions, to, thereby (f) Zero-ing out the revenue and expense accounts, making them ready to start accumulating the revenue and expense for the next period. (Ditto the gains/losses and distribution accounts). (g) Preparing the financial statements Item (b) is known as a striking an Adjusted Trial Balance. Item (e) is known as making the Closing Entries, and automatically results in item (f). Memorizing the list of items above (a) through( g) is not as important as knowing and understanding what all of these activities are, and why we are doing them!

2 The Matching Principle A period s Income Statement should reflect all revenue earned during the period (revenue), and must report all expenses incurred during the period. Note the words, earned and incurred. This is NOT the same as paid during the period! This concept results in what we call Accrual Accounting, as opposed to Cash accounting. GAAP requires Accrual Accounting for almost all businesses. Accounts Receivable (sometimes just called, Receivables ) When a business makes a sale on credit (sometimes called making a sale on account ) the business will record the revenue in the period in which the sale is made, and will add the amount to an asset account called Accounts Receivable (or A/R). Later, when the business collects the money from the customer, the cash received is recorded to the cash account, and the A/R amount is cleared. Example: Cato Consultants provided $84,000 of consulting services to its clients. Cato has completed the work, and billed the clients, but has not yet collected any cash. ( 2 in textbook, page 73) ASSETS = LIABILITIES + Cash A/R Common Stock Revenue Expense Distributions At this point in time, Cato has revenue on its income statement. The balance sheet show a shortterm asset (Accounts Receivable, or A/R), but no cash from the sales. Later, Cato collected $60,000 cash from customers in partial settlement of its accounts receivable ( 3 in textbook, page 73) ASSETS = LIABILITIES + Cash A/R Common Stock Revenue Expense Distributions

3 Accounts Payable (sometimes just called, Payables ) When a business incurs an expense on credit (sometimes called incurring an expense on account ) the business will record the expense in the period in which the expense is incurred, and will add the amount to a liability account called Accounts Payable (or A/P). Later, when the business pays, the cash disbursed is deducted from the cash account, and the A/P amount is cleared. Example: Cato Consultants hires a salaried employee who works during the period, and will be paid in the next period. The employee has completed his or her work, and the money is owed to the employee, but has not yet been paid by Cato. ( 6 in textbook, page 75) ASSETS = LIABILITIES + Cash A/R Common Stock Revenue Expense Distributions Notice in this case, there is no record of the employee actually getting paid. Cato has a legal obligation to pay, however, which must be reported as a Liability on its Balance Sheet. Closing Below is the Horizontal model for the entire set of transactions of Cato (the example in the textbook pages 72-80). (Note, we only covered events 2, 3, and 6 in class) Cash A/R A/P Common Stock Revenue Expense Distributions R/E TOTAL To aid in closing, often a company will produce a report of the totals in its accounts. This report is called a Pre-Closing Trial Balance. The Income Statement will show Net Income of $66. (Revenue minus expense, or $84-$18) There were no distributions in the period. The Closing process will close out the Revenue and Expense Accounts, moving their net total to the Account, getting ready to start the next period.

4 Cato s Income Statement For the Period #1 Revenue $ 84,000 Less Expenses $ -18,000 NET INCOME $ 66,000 Cato s Balance Sheet As of the end of Period 1 Assets: Cash $53,000 A/R $24,000 TOTAL ASSETS $77,000 Liabilities Salaries Payable $6,000 TOTAL LIABILITIES $ 6,000 Equity Common Stock $ 5,000 $66,000 TOTAL $71,000 TOTAL LIABILITIES PLUS : $77,000 Below are Cato s opening balances in the accounts at the beginning of Period 2. Notice the empty Revenue and Expense (and Distributions) accounts, and the opening balance in. Cash A/R A/P Common Stock Revenue Expense Distributions R/E

