Financial Accounting:
Cash: .
Characteristics:
→ Most liquid of assets (first assets on the balance sheet, followed by less liquid assets)
→ Anonymous and highly portable
→ Component when determining if a company has liquidity (ability to pay current liabilities)
→ Readily available to settle current liabilities
Cash and Cash Equivalents:
→ Cash:
● Currency, coins and deposits in bank accounts
● Checks from customers and others, cashier’s checks, certified checks, and money orders
→ Cash equivalents: Short-term and highly liquid investment instruments that are…
● Readily convertible to cash
● Close enough to due date (3 months) so that market fluctuations cannot affect their value
● Instrument such as US Treasury Bills
Bank Reconciliation: Balance of a checking account (bank statement) rarely equals the general ledger cash
balance (accounting records) because the bank is not up to date with amounts in the general ledger and
there are amounts on the books of the company that will not be recorded until the bank statement arrives
→ Bank Side: Always reconcile first (do not require journal entry)
● Add:
○ Deposits in transit (not yet recorded by the bank)
○ Bank Errors
● Substract:
○ Outstanding check (not yet received by the bank)
○ Bank Errors
→ General Ledger Side: Will come from the bank statement (require a journal entry)
● Add:
○ Interest received
○ Collections from your customers which the bank has performed
○ Previously unrecorded deposits
● Subtract:
○ Bank service charges
○ Electronic fund transfer (EFT) payments
○ Insufficient funds (NSF) checks deposited
○ Fees for NSF checks
○ Loan payments to the bank
○ Journal Entry Errors
■ Reverse the original entry as though it did not happen
■ Record the proper amount
→ Ending Adjusted Bank Balance must agree to the ending Adjusted Book Balance
Accounts Receivable: .
Accounts Receivable: Promise to pay at a later date
→ Maintained by customer for sending out statements and to analyze individual receivables
→ Maintained in the AR subsidiary ledger and sales in the subsidiary sales journal → General ledger will
have one total for AR and Sales
Allowance for Bad Debts/Doubtful Account: (credit based contra-asset account of AR): Extend credit must
record any Bad Debts Expense → AR will be reported at net realizable value (expected cash collection)
→ Not related to a specific customer’s account but rather AR in its totality
● When a specific customer’s account is written off debit ADA and credit customer’s AR
○ Allowance is reduced and BDE is not recorded because the expense was matched
against the associated sales in the earlier period
○ ADA and AR reduced by equal amount → No effect on net realizable value
● When customer pays, debit AR and credit ADA (then debit cash and credit AR)
→ Methods:
● Percentage of Receivables (balance sheet approach): Assumes a portion of AR will be
uncollectible based on company experience and current business environment
○ If credit balance in ABD → Subtract this balance from the projected balance
○ If debit balance in ABD → Add to this balance to the projected balance
● Aging of Receivables: Layers of accounts receivable based upon how long the accounts
receivable has been due (larger percentages applied to those balances that have been
outstanding longer) and percentages are based upon the company’s experience and current
economic climate
● Percentage of Sales
Selling Receivables: Sometimes companies will sell their receivables to a bank or a factor (takes % of the AR
as fee and assumes risk of collection) in order to realize collections earlier
→ Debit Cash and Factor Fee Expense and credit AR
Pledging Receivables: Companies can also pledge their receivables as security for a loan, but still has
collection responsibilities
→ No journal entry is required since ownership does not pass to the bank, must be disclosed in the
notes to the financial statements
Merchandising Companies Accounting for Sales and Purchases: .
