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									Chapter 1

    A.   The Players
         1.     Managers may or may not be owners.
         2.     Owners (stockholders) are investors. They may also be managers. Owners
                invest money and/or other property in a company in exchange for the
                company's stock. The motives for investments are two fold:
                a.       To meet short-term investment goals via periodic dividend receipts.
                b.       To meet long-term investment goals through stock appreciation.
                         Varying events may cause owners to sell their interest in a company
                         to "new" owners.
         3.     Additional money for the company may be acquired by borrowing from
                creditors. The lenders' goals are also two fold:
                a.       To earn interest on the loan.
                b.       To receive debt repayment.
    B.   The Business Operations
         1.     An understanding of business operations is essential for proper interpretation
                of a company's financial statements.
         2.     It is important to know about:
                a.       Suppliers - the companies from whom goods or services are
                b.       Customers - the companies or individuals to whom goods or services
                         are sold.
    C.   The Accounting System
         1.     An understanding of the industry is important.
         2.     An understanding of the accounting system and how it collects and
                processes information to produce reports is critical.
                a.       Managerial accounting systems prepare reports for internal decision
                         makers (managers).
                b.       Financial accounting systems prepare reports for external decision
                         makers (investors, creditors, suppliers, and customers).

         – LO 1
         1.     Financial statements should be accurate and should contain adequate
                disclosures. Decision makers rely on these statements. If errors are made in
                the statements, lawsuits may result from decisions made on these erroneous
         2.     Financial statements summarize business activities. These reports are
                prepared annually. Interim statements may be prepared more frequently
                (monthly or quarterly).
         3.     Understanding business definitions and key relationships is crucial to using
                financial statements.
    A.   The Balance Sheet
         1.     Structure
                a.      Company name - the accounting entity (separate entity assumption).
                b.      Title - Balance Sheet or Statement of Financial Position.
                c.      Date - at a point in time.
d.   Unit of measure - U.S. dollars, Mexican pesos, etc., which may be
     presented in thousands, millions of dollars, pesos, etc.
     2.     Formats
            a.     Side by side - Assets on the left and liabilities & stockholders' equity
                   on the right.
            b.     Top down - Assets at the top and liabilities & stockholders' equity at
                   the bottom.
            c.     Assets are presented in the order of liquidity. Liabilities are listed in
                   the order of their maturity dates.
            d.     Use of dollar signs, underscores, and double underscores on all
                   financial statements.
     3.     Basic Accounting Equation (Balance Sheet Equation)
                                         A       =   L + SE
                        Economic resources       =   Sources of financing
                            What you have        =   Where it came from

                                        A–L      =   SE
                                   Net assets    =   Owners’ equity or residual equity
     4.     Elements
            a.    Assets (A)
                  Assets are economic resources owned by the company as a result of
                  past transactions.
                  They represent economic resources expected to provide future
                  benefits to the company.
                  Examples - cash, accounts receivable, inventories, plant and
                  equipment, etc.
                  Initial recording is at the original cost to acquire it (cost principle).
            b.    Liabilities (L)
                  Liabilities are amounts owed by the company as a result of past
                  - Creditor financing creates debt to be repaid in the future (notes
                       payable). Other amounts owed arising from past events (wages
                       payable, accounts payable, etc.).
            c.    Stockholders' Equity (SE)
                  Stockholders' Equity results from two basic categories:
                  - Contributed Capital (CC) - amounts invested by the owners.
                  - Retained Earnings (RE) - accumulations of undistributed earnings
                       (amounts earned by the company reduced by previous
                  - Owners of corporate stock are generally not personally liable for
                       company's debts.
B.   The Income Statement
     1.     Structure
            a.      Company name -the accounting entity (separate entity assumption).
            b.      Title - Income Statement or Statement of Earnings or Profit & Loss
            c.      Date - for a specified time period ended on the balance sheet date
                    (an accounting period).
            d.      Unit of measure - U. S. dollars, Mexican pesos, etc., which may be
                    expressed in thousands, millions of dollars, pesos, etc.

     2.     The income statement equation is:        NI =    R-E
     3.     Elements
            a.      Revenues (R)
                    These are inflows of net assets from the sale of goods or services in
                    the normal course of business. The inflows may be cash or accounts
                    receivable (the promise of future payments from customers).
                    Revenue recognition is in the period that goods or services are sold.
                    This may not be the same period as the collection for those goods or
            b.      Expenses (E)
                    These are outflows of net assets representing resources used to earn
                    the revenues during the period.
                    - Cost of Goods Sold (CGS) expenses - the costs to buy goods for
                     or to make the goods that are sold.
                    - Selling, General & Administrative expenses - other expenses
                     by the company not directly related to the product costs. These are
                     period costs.
                    Expense recognition is in the period incurred to earn revenues (the
                    matching principle). This may not be the same period that the
                    payment for the expense is made.
            c.      Net Income (NI)
                             This is also called net earnings, profits, or bottom line.
                             If revenues exceed expenses, net income (NI) results.
                             If revenues are less than expenses, net loss (NL) results.
                             If revenues equal expenses, breakeven results.
C.   The Statement of Retained Earnings (this information may be contained in the
     Statement of Stockholders’ Equity)
     1.     Structure
            a.      Company name - the accounting entity (separate entity assumption)
            b.      Title - Statement of Retained Earnings
            c.      Date - for a specified time period ended on the balance sheet date
                    (an accounting period)
            d.      Unit of measure - U.S. dollars, Mexican pesos, etc., which may be
                    expressed in thousands, millions of dollars, pesos, etc.
            e.      This statement shows increases and decreases to the retained
                    earnings account for the period.
     2.     Elements
                    The basic retained earnings equation is:
                    Ending RE = Beginning RE + NI or ( -NL) - Dividends Declared
D.   The Statement of Cash Flows
     1.     Structure
            a.      Company name - the accounting entity (separate entity assumption)
            b.      Title - Statement of Cash Flows
            c.      Date - for a specified time period ended on the balance sheet date
                    (an accounting period)
            d.      Unit of measure - U.S. dollars, Mexican pesos, etc., which may be
                    expressed in thousands, millions of dollars, pesos, etc.
            e.      This is the only financial statement prepared on the cash basis rather
            than on          the accrual basis.
            2.      Elements
                    a.     This statement shows cash inflows (receipts) and cash outflows
                    b.     Three categories are used to classify these cash flows.
                           Operating activities - directly related to normal business activities.
                           Investing activities - acquisitions and sales of plant and equipment,
                           intangibles, and other investment assets.
                    c.     Financing activities - involves dealings with the company owners and
            3.      Combining the three categories of net cash inflows and outflows indicates the
                    change in cash during the period.
E.        Relationships Among the Statements
            1.      The four financial statements are related to one another.
                    a.     Net income from the income statement is shown as an increase to
                           RE (or net loss is a decrease to retained earnings).
                    b.     Ending retained earnings from the statement of retained earnings
                           appears in the SE section of the balance sheet.
                    c.     The statement of cash flows relates to last year's balance sheet
                           (beginning cash balance) and to the current balance sheet (ending
                           cash balance).
F.          The Notes
            1.      These are an integral part of the financial statements. The statements cannot
                    be adequately interpreted without reading the supplemental information in
                    these notes (footnotes).
            2.      There are three basic types of notes.
                    a.     Descriptions of accounting rules applied in the financial statements.
                    b.     Details about line items in the statements.
                    c.     Disclosures about items not listed in the statements.

