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Top 3 Expenses of a Restaurant Profit and Loss Statement document sample
Chapter 1 CHAPTER OUTLINE I UNDERSTANDING THE BUSINESS – LO 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 purchased. 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). II THE FOUR BASIC FINANCIAL STATEMENTS: AN OVERVIEW – 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 statements. 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 transactions. - 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 dividends). - Owners of corporate stock are generally not personally liable for the 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 Statement. 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 services. b. Expenses (E) These are outflows of net assets representing resources used to earn the revenues during the period. Examples: - Cost of Goods Sold (CGS) expenses - the costs to buy goods for resale or to make the goods that are sold. - Selling, General & Administrative expenses - other expenses incurred 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 (payments). 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 lenders. 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 I BUSINESS BACKGROUND 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 companies. 3. Analysis of investing and financing activities of a business should be explored . II OVERVIEW OF THE CONCEPTUAL FRAMEWORK – LO 1, 2 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 dates. 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 and/or 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 reflects 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' Equity 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. III WHAT BUSINESS ACTIVITIES CAUSE CHANGES IN FINANCIAL STATEMENT AMOUNTS? – LO 3 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. or 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. IV HOW DO TRANSACTIONS AFFECT ACCOUNTS? – LO 4 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 accounts. 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 account. 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. V HOW DO COMPANIES KEEP TRACK OF ACCOUNT BALANCES? – 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 accounts). A. The Direction of Transaction Effects 1. It is important to understand which accounts increase and decrease because of a transaction. 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 account. 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 entry. 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 accounts. 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. VII HOW IS THE BALANCE SHEET PREPARED? – LO 6 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 I BUSINESS BACKGROUND 1. Companies should develop objectives and plans to achieve their goals. Projecting 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. II WHAT BUSINESS ACTIVITIES AFFECT THE INCOME STATEMENT? – 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 growth. 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 expense, 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 Expenses. 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 peripheral 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 Assets This ratio measures the amount of sales generated per dollar invested in assets. It indicates whether a company uses its assets efficiency. III HOW ARE OPERATING ACTIVITIES RECOGNIZED AND 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 recognition. 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). IV THE EXPANDED TRANSACTION MODEL- LO 5 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 decreased. 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 declared. 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. VI HOW ARE UNADJUSTED FINANCIAL STATEMENTS PREPARED? - 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 I BUSINESS BACKGROUND 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 estimates. 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. II ADJUSTING REVENUES AND EXPENSES – LO 1, 2 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 closed. 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 error. d. Account balances may have been copied incorrectly to the trial balance. 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 expense). 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 adjusting entries will usually be delayed until the financial statements are "out the door". 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 process. 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.) III PREPARING FINANCIAL STATEMENTS – LO 3, 4 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 outstanding 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. IV CLOSING THE BOOKS – LO 5 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 period. 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 period. 2. To make sure no temporary account balances remain. That is, temporary accounts should have zero balances at this point. Chapter 6 I BUSINESS BACKGROUND 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. II ACCOUNTING FOR SALES REVENUE – LO 1, 2, 3 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 verifiable. 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 expenses. 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 avoided. 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 periodically. 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' practices. 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 alternative. 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). III MEASURING AND REPORTING RECEIVABLES – LO 4, 5 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 customer. 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 percentage. 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 company’s credit granting and collection activities. Net credit sales Receivables Turnover = Average net trade accounts receivable IV REPORTING AND SAFEGUARDING CASH – LO 6 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 "cash". 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 disbursements. - 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 control. - Separate approval for purchases and approval for payments. - Separate responsibilities for payment approval and check signing approval. - Reconcile the bank accounts at least monthly. This task should be done by people other than check signers or those responsible for recordkeeping. 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 posting.) 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. f. 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. V EPILOGUE 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. VI CHAPTER SUPPLEMENT A. Recording Discounts and Returns 1. Examples of recording discounts and returns are given in this supplement. 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 See website at www.mhhe.com/libby4e.
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