Chapter One Accounting Foundations. Copyright © Houghton Mifflin Company.All rights reserved.1 - 2 Reliability of QUALCOMM Financial Statements Auditor’s

Chapter One

Accounting Foundations

Copyright © Houghton Mifflin Company.All rights reserved. 1 - 2

Reliability of QUALCOMM Financial Statements

• Auditor’s report, company’s adherence to GAAP, and management’s certification

• Why do investors and analysts trust QUALCOMM numbers?


Section A: The Four Financial Statements

• Balance Sheet

• Income Statement

• Statement of Changes in Stockholders’ Equity

• Statement of Cash Flows


Balance Sheet

• Provides information about the financial position of a company at a specific point in time

Assets

Liabilities

Stockholders’

Equity


Balance Sheet Elements

Liabilities:Liabilities:Probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or perform services to other firms in the future as a result of past events

Stockholders’ Stockholders’ equity:equity:Residual interest in the assets of a firm that remains after deducting its liabilities (for a corporation)

Assets:Assets:Probable future economic benefits obtained or controlled by a firm as a result of past transactions or events


Asset Section of the Balance Sheet

• Current assets—reasonably expected to be realized in cash, sold, or consumed during normal operating cycle or within one year

• Operating assets—will last beyond one year; tangible assets used to create revenue from operations


Liability and Equity Section of the Balance Sheet

• Stockholders’ equity—commonly made up of stock and retained earnings, reduced by dividends issued

• Current liabilities—expected to be liquidated using current assets or refinanced by other current liabilities during one cycle or one year

• Noncurrent liabilities—obligations that will take more than one year to satisfy


Concepts Underlying the Balance Sheet

• Economic Entity Assumption

• Historical Cost Principle

• Monetary Unit Assumption

• Going Concern Assumption


Economic Entity Assumption

• Accounting for a business should be kept separate from the accounting for other entities controlled by the owner or the personal accounts of the owner

Company’s Accounting

Records

Owner’s Personal

Accounting Records


Historical Cost Principle

• Assets and liabilities are first recorded at the value of what is given in exchange for them—their original, or historical, cost

• When cash is not involved, the price is based on the fair value of what is given or what is received, whichever is more clearly determinable


Monetary Unit Assumption

• Currency is an appropriate unit of measure for assessing the value of a firm in financial reporting

• In most instances, the monetary unit is considered to be stable


Going Concern Assumption

• A firm will continue to operate indefinitely (in the absence of evidence to the contrary)

• Thus, the firm must depreciate long-term assets, recognize revenue in the period earned, and value assets based on their expected future cash flows rather than their liquidation values


Income Statement

• Provides information about the amount of net income earned by a firm over a stated period of time

Income

and

Gains

Expenses

and

Losses

Net income or loss


Income Statement Elements

• Revenues:Revenues:Inflows or enhancements of the assets of a firm or settlements of its liabilities from delivering or producing goods, rendering services, or carrying out other activities that constitute the firm’s central operations

• Expenses:Expenses:

Outflows or other using up of assets or incurrences of liabilities from delivering or producing goods, rendering services, or carrying out ongoing central operations


Income Statement Elements

• Gains: Gains: Increases in equity from peripheral or incidental transactions of a firm and from other transactions and events affecting the firm except