Chapter 2

            1. An understanding of a company's financial statements requires knowledge of
               business activities and their effects on account balances.
            2. Financial statement analysis will allow the decision maker to arrive at decisions
               about a company. This evaluation can be used to compare one company to other
            3. Analysis of investing and financing activities of a business should be explored .

            The concepts presented in Exhibit 2-1 are the framework of objectives, terms,
            concepts, and principles used in financial accounting and reporting.
     A.     Concepts Emphasized in Chapter 2
            1. The primary objective of external financial reporting is to provide useful economic
               information about a business to external parties (investors and creditors) so they
               can make sound financial decisions. These decision makers need a reasonable
               understanding of accounting concepts and procedures. They need to be able to
               use financial information to help them predict future cash flows related to
               investing and financing.
2. Underlying assumptions of accounting help the decision maker to understand
   what accounting information purports as well as the inherent limitations of that
   information. Recall assumptions noted earlier in the text:
   a. Separate-entity assumption - "business" transactions are separate from
        “owner” transactions.
   b. Unit-of-measure assumption - accounting information will be measured and
        reported in the national monetary unit of that company.
   c. Continuity (going-concern) assumption - a business is expected to continue
        operations in the foreseeable future without forced liquidation.
B.         Elements of the Balance Sheet
           1. Balance sheet elements present the basic accounting equation (A = L + SE).
              a. Assets(A) are probable future economic benefits owned by a company
                  resulting from past transactions. Assets on the balance sheet are listed in the
                  order of liquidity. Assets are recorded at the cost (cash or cash-equivalent) to
                  acquire them.
              b. Liabilities (L) are probable obligations owed by a company resulting from past
                  transactions. These amounts are expected to be paid to the creditors in the
                  future. Liabilities are listed on the balance sheet in the order of maturity
              c. Stockholders' equity (SE) is the owners’ residual interest in net assets
                  (assets minus liabilities). There are two categories of SE:
                  - Contributed capital (CC) results from owners providing assets to the
                    company in exchange for stock (evidence of ownership). These are the
                    investments of the owners.
                    - Retained earnings (RE) result from undistributed earnings
                    generated by the
                      operations of the company. RE is reduced by declared dividends
                    to date.
                    Owners buy stock with the intent of receiving corporate distributions
                    enjoying capital gains upon the sale of their stock holdings.
              d. Current Ratio = Current assets / current liabilities. This is a
                 measure of a company's ability to pay its currently coming due
                 debt. This is a short-term focus.
           2. Debt-to-equity ratio measures the proportion of debt to stockholders’ equity. It
               the company’s equity position and the level of risk a company assumes by
               financing the business through debt.

                                                     Total liabilities
                           Debt-to-equity =
                                               Total stockholders’ equity

           3. Financial Leverage Ratio measures the relationship of assets to equity. Debt
              financing is riskier.

                    Financial Leverage Ratio = Average Total Assets/Average Stockholders'

           4. The cost principle states that the cash (or cash-equivalent) cost should be used
              to initially record financial statement elements. This historical cost amount is
              measured on the initial transaction date and does not typically reflect ma rket
              value changes. Exceptions to this general rule are noted throughout the text
              where appropriate.

      A.   Nature of Business Transactions
           Transactions are certain recorded economic "events" which impact an entity. A
           transaction is either:
1. a direct exchange of assets/liabilities between a business and an external party.
   Examples: sales, borrowing, owner investments.
2. a measurable event internal to the business which is not a direct exchange.
   Examples: Losses from casualties and adjustments to record usage of assets
   previously purchased (depreciation).
       Some "events" are external to the business but have not yet given rise to a
       transaction and are not subject to recording. Examples: signing a lease, taking a
       customer order, hiring a new employee. Each of these situations involves future
       promises but no assets or liabilities have been established in their regard.
  B.   Accounts
       1. Define an account as a standardized format to accumulate the dollar effects of
           transactions on a specific financial statement item.
       2. A chart of accounts (COA) is a listing of the accounts a company uses to record
            the transactions of its business operations. The order of the COA listing
            facilitates the financial reporting for a company. For the balance sheet focus,
            assets are listed first in order of liquidity. They are followed by liabilities in order
            of maturity. Next, stockholders' equity lists contributed capital accounts and
            retained earnings. Finally, revenue and expense accounts follow. COA vary
            widely based on the industry of the company. However, several common
            accounts exist for many businesses. Payables and unearneds are liabilities.
            Prepaids are assets.
       3. In formal record keeping systems, unique numbers are used for each account
            listed in the COA.
       4. More detailed listings are kept for several accounts. These are called subsidiary
           ledgers. Examples include accounts receivable, inventories, equipment, accounts
           payable, and notes payable.