Merchandising Companies: Wholesalers who buy from manufacturers and sell to retailers or retailers who
buy from either manufacturers or wholesalers and sell to the final customer
→ Revenues refer to service companies whereas sales refer to merchandising companies
Inventory (current asset): Represent what a company owns and intends to sell
→ Beginning Inventory + Purchases = Goods Available for Sale
● Ending Inventory (asset): Can be counted and is considered objective (BS)
● Cost of Goods Solds (expense): Cost of buying/preparing merchandise for sale (IS)
○ BI + P = GAFS - EI = COGS
→ Perpetual system of inventory: Updates records for each sale and purchase of inventory (another
system called “Periodic System” which updates its records at the end of the month)
Gross method of sales discount → % discount/discount period, n/credit period
→ Buyer:
● Debit AP + Credit Cash (x % with discount) and Inventory (% discount)
→ Seller:
● Debit Cash and Sales Discount (contra-sales account → debit based since sales is credit
based) + Credit AR
Returns:
→ Buyer:
● Debit AP + Credit Inventory
→ Seller:
● Debit OR + Credit Sales
● Debit COGS + Credit Inventory
● Debit Sales Returns/Allowances + Credit AR
Adjusting Journal Entry: At end of accounting period, inventory is counted/adjusted for losses such as
theft, shrinkage (losses due to theft/damage, size reductions for evaporation, deterioration, etc), or damage
→ Higher than balance → Credit COGS
→ Lower than balance → Debit COGS
Transfer of Ownership:
→ Free on Board (shipping term), also effects when shipping and insurance costs attach to inventory
● FOB Shipping Point → Buyers owns when it leaves seller’s place of business
○ Buyer records freight and insurance as an additional cost of inventory (debited)
● FOB Destination → Buyer owns when it arrives at buyer’s place of business
Calculation of Net Purchases for a Buyer: Purchase discounts and returns and allowances are not in the
chart of accounts for a buyer (credits inventory)
Calculation of Net Sales for a Seller: Used by seller to calibrate the sales discount policy and monitor sales
returns and allowances for quality control (internal)
Multi Step Income Statement: Gross profit (Net Sales - COGS) is calculated as GP/Net Sales which yields a
% that means there is % of income available for other expenses after paying COGS (% of net sales is spent
on purchasing inventory)
Classified Balance Sheet for Merchandisers:
→ Operating cycles: Time span from which cash is used to acquire goods/services until cash is
received from the sales of goods/services
● A year or the company’s operating cycle (whichever is longer)
○ For merchandisers are usually less than a year → Inventory is always a current asset
● Determine which assets are expected to be used up in the current period and are classified
as “current” → If not it is considered to be long-term
Inventory: .
Costs: Whatever costs are needed to bring an item to its location in a salable condition
→ Purchase price
● Less any sales discount or sales allowance
● Plus insurance and freight when goods are shipped FOB shipping point and other costs
including tariffs, storage costs, refurbishment costs
Inventory Methods:
→ Can choose any method but must remain consistent in their use
● Same GAFS
● Choosing revolves around profit planning, tax implications, practical considerations, etc
● Is not required to mimic the actual flow of goods
→ Specific identification:
● Beginning inventory + All purchases - All sales (cost of each item sold) = Ending inventory
→ First in, first out:
→ Last in, first out:
→ And weighted average:
→ Effects: On the dollar value associated with ending inventory (BS) and the dollar value associated
with cost of goods sold (IS)
● When the cost of purchasing inventory rises …
○ FIFO: EI will be higher and COGS lower (EI higher and Net Income higher)
■ Profit planning (company is more profitable)
○ LIFO: EI will be lower and COGS higher (EI lower and Net Income lower)
■ Tax advantage (will pay lower taxes)
◆ It must also be used for financial statements
○ Weighted average: Yields a result between FIFO and LIFO
■ Smoother results
● When the cost of purchasing inventory becomes cheaper …
○ FIFO: EI will be lower and COGS higher (EI lower and Net Income lower)
○ LIFO: EI will be higher and COGS lower (EI higher and Net Income higher)
○ Weighted average: Yields a result between FIFO and LIFO
■ Smoother results
→ Lower of Cost or Market (LCM): Can be applied to individual items, classes of items or inventory as
a whole
● Value of items for sale are often subject to fast paced changes and can decline their value
rapidly (first exception to the cost principle)
● Inventories must be valued at the lower of cost or market (conservatism constraint)
○ If the market value to replace an item (today’s purchase price) is lower than the
original purchase amount → Item must be valued at market value
○ If the market value is higher to replace an item than the original purchase price →
Remains in inventory at the original price
Long-Term Assets: .