5 Example Continues Period 2 Cato Pays the $6,000 salaries payable obligation to the employee. This reduces cash, and clears the Accounts Payable balance. ( 1 in period 2, page 82 in the textbook). Cash A/R A/P Common Stock Revenue Expense Distributions R/E HINT: Notice that EVERY ENTRY maintains the Accounting Equation! Often, you can determine whether an entry should be positive or negative by looking at its effect on cash. Make the entry to cash and figure out what you must do to maintain the equation! Accounting for Supplies Inventory If a company maintains a large inventory of supplies, the supplies should be shown as an asset. Example: Cato purchases $800 ($0.8k) of supplies, on account. Cash A/R Supplies A/P Common Stock Revenue Expense Distributions R/E Usually, supplies are used frequently and it would be a pain to record them as they are used. So we usually figure out how much we used during a period and make a single, adjusting, entry at the end of the period. In our example, Cato has $150 of supplies on hand at the end of the period, meaning they used $650 ($0.65k) during the period. Cash A/R Supplies A/P Common Stock Revenue Expense Distributions R/E ADJ Notice that this transaction does NOT affect the payable. We still have not paid for the supplies, and still own $800 to our supplies vendor.

6 Difference between Cost and Expense Accrual Accounting draws a distinction between a COST and an EXPENSE. A cost is the measure of a monetary sacrifice. An expense is defined as the using up of an asset in the course of trying to produce revenue. Accounting for Prepaids Some costs, such as the electric bill, a repair bill, etc. can be expenses. Other costs, however, are actually assets the right to collect a good or service in the future. Example: A company pays $12,000 for a full year of rent in advance. This means that the company now owns a right to use the building for one year. Ownership of a right is an Asset. (The company does NOT own the building, it only owns the right to occupy the building.) In this case, the right to a future good or service is called a Prepaid. Some people call this a Prepaid Asset because it is an asset, while others call it a Prepaid Expense because it will most likely BECOME an expense at a later date. We prefer the term Prepaids. The entry will reduce cash, but will increase a short-term asset titled, Prepaids. Later, as the right to occupy is used up (by the passage of time), we will need to adjust the prepaid to show the amount left at the end of any given period. At each period s closing, we need to determine the amount of Prepaid left, and write-off (as an expense) the amount we have used. Accounting for Unearned Revenue Sometimes, our customers pre-pay us for goods or services that we will provide them in the future. THEY will record a prepaid on their books. However, WE will record something called Unearned Revenue. This is NOT yet revenue. We must actually perform the service for the customer. Since the customer has already paid us, we must legally provide the service or refund the customer s money. An obligation is called a Liability. Thus, Unearned Revenue is a Liability account. At the time the customer pays us in advance, we add to cash, and add a liability, Unearned Revenue, thus keeping the Master Accounting Equation. Later, when we actually perform the service, we have EARNED the Revenue. Thus, we record Revenue (by adding it to the revenue account), and we clear the Liability by reducing the Unearned Revenue account.

7 Accounting for Accrued Interest When a company takes out a loan for a significant period of time, often the creditor wants to be paid back with interest at the end of the loan period. Interest is related to the passage of time. If the bank loans you $1000, at 5% simple annual interest, at the end of 1 year you will owe the bank $1050. If you take out a 2-year loan for $1000, at 5% simple annual interest, at the end of the first year you will own $1050, but do not have to pay back anything. At the end of the second year will pay back at total of $1010. But GAAP points out that you really did own the first year s interest at the end of the first year! Thus, GAAP rules require businesses to record the interest expense in the year in which it is incurred, not paid. GAAP also requires businesses to report the amount they owe on the loan, including all unpaid interest, as a liability. Hence, if a business takes out a loan which carries interest, the business must make an adjusting entry showing the interest expense and the new amount owed including interest. In this example, A is where we took out the loan. B is the adjusting entry showing the accrual of the first year s interest. Cash Loan Payable Common Stock Revenue Expense Distributions R/E A B 50 50