       1. Keeping historical records affecting accounts provides information to managers in
          order to evaluate the effects of past decisions and to plan for the future.
          Therefore, it is important for managers to understand how past transactions affect
          financial statement items (accounts) and how future events may impact those
  A. Principles of Transaction Analysis
       1. This analysis involves studying a transaction to determine its economic effect on
          the entity in terms of the basic accounting equation (accounting model). This
          understanding is necessary to determine how transactions affect financial
          statement accounts.
       2. Basic Accounting Equation: A = L + SE.
       3. Principles for transaction analysis:
          a. Duality of effects - each transaction affects at least two accounts.
              Identification of the appropriate accounts and the direction of the effects
              (increase or decrease) is key. The fact that every transaction has at least two
              effects on the basic accounting equation is the essence of the double-entry
              system of record keeping. Whether a transaction is external (involves an
              exchange) or internal (involves an adjustment), the duality of effects results.
          b. Accounting equation - it must remain in balance. After each transaction, the
              accounting equation must be tested for equality. That is, A = L + SE must
              constantly be considered.
       4. Transaction analysis process:
          a. Accounts and effects
              - Identify the accounts affected.
              - Classify each account as A, L, or SE.
              - Determine the direction of the effect (increase or decrease) for each
          b. Maintaining the Accounting Equation Balance
              - Verify that A = L+ SE after each transaction.
   B. Analyze Papa John's Transactions
In this chapter, several transactions are analyzed using the principles of the
transaction analysis approach.
         – LO 5
            The two tools to aid in reflecting the results of transaction analysis are journal
            entries and T-accounts (a simplified visual substitute for general ledger
    A.   The Direction of Transaction Effects
         1. It is important to understand which accounts increase and decrease because of a
         2. By referencing the accounting equation, increases are on the left for assets
            (which are on the left side of the accounting equation) and increases are on the
            right for liabilities and stockholders' equity (which are on the right side of the
            equation). Decreases work just the opposite.
         3. Debit means the left side of an account while credit means the right side of an
         4. By referencing the accounting equation, debits increase asset accounts and
            credits increase liability and stockholders' equity accounts. Credits decrease
            asset accounts and debits decrease liability and stockholders' equity accounts.
         5. The normal balance of an account is on the increase side. Therefore, asset
            accounts normally have debit balances while liability and stockholders' equity
            accounts usually have credit balances.
         6. Total debits must equal total credits in a transaction. This is necessary to keep
            the accounting equation in balance at all times.
B.       Analytical Tool: The Journal Entry
         1. A journal is part of the bookkeeping system of a company. It contains a
            chronological listing of journal entries. It is referred to as the “original” book of
         2. A journal entry expresses the effects of a transaction on accounts in a "debit =
            credit" format. Its source is a business document. A journal entry should include a
            transaction date.
         3. A "simple" entry affects two accounts. A "compound" entry affects more than two
         4. In a journal entry, debit accounts and amounts should be listed first followed by
            credits. Credit accounts and amounts are often indented below the debit
            portion(s) of the journal entry.
C.       Analytical Tool: The T-account
         1. Journal entries, per se, do not provide account balances. Account balances are
            found in the ledger (a group of accounts). The ledger is referred to as the “final”
            book of entry.
         2. Posting is the act of transferring journal entry amounts to the appropriate
            accounts in the ledger.
         3. A T-account is a simplified version of a ledger account. This tool allows for
            summarization of journal entry effects on an account. The balance of the account
            can be determined with T-accounts.
D.       Transaction Analysis Illustrated
         1. Use transaction analysis as well as the journal entry and T -account tools to
            process typical transactions.
         2. There are beginning balances in many balance sheet accounts since the ending
            balances carry over to the new period.
         3. It is essential to understand:
            a. the accounting model
            b. the transaction analysis process
c. recording the dual effects of each transaction
d. the dual-balancing system
Note: Practice is important in order to grasp these critical concepts.
          1. Account balances for asset, liability, and stockholders' equity accounts are used
             to prepare a balance sheet. Balances from T-accounts are used in this chapter
             for that purpose.
          2. If comparative balance sheets are prepared, the most recent amounts are usually
             presented first (in the left column) with the older amounts to the right.
          3. The balance sheet presents the accounting equation: A = L + SE
             Several account balances change during the accounting period, but the
             accounting equation must still remain in balance.

Chapter 3

          1. Companies should develop objectives and plans to achieve their goals.
             income statement items is important to the achievement of targeted
             performance. Published income statement amounts can be compared
             with forecasted income statement amounts to determine if the
             company's goals were met. Financial analysts also develop their own
             expectations of a company's future performance.
          2. It is important to determine which business transactions affect the
             income statement accounts and how these transactions are measured.
             After these factors are determined, the income statement should reflect
             the results of these business transaction activities.

          – LO 1, 2, 3
     A.   The Operating Cycle
          1. The operating cycle is the "cash-to-cash" cycle (earnings process). The
             motive of a business is to turn cash i nto more cash. This cycle
             represents the time it takes to purchase goods or services, pay the
             suppliers for these goods or services, make sales to customers, and
             collect cash from those customers.
          2. The operating cycle applies to merchandising and manufacturing
             companies as well as service companies. The length of time for a
             company’s operating cycle depends on the nature of its business.
             Reducing the operating cycle can lead to greater profits and faster
          3. The time-period assumption recognizes that decision makers need
             periodic information about a company. Therefore, the long life of a
             company needs to be broken down and reported in shorter time
             periods. Annual income statements are for the period of a year.
             "Interim" reports are prepared more frequently (monthly or quarterly).
          4. The time-period assumption is important in recognition issues (when to
             report) and
              measurement issues (how much to report).
B. Elements on the Income Statement
   1. The income statement reports revenues, expenses, gains, and losses.
      The income statement format often presents subtotals such as
      operating income and income before income taxes. This type of format
      is called a multi-step income statement.
      a. Revenues are inflows of net assets (A - L) from normal ongoing
          operations. When revenues are recognized, assets increase or
          liabilities decrease. The revenue accounts vary widely based on the
          type of company. Two revenue sources for Papa John's are
          Restaurant and Commissary Sales and Franchise Fees.
  b. Costs and Expenses are outflows of net assets from normal
     ongoing operations.
      They are necessary to generate revenue. When expenses are
     incurred, assets
      decrease or liabilities increase. Expenses include costs of supplies
     used, wages
      expense, occupancy expenses, depreciation expense, amortization
      interest expense, income tax expense, selling expenses, and
     general and
      administrative expenses. Three primary expenses for Papa John's
     are Cost of
      Sales, Salaries and Benefits Expense, and all Other Operating
     Costs and
  c. Other Revenues, Gains, Other Expenses, and Losses.
      Other revenues and gains are inflows of net assets from peripheral
      transactions (other than from the central operations of a business).
      When other revenues and gains are recognized, assets increase or
      liabilities decrease (or both). Examples are investment income and
      selling non-inventory property for more than their cost.
      Other expenses and losses are outflows of net assets from
      transactions. When other expenses and losses are recognized,
     assets decrease
      or liabilities increase (or both).Examples are interest expense and
     selling non-
      inventory items for less than their cost.
  d. Income Tax Expense.
      This is the last expense listed on the income statement for profit-
      making corporations. The expense is calculated on pretax income
      (all revenues and gains less all costs, expenses, and losses).
  e. Earnings Per Share.
      This is required disclosure on corporate income statements. It is
      computed as:

      EPS = Net Income / Weighted average number of common shares

2. Asset Turnover

     Asset Turnover = Sales (Operating) Revenue/ Average Total

  This ratio measures the amount of sales generated per dollar invested
  in assets. It
  indicates whether a company uses its assets efficiency.
         MEASURED? – LO 4
      A. Accrual Accounting
         1. Cash basis accounting records revenues when cash is received and
            records expenses when cash is paid. Many small companies not
            reporting to external users use cash basis accounting.
         2. Cash basis accounting is not generally appropriate (is not GAAP) for the
            preparation of balance sheets and income statements.
         3. Cash basis accounting is used (is GAAP) for the preparation of the
            statement of cash flows.
         4. Accrual basis accounting requires the reporting of revenues when
            earned and expenses when incurred, regardless of the timing of cash
            receipts and cash payments.
      5. Accrual basis accounting is appropriate (is GAAP) for the preparation
         of the balance sheet, statement of retained earning, statement of
         stockholders’ equity, and the income statement.
      6. There are two important accounting principles for the accrual basis of
         accounting. They are the revenue principle and the matching principle.
         These are important concepts for recognition and measurement issues.
   B. The Revenue Principle
      1. The revenue principle requires that four conditions be met for revenue
             a. The earnings process is complete or nearly complete (the
                promised acts have been performed). That is, goods have been
                delivered or services have been rendered.
             b. An exchange transaction takes place (the customer pays or
                promises to pay for the performed act). That is, an agreement for
                customer payment is acknowledged.
             c. The price is fixed or determinable.
             d. Collection is reasonably assured (the customer is expected to
                pay and it is
                probable that payment will be received). Credit policies are
                usually established by the company to help ensure this outcome.
         2. Revenue is normally recognized at the point of the sale regardless
of when cash is
         actually received.
      3. A liability account is used when cash is collected from the customer
         before goods or
         services are delivered. The liability results from a revenue deferral
         since the earnings will be recognized in the future.
      4. An asset account is used when cash is NOT collected from the
         customers by the
         time goods or services are delivered. The asset results from a revenue
         accrual because the earnings are accrued or increased before cash is
         actually collected in the future.
      5. Revenues, deferred revenues, and accrued revenues are recorded
         using the cost
         principle. That is, the cash or cash-equivalent price is used to record
         the effects on assets, liabilities and/or revenues.
      6. Revenues are inflows of net assets. Revenues are increases in assets
         or decreases in liabilities.
  C. The Matching Principle
      1. The matching principle requires that expenses be recorded when
         incurred in earning
         revenues – a matching of costs with benefits. This recognition is
         required regardless of when cash is actually paid. Expenses are
         resources used up to generate revenues.
   a. An asset account is established when cash is paid for property or
        services before they are "used up". The asset results from an
        expense deferral since it will be used in the future (deferred).
   b. A liability account is used when cash is not paid out when services
        are provided by employees or goods are received from suppliers.
        The liability results from an expense accrual because the expense
        has been accrued or increased before cash is actually spent. The
        cash payment will occur in the future.
2. Expenses are outflows of net assets. Expenses cause decreases of
   assets or increases in liabilities. Expenses are recorded by the
   historical cost expended or to be expended (cost principle).
 A. Transaction Analysis Rules
      1. Retained earnings in the stockholders' equity portion of the accounting equation
         is affected by the recognition of revenues and expenses. It is also affected
         (reduced) by distributions to shareholders (dividends declared). Dividend
         distributions must be authorized by the board of directors. Debits decrease
         retained earnings while credits increase retained earnings. Revenues have
         credit balances while expenses and dividends declared have debit balances. If
         revenues exceed expenses, net income results (increases retained earnings). If
         expenses exceed revenues, net loss results (decreases retained earnings).
      2. A summary of debit and credit fundamentals:
         a. Accounts which increase by debits and decrease by credits:
            Assets, Expenses (operating activities), Dividends Declared
            (financing activity),
            and Losses (investing activities). These accounts normally have
            debit balances.
         b. Accounts which increase by credits and decrease by debits:
            Liabilities, Revenues (operating activities), Gains (investing
            activities), Contributed Capital (financing activities), and Retained
            Earnings (operating and/or financing activities). These accounts
            normally have credit balances.
      3. A summary of transaction analysis rules:
         a. Identify the accounts affected (at least two accounts).
         b. Determine which accounts are increased and which accounts are
         c. The accounting equation must always be in balance (equality rule).
         d. The total dollar value of the debits in the transaction should equal
            the total dollar
             value of the credits (debit/credit rule).
      4. a. When recording a revenue (a credit), an asset or liability is debited
            by the same amount.
         b. When recording an expense (a debit), an asset or liability is credited
            by the same amount. This is also true when recording dividends
      5. Identify journal entries made during the accounting period which will
         require adjustments at the end of the accounting period (this will be
         explored in
         Chapter 4).
B. Analyzing Papa John's Transactions
             In this chapter several transactions are analyzed using the principles of the
             transaction analysis approach.