Long-Term Assets: Have a useful life of ≥1 accounting period and are used in operations to produce income
(not an investment)
→ Depreciation is expensed consistently and the “accumulated depreciation” (contra asset, credit)
collects all depreciation for the asset from the time the asset was placed in service
● Net Book Value for an Asset → Cost - Accumulated Depreciation
● Depreciable Base of an Asset → Cost - Salvage Value
Plant Assets:
→ Cost: All necessary and reasonable expenditures to acquire and prepare a plant asset for its
intended use
● Land acquisition costs → Removal of structures (less salvage) to prepare the land for use
● Land improvements (unlike land are depreciated) → Parking lots, fences, signs, shrubs and
lighting systems
→ Depreciation: Process of allocating the cost of a plant asset to expense in the accounting periods
benefiting from its use
● All plant assets except land are depreciated
● Factors:
○ Cost - Salvage value (estimate of value at end of benefit period) = Depreciable Base /
Useful Life (length of time it is productively used in operations)
● Methods:
○ Straight Line Method: Full or partial year
○ Units of Production Method:
○ Double Declining Balance Method: 100% / Useful Life = % x 2
→ Shown on the balance sheet net of accumulated depreciation → Helps the readers of the financial
statements compare assets and determine how long the assets have been in service
→ Can be discarded or sold
● Disposal → Can only be a loss
○ Credit asset based on the general ledger amount
○ Debit the accumulated depreciation based on the general ledger amount
○ If not fully depreciated → Debit Loss on Disposal of Asset
● Sale → Gain or loss
○ Credit asset based on the general ledger amount
○ Debit the accumulated depreciation based on the general ledger amount
○ Debit cash received
○ If there is difference → Debit Loss on Asset Disposal or credit Gain on Asset Disposal
Natural Resources:
→ Assets that are physically consumed when used (timber, mineral deposits and oil/gas fields)
→ Cost: All reasonable and necessary expenses to acquire and prepare asset for its intended use
→ Depletion: (not depreciation) Allocate the cost of the asset to the period when it is consumed.
● Units of Production Method
Intangible Assets:
→ Non-physical assets used in operations that confer on their owner certain rights, privileges or
competitive advantages
● Patents: Gives the owner exclusive rights to manufacture and sell an item or process for 20
years
● Copyrights: Gives the owner exclusive rights to publish and sell a musical or literary work
during the life of the creator plus 70 years
→ If purchased → Recorded at cost
● If developed internally, only some limited costs can be capitalized.
→ Amortized (not depreciated) → The cost is amortized over the period the asset is expected to benefit
the company but can never be more than its legal life
● If the asset has an unlimited life, it is NOT amortized
→ Goodwill: It implies the company as a whole is worth more than the value of the individual assets
and liabilities when a company acquires another company
Current Liabilities: .
Short-Term Notes Payable:
→ Written promise to pay a specified amount on a definite future date within one year or the
company’s operating psyche (whichever is longer)
→ Liabilities exist as a result of a past transaction or event → Notes Payable, Estimated or Contingent
● Represent a present obligation
● Requires a future payment of cash or services
● Current liabilities are due within one year or company’s operating cycle (whichever is longer)
→ Notes Payable/Receivable exchange:
→ Calculate Note Maturity Date: Use calendar year to calculate # of days until financial statement
date or maturity date
Long-Term Liabilities: .
Bonds Payable:
→ Companies obtain financing for large projects through the sale of bonds (do not affect corporate
ownership percentages)
● Carry a par or face value and issuer agrees to pay back the face value of the bond at maturity
● Carry annual stated rate of interest (tax free) half of which is paid twice a year to holder
→ Traded on the open market
● Stated rate of interest may be the same, higher or lower than the market rate
○ Same → Sells at par value
○ Higher → Sells at a premium (more attractive)
○ Lower → Sells at discount (less attractive)
■ Investors will purchase but only if they can buy it at less than face value
Equity: .
Corporation: Separate and distinct entity from the stockholders → Entity able to borrow money, enter into
contracts, hire employees, buy and sell property
→ Heavily regulated by both federal and state governments
● Must be formed in a particular state and is subject to the rules of that state
● Publicly traded shares are regulated by the federal government, and the Securities and
Exchange Commission
● Must follow GAAP
→ Privately held corporations are owned by a small number of stockholders and are not publicly
traded and thus are subject to fewer regulations
→ Taxed at the federal and local level as a separate entity
● Individual shareholders are also taxed on any dividends received
→ Ability to sell shares of stock to raise capital
● Control of the company may change
→ Separate legal entity
● Survives the lifetime of the founder (unlike sole proprietorships or partnerships)
→ Creditors can make claims against the corporation not the personal assets of the stockholders
● In liquidation creditors must be fully satisfied and remainder goes to stockholders (liabilities
listed before equity)
→ Stockholders: Owners of the corporation and have liability limited to the value of the stock they
could lose if the corporation acts poorly or improperly
● Do not make decision on behalf of the corporation → Vote for a Board of Directors
● Equity → Retained Earnings (cumulative income/loss from the corporation’s inception) and
Paid in Capital (cash, services, assets a company receives in exchange for stock)
● Common stockholders (when a company has only one class of stock)
○ Right to vote annually on the board of directors
○ Share proportionally in any declared dividend
○ Receive the right to buy same % of stock when new stock issued (preemptive rights)
■ Cannot issue new stock to change % of stock ownership by a stockholder
○ Equally share in remaining assets in liquidation once the creditors are fully satisfied
● Preferred shareholders (when a company has two classes of stock)
○ Receive the right to dividends at a fixed rate before the common shareholders
○ Receive the right to assets in liquidation before common shareholders
○ Do not ordinarily have voting rights
○ Cumulative → Receive the right to all dividends in arrears (previously not paid)
before the common shareholders are paid dividends
○ Noncumulative → Any dividend rights to prior year dividends are forfeited; each
year has a stand-alone calculation as to the dividends payable
○ Callable → Corporation can retire them at will
○ Convertible → Right to convert to common shares
○ Participating preferred stock → Preferred stock with a feature allowing preferred
stockholders to share with common shareholders in any dividends in excess of the
percent or dollar amount stated on the preferred stock
→ Dividends are paid from retained earnings (not available unless declared by Board of Directors, and
there are sufficient retained earnings)
● Date of Declaration: Debit RE + Credit Common Dividend Payable
● Date of Record: No JE
● Date of Payment: Debit Common Dividend Payable + Credit Cash
Stock Issuance: Authorized shares (normally far exceeds the number of shares sold) → Authorized CS:
Issued CS - TS = Outstanding Shares
→ Par value (assigned by Board of Directors) → Legal minimum capital (usually the lowest amount a
stock can be sold for and the amount in reserve to pay creditors)
● Not really used any longer → Stocks usually are purchased at a price above their par value
● Limits the amount recognized in the general ledger related to the value of the common or
preferred stock
○ An account entitled “Common (Preferred Stock) - $10 Par (Stated) Value” is credited
for the number of shares issued times the par value (most companies use par value
not stated value)
○ Any amount over the par value is credited to an account called “Paid in Capital in
Excess of Par (Stated) Value, Common (Preferred) Stock”
● Corporation can split its stock to 2 to 1 or 3 to 1 in order to reduce the par value of the stock
○ Ownership percentages are unchanged when stock is split but market value of the
stock decreases making it easier for owners to sell the stock
○ The initial stock split has no effect on the value of in the common stock or paid in
capital accounts, but the description of the stock changes
○ There is no need to journalize a stock split, only change the descriptions on the
balance sheet and statement of stockholder’s equity
→ Stated value (assigned by Board of Directors)
● Similar to par value
→ No par value
● Entire amount paid for the stock is credited to Common (Preferred) Stock
○ “Paid in Capital in Excess of Par Value” is not used
→ Treasury Stock: Corporation can repurchase its stock from its stockholders (contra-equity account)
List of Ratios: .
Financial Leverage: Stockholders look at debt from a financial leverage perspective.
→ Refers to borrowing money to acquire assets in an effort to increase sales and profits
→ A company can have either positive or negative financial leverage depending on the difference
between its rate of return on total assets and the rate of return that it must pay its creditors
● If the company’s rate of return on total assets exceeds the rate of return the company pays
its creditors, financial leverage is positive
○ Having debt can substantially benefit common stockholders
● If the rate of return on total assets is less than the rate of return the company pays its
creditors, financial leverage is negative
○ Common stockholders suffer
→ Given the potential benefits of maintaining positive financial leverage, managers do not try to avoid
debt, rather they often seek to maintain a level of debt that is considered to be normal within their
industry
Return on Total Assets:
→ The return on total assets is a measure of operating performance that is defined as follows:
→ Interest expense is added back to net income to show what earnings would have been if the
company had no debt
→ With this adjustment, a manager can evaluate his company’s return on total assets over time
without the analysis being influenced by changes in the company’s mix of debt and equity over time
● Enables managers to draw more meaningful comparisons with other companies that have
differing amounts of debt
→ Notice that the interest expense is placed on an after-tax basis by multiplying it by the factor (1 − Tax
rate)