    - LO 6
 A. Unadjusted Income Statement
1. At this point, an unadjusted income statement can be prepared. Since
   adjusting entries have not been prepared yet, this income statement is
   incomplete and it is not in conformity with GAAP based on accrual
   accounting principles. Accounts need to be updated for revenues
   earned and expenses incurred. The adjusting entry process for
   accruals and deferrals is the focus of Chapter 4. The preparation of a
   complete income statement will be emphasized in the next chapter.
   B. Unadjusted Statement of Retained Earnings
       1. An unadjusted statement of retained earnings can be prepared next. It
          presents the beginning balance of the retained earnings account, the
          changes in this account (an increase for net income or a decrease for
          net loss and a decrease for dividends), and its ending balance. Net
          income or net loss comes from the income statement. The ending
          balance for retained earnings goes to the balance sheet. Therefore,
          this statement ties together information on the income statement and
          the balance sheet.
   C. Unadjusted Balance Sheet
               1.    An unadjusted balance sheet can now be prepared to reflect
the balances of assets, liabilities, and stockholders’ equity accounts before end-
of-period adjustments

Chapter 4

      1. Management is responsible for the financial statements of a company
          that are used by investors, creditors, and others.
      2. The financial statement information should be relevant (timely) and
          reliable (verifiable and unbiased). The result of this high quality
          information is useful in analyzing the past and predicting the future.
      3. Following the revenue principle (recognition when earned) and the
          matching principle (recognize when incurred to generate revenues)
          requires adjustments of revenue and expense accounts.
      4. Measuring revenue and expense items requires managers to make
      5. The adjusting entry process goes beyond the day-to-day bookkeeping
         function. It requires a great deal of knowledge, judgment, and
         experience. As such, manipulation of income needs to be closely
         scrutinized. This is an ethical issue.
      6. The closing process clears all temporary accounts to a zero balance so
         they are ready for the accumulation of amounts in the new period.

      A. The Accounting Cycle
         1. During the period, transactions are analyzed, recorded in journals,
            and posted to the general ledger.
         2. At the end of the period, accounts are analyzed, adjustments are
            determined, financial statements are prepared, and the books are
      B. Unadjusted Trial Balance
         1. The first step at the end of the accounting cycle is to prepare an
            “unadjusted” trial balance. This is merely a listing of accounts
            (usually in financial statement order) and their balances. Debit
            balances are placed in the left money column and credit balances
        are placed in the right money column. A trial balance is a "try to
        balance". It is a schedule for internal purposes to test debit-credit
        equality. It is NOT a financial statement.
   2. There are several reasons for an imbalance to exist.
      a. Journal entries did not balance.
      b. Posting errors occurred.
      c. Computing the balance of an account may have a calculation
      d. Account balances may have been copied incorrectly to the trial
C. Analysis of Adjusting Entries
   1. Since accrual accounting requires that revenues be recognized
       when earned and expenses be matched to such revenues when
       incurred, adjusting entries are necessary at the end of the
       accounting cycle. A good analytical tool for considering adjustments
       is a timeline.
   2. The two types of adjusting entries are deferrals and accruals.
       Unearned revenues (deferred revenues) and prepayments
       (deferred expenses) are referred to as deferrals.
      a. The need for deferrals results from the fact that a transaction has
           previously been recorded. That is, cash has already flowed in a
           transaction (received for deferred revenue/paid for deferred
      b. It is necessary to "update" accounts that do not have proper
            balances at the end of the period. This is accomplished by
            referring to the original transaction entry and preparing a
            timeline to analyze the effects of the passage of time.
      c.        There are two ways to analyze most deferrals.
            Determine the proper balance in a revenue or expe nse account
          (the income
            statement approach).
            Determine the proper balance in an asset or liability account
          (the balance
            sheet approach).
            Note that the adjusted ending balances of the affected accounts
          will be the
            same under either approach.
      d. With the analysis completed, the adjustment may be journalized
          and posted.
            However, in the real world, the actual journalizing and posting of
            entries will usually be delayed until the financial statements are
          "out the
   3. Revenues and expenses may need to be "accrued".
              a. The need for accruals results from the fact that earned revenues
                 and incurred
                  expenses may not have resulted from transactions. That is, cash
                 has not yet
                  flowed from an external transaction.
              b. It is necessary to "update" accounts that do not have proper
                 balances at the
                  end of the period. This is accomplished by computing what
                 amounts should be
                  entered into the accounts under consideration.
              c. Analyze the activities that have taken place.
                  - Revenues that have been earned but are unrecorded.
                  - Expenses that have been incurred but are unrecorded.
           4. There are three steps necessary to complete the adjustment
              Step 1 - Determine whether the adjustment is to an existing
              unearned revenue or prepayment or to an unrecorded accrued
              revenue or expense.
              Step 2 - Compute the revenue earned or expense incurred up to the
              end of the accounting period.
              Step 3 - Record the adjusting journal entry.
      D. Papa John's Illustration -- Unearned Revenues and Prepayments
         1. The result of completing the adjustment process for unearned
               revenues requires an increase to a revenue account and a
               decrease to a liability accounts for earning amounts previously
               received in cash but deferred (delayed) from recognition. An
               illustrated example includes fees received in advance of completing
               services or delivering goods.
         2. The result of completing the adjustment process for prepayments
            requires an increase to an expense account and a decrease to an
            asset (or increase contra-asset) account for prepaid expense
            expiration. Illustrated examples include insurance expiration, rent
            expiration, supplies used, inventory sold, and depreciation of
            property and equipment.
      E. Papa John's Illustration -- Accrued Revenues and Expenses
         1. The results of completing the adjustment process for accrued
             revenues increases a revenue account and increases an asset
             account for earnings amounts not yet received in cash. (An
             illustrated example includes franchise fees earned but cash is not
             yet received.)
             2. The results of completing the adjustment process for accrued
                expenses requires an increase in an expense account and an
                increase in a liability account for expense incurred but not yet paid.
                (Illustrated examples include salaries incurred, income tax incurred,
                interest incurred, and utilities incurred but not paid.)

         1. Since the updated account balances are now available, financial
            statements can be prepared. A worksheet can be helpful to derive
            these updated balances.
         2. Order of statement preparation due to certain relationships:
            a. First, the Income Statement is prepared since net income is needed
                for the Statement of Stockholders' Equity.
            b. Next, the Statement of Stockholders' Equity is prepared since
                ending retained earnings must be determined for the Balance Sheet.
            c. Then, the Balance Sheet is prepared.
         3. Cash flow information can also be collected.
         4. The frequency of financial statement preparation will depend on the
            company's needs. Typically, preparation of these statements is done
            monthly, quarterly and/or annually.
      A. Income Statement
         1. It presents revenues - costs - expenses - + gains - losses = net income
            (net loss) during the period. It is also referred to as the profit a nd loss
            statement or P & L.
         2. For corporations, the income statement (or the notes thereto) must
            present earnings per share (EPS). For simple capital structures, it is
            calculated as follows:

                       Net income available to common
                 EPS = stockholders

                          Average number of common shares

      B. Statement of Stockholders' Equity
         1. It presents changes in retained earnings during the period.
            Beginning retained earnings + net income (or -net loss) - dividends =
            Ending retained earnings. If this were prese nted separately, it would be
            the statement of retained earnings.
         2. It also presents changes in contributed capital during the period.
            Beginning contributed capital + stock issues - stock repurchases and
            retirements = Ending contributed capital.
      C. Balance Sheet
         1. It presents Assets = Liabilities + Stockholders' Equity (the accounting
            equation) at a point in time at the end of business on that date. This is
            also known as the Statement of Financial Position since it shows what
            the company owns, what the company owes, and the “residual”
owners' equity on that date. Assets are presented in order of liquidity
and liabilities are presented in order of due dates.
    A. End of the Accounting Cycle
       1. Real accounts are NOT closed at the end of the accounting cycle.
          They are permanent accounts whose balances carry over to the
          beginning of the next accounting period. These permanent accounts
          include assets, liabilities, and owners' equity accounts. They will only
          have zero balances as a result of transactions or adjusting entries.
       2. Nominal accounts ARE closed at the end of the accounting cycle.
          These temporary accounts include revenues, gains, expenses, costs,
          and losses from the income statement. Dividends declared accounts
          are also temporary accounts. These are accounts that accumulate
          amounts for the accounting period. They are then closed out so they
          are ready to start the accumulation process for the next accounting
       3. In closing entries, if temporary accounts have debit balances, they will
          be "credited away". If they have credit balances, they will be "debited
          away". The offset in the closing entries is to retained earnings.
   B. Post-Closing Trial Balance
          The last step at the end of the accounting period should be the
          preparation of a post-closing trial balance. After the closing entries are
          journalized and posted, a listing of the remaining (surviving) accounts
          and their balances is prepared for two reasons:
          1. To make sure that debits equal credits to start the new accounting
              2.     To make sure no temporary account balances remain. That
is, temporary accounts should have zero balances at this point.

Chapter 6

       1.     It is important to understand the impact of net sales on the income statement
              and how the net sales amount is derived.
       2.     Cash and accounts receivable are important items listed as current assets on
              the balance sheet. They are critical elements for the cash management of a
              business. They are also key in terms of fraud prevention. Proper internal
              controls over these assets should help to avoid misappropriation of their use.
       3.     Financial statement users (lenders, shareholders, and analysts) carefully
              monitor these elements in the financial statements.
       4.     The growth strategy of a company requires careful coordination of marketing,
              production, and financing activities.

       1.     Revenue Principle Revisited
              The revenue principle requires that revenues be reported when earned. This
              is determined at the point when an exchange has taken place, the earnings
              process is complete or nearly complete, and collection is probable. The
              collection may be cash or the cash equivalent (for example, credit cards or
              traded-in property). The seller of goods normally records sales revenue when
             goods are transferred to the buyer. Service companies usually record
             revenue when services are provided to the customer. The revenue
             recognition rules which a company follows should be disclosed in the notes
             to the financial statements. The rules should be applied consistently.
     2.      If the sale involves a noncash asset for payment, revenue is recognized in
             the amount of "value" given up or "value" received, whichever is more
     3.      Net sales presented on the income statement equals gross sales less sales
             returns and allowances. Sales discounts and credit card discounts may also
             be deducted to arrive at net sales or they may be presented as operating
A.   Credit Card Sales to Consumers
     1.      Cash Sales
             a.       "Cash" sales are sales for cash (currency) or customer checks.
             b.       The entry to record cash sales includes a debit to Cash (A) and a
                      credit to Sales Revenue (R).
             c.       If a company has more than one location, it may keep track of the
                      sales at each location for planning purposes.
     2.      Credit Card Sales
             a.       Many companies accept credit cards as “collections” for goods and
                      services. Some widely accepted credit cards include American
                      Express, Discover Card, MasterCard, and VISA. Credit cards are
                      accepted for payment for several reasons:
                      i.       Acceptance will increase the number of customers.
                      ii.      Competitors accept credit cards.
                      iii.     The costs of directly extending credit to customers is avoided.
                      iv.      Bad debts due to insufficient funds checks (bad checks) is
                         v.        The credit card company absorbs losses from fraudulent card
                                   use if the merchant complies with the credit approval
                                   verification process.
                          vi.      The seller often receives money sooner than when directly
                                   extending credit. The credit card receipts are deposited
                                   directly to the company's bank account or the receipts are
                                   submitted to the credit card company for payment
                 b.       Credit card companies provide valuable services (noted above) for
                          the use of their "charge card" system. As a result, credit card
                          companies charge a fee for their services. The fee is called a credit
                          card discount. The fee is usually a percentage of the amounts of the
                          credit card receipts. It is an expense or cost to the merchant. This
                          expense may be reported as a contra revenue account (a reduction
                          of gross revenues in arriving at net sales) or as a selling expense (an
                          operating expense). In either case, net income is reduced by the
                          credit card discount charge.
     B.   Sales Discounts to Businesses
          1.     Credit sales made on open account create a customer's promise to pay for
                 goods or services at a later date. This is less formal than a promissory note.
                 Credit sales are granted because of greater sales potential and competitors'
          2.     When credit is extended, credit terms are printed on the invoice.
                 Abbreviations and symbols are used for this purpose. The credit period
                 indicates when the invoice amount (net of sales returns and allowances) is
                 due. Examples are "n/30" and "10, EOM."
          3.     Sales discounts (cash discounts) may be granted by a company to
                 encourage early payment of open account charges. Early payment should be
                 made within the discount period. Examples are "2/10, n/30" and "2/10, 1/20,
                 n/60." A sales discount provides significant savings when considering the
                 discount rate on an annualized basis. The sales discounts account may be
                 reported as a contra revenue account (a reduction of gross revenues in
                 arriving at net sales) or as a selling expense (an operating expense). In either
                 case, net income is reduced by the sales discount.
C.        Sales Returns and Allowances
          1.     Sales Returns and Allowance (SR&A) is a contra revenue account used to
                 record the return of goods previously sold which proved to be unsatisfactory
                 to the buyer. In addition, this account is used to make adjustments to the
                 sales price (i.e., reduce the original sales price) of damaged goods or goods
                 not meeting customers’ specifications. In the latter case, the goods are not
                 returned, but they are ultimately sold at a "reduced" price. Since this is a
                 contra revenue account, it has a debit balance. It reduces gross sales to
                 arrive at the net sales presented on the income statement.
          2.     It is important to maintain this account rather than to directly debit the sales
                 revenue account. This account provides important information for
                 management regarding the quality of service and customer satisfaction.
     D.   Reporting Net Sales
                 Net Sales computation:

                     Sales Revenue
                     - Sales Returns and Allowances
                     - Sales Discounts (if a contra revenue)*
                     - Credit Card Discount (if a contra revenue)*
                Net Sales

               * These accounts may be presented under operating expenses as an
                 The gross profit percentage can be computed as follows:

                                                     Gross Profit
                       Gross Profit Percentage =
                                                      Net Sales

                   This ratio represents the markup percent. The higher the gross profit ratio,
                   the greater the markup (sales revenue over product cost).

      A.   Classifying Receivables
           Receivables are claims against other companies or persons for cash, goods, or
           services. Two common types of receivable are:
           1.      Accounts Receivables (A/R) (also called trade receivables) are open
                   accounts owed to a company by trade customers. They are created when
                   sales are made on credit in the normal course of business. The credit period
                   determines the classification on the balance sheet. Normally A/R is a current
                   (short-term) asset.
                   a.       A nontrade receivable arises from transactions other than in the
                            normal course of business. Examples would be loans to officers and
                            employees not evidenced by a note. Nontrade receivables could be
                            classified as current or noncurrent assets depending on when
                            payment is expected.
           2.      Notes Receivables (N/R) are written promises to pay evidenced by formal
                   documents. A N/R usually contains the following information:
                   a.       Sum of money due (principal)
                   b.       Date the principal is due (maturity date)
                   c.       Interest rate and interest due dates
                   Adjusting journal entries may be needed at the end of the accounting perio d
                   to recognize accrued interest revenue. N/R may be classified as a current or
                   noncurrent asset depending on the due date of the note.
           3.      Companies maintain separate records (subsidiary A/R ledger) for each
                   customer. However, the total balance of the A/R account (control account) is
                   presented on the balance sheet.
           4.      Extending credit to customers is not without cost to the company. Billing
                   systems and credit personnel must be maintained. Also, the reality is that not
                   all customers will pay their debts to the company.
      B.   Accounting for Bad Debts
           1.      Bad debt expense (doubtful accounts expense, uncollectible accounts
                   expense, or provision for uncollectible accounts) is the estimated expense
                   associated with uncollectible accounts receivable. Bad debt expe nse should
                   be recorded in the same accounting period in which the related sales are
                   made (matching principle).
           2.      The allowance method bases bad debt expense on an estimate of
                   uncollectible accounts. A company would not extend credit to a customer that
                   it did not believe would pay for credit purchases. However, it is inevitable that
                   some customers will not pay. Under the allowance method, a company
                   estimates its expected bad debts.
           3.      The bad debt estimate is recorded as an adjusting journal entry at the end of
                   the accounting period. When preparing the entry, Bad Debt Expense is
                   debited and Allowance for Doubtful Accounts is credited. Allowance for
                   doubtful accounts (allowance for bad debts or allowance for uncollectible
                   accounts) is a contra (offset) asset account containing the estimated amount
                   of uncollectible accounts receivable. A/R cannot be credited for the estimated
amount of uncollectible accounts since it is not known which specific
accounts will not be paid.
     4.      Bad Debt Expense is presented as a selling expense on the income
             statement. Bad Debt Expense is a temporary account. As such, it is closed at
             the end of the accounting period.
     5.      When it is determined that an account will not be paid by a customer, that
             account should be written off. This is accomplished by preparing a journal
             entry at the time the inability to collect is determined. At that point, debit
             Allowance for Doubtful Accounts and credit A/R for the uncollectible amount.
             The specific account in the A/R subsidiary ledger should also be credited.
             Only balance sheet accounts are involved when writing off uncollectible
             accounts. Also, note that the net realizable value (A/R minus Allowance for
             Doubtful Accounts) is not changed by write-offs since both of these accounts
             are reduced by the same amount. No income statement accounts are
             affected when an uncollectible account is written off.
     6.      If a customer pays an account that was previously written off, the "write -off
             entry" must be reversed (debit A/R and credit Allowance for Doubtful
             Accounts). This is followed by recording the collection of cash. It is important
             to "reinstate" the A/R in order to maintain a complete credit history for each
     7.      At the end of the accounting period, the unadjusted balance of Allowance for
             Doubtful Accounts may have either a debit balance (wrote-off more than
             previously estimated) or a credit balance (not all estimated amounts have
             been written off). After the end-of-period adjustment is made, the account
             balance will again be a credit balance (i.e., contra account to A/R). Note that
             adjustments to prior periods are not made for incorrect estimates.
C.   Reporting Accounts Receivable and Bad Debts
     1.      The allowance for doubtful accounts is netted against A/R to report the "net
             realizable value" of receivables for balance sheet reporting. This net amount
             represents what the company expects to collect from customers.
     2.      Publicly traded companies include a detailed schedule of bad debt
             information in their Annual Report Form 10-K filed with the SEC.
D.   Estimating Bad Debts
     1.      There are two basic methods of estimating bad debt expense for the end -of-
             period adjustment. Both are acceptable under under GAAP.
             a.       Percentage of credit sales method bases bad debt expense on an
                      historical percentage of credit sales that resulted from previous bad
                      debts. An established company references past history of bad debts
                      while newer companies often reference the experience of other
                      companies in the industry. The average percent of credit sales that
                      result in bad debts can be computed as "Total Bad Debt Losses"
                      divided by "Total Credit Sales". The bad debt expense balance is
                      computed as the amount of credit sales times the computed
             b.       Aging of accounts receivable method estimates uncollectible
                      accounts based on the age of A/R. Typically, older A/R are less likely
                      to be collected than newer A/R. Management may estimate the rate
                      of loss in each "age" category (1-30 days, 31-60 days, etc.). These
                      rates are applied to the various category balances to determine the
                      amount estimated to be uncollectible. Small companies may look at
                      each individual account balance to determine the estimated
                      uncollectible amounts. In either case, the estimated uncollectible
                      amount should be the balance of allowance for doubtful accounts a t
                      the end of the accounting period. The unadjusted amount is
compared to the estimated uncollectible amount to determine the
amount of the adjustment needed.
          2. While the income statement reports sales revenue on the accrual basis, the
             statement of cash flows reflects the cash collections from customers for the
             same period. Bad debt expense is reported on the income statement.
             However, bad debt expense does not appear on the statement of cash flows
             (using the direct method) since it does not affect the cash account.
  E. Control over Accounts Receivable
      1.     Practices to help minimize bad debt losses include:
             a.      Require approval of customers' credit history by a person
                     independent of the sales and collection function.
             b.      Age accounts receivable periodically and contact customers with
                     overdue payments.
             c.      Reward both sales and collections personnel for speedy collections
                     so that they work as a team.
      2.     The receivables turnover ratio is a measure of the effectiveness of a
             credit granting and collection activities.

                                                            Net credit sales
                       Receivables Turnover =
                                                  Average net trade accounts receivable

     A.   Cash and Cash Equivalents Defined
          1.      Cash is money or any instrument that banks will accept for deposit or
                  immediate credit to the depositor's account, such as a check, money order,
                  or bank draft. Cash on hand and cash in banks are both considered to be
          2.      Cash equivalents are short-term investments with maturities of three
                  months or less that are readily convertible to cash and whose value is
                  unlikely to change. Certificates of deposit and U.S. government treasury bills
                  are examples of cash equivalents.
          3.      Frequently cash and cash equivalents are combined into one line item on the
                  balance sheet.
B.        Cash Management
                  Cash can be used by anyone. Therefore, management has the responsibility
                  to protect it for its intended business purposes. Such responsibilities include:
                  a.      Protect cash from theft and fraud.
                  b.      Accurately account for cash flows and resulting balances.
                  c.      Assure adequate amounts of cash are available for current
                          operations, debt payment, and emergency needs.
                  d.      Invest idle cash to earn revenues.
 C.       Internal Control of Cash
          1.      Internal controls are policies and procedures designed to safegu ard all
                  assets of the business (including cash) and to ensure the accuracy of
                  financial records. Controls over assets are designed to protect them from
                  unauthorized use. Controls over the accounting records are designed to
                  prevent errors and fraud.
          2.      Effective internal control of cash includes:
                  a.      Implement separation of duties.
                          - Separate jobs of receiving and disbursing cash.
                          - Separate procedures of accounting for cash receipts and cash
                          - Separate handling of cash and accounting for cash.
            b.       Evaluate responsibilities assigned to individuals.
                     - Deposit cash receipts daily and keep any cash on hand under strict
                     - Separate approval for purchases and approval for payments.
                     - Separate responsibilities for payment approval and check signing
                     - Reconcile the bank accounts at least monthly. This task should be
                       by people other than check signers or those responsible for
     3.    Effective internal control policies and procedures are important steps to
           curtail fraud and to minimize the misuse of business assets. They provide a
           crucial set of checks and balances within a company. The company's
           independent auditor should review these policies and procedures.
D.   Reconciliation of the Cash Accounts and the Bank Statements
     1.    A bank statement is a periodic report (usually monthly) from a bank that
           shows recorded deposits, cleared checks, other debits (bank service
           charges and NSF checks) and other credits (interest earned and note
           collections), and a running bank balance.
     2.    Bank reconciliation is the process of verifying the accuracy of both the bank
           statement and the cash account of the business. A bank reconciliation should
           be prepared as each bank statement is received for each bank account.
           Several timing differences may cause the bank statement balance to differ
           from the company’s cash account balance.
     3.    a.        Items to increase the cash account balance include note collections,
                     interest earned, and other credit memos. (Often the company is
                     unaware of these transactions until the bank statement arrives.)
           b.        Items to decrease the cash account balance include NSF checks,
                     bank charges, and other debit memos. (Often the company is
                     unaware of these transactions until the bank statement arrives.)
           c.        Items to increase the bank statement balance include deposits in
                     transit. (These are deposits at the bank after the cutoff time for bank
           d.        Items to decrease the bank statement balance include outstanding
                     checks. (These checks have been written and mailed but they have
                     not been presented to the bank for payment.)
           e.        Errors could have occurred with the company or the bank.
                Ending cash balance per books               Ending cash balance per bank statement
                + Interest paid by bank                     + Deposits in transits
                - NSF checks and bank service charges - Outstanding checks
                +/- Company errors                          +/- Bank errors
                Ending correct cash balance                 Ending correct cash balance

     4.     The reconciled (corrected) cash account balance and the reconciled
            (corrected) bank statement balance should be the same after the
            reconciliation process. The bank reconciliation procedure is an important
            aspect of internal control for cash.
     5.     The additions and deductions to the company's cash account related to the
            bank reconciliation require journal entries to update the cash account for
            proper balance sheet presentation.
     6.     The additions and deductions to the bank statement balance do not require
            journal entries on the part of the company. The bank should be notified of
any errors on its part. The other reconciling items (timing differences) will be
updated automatically as the bank posts deposits in transit and clears
previously outstanding checks.
     Successful companies must control inventories, control production and purchase
     costs, and update their product lines to satisfy customer needs. By increasing sales
     and lowering cost of goods sold, gross profit will increase.

     A. Recording Discounts and Returns
         1.   Examples of recording discounts and returns are given in this
         2.   Credit card discounts and sales (cash) discount can be classified as
            either expenses or contra-revenue accounts. Sales returns and allowances
            should always be presented as a contra-revenue in arriving at net sales.
     B. Applying the Revenue Principle in Special Circumstances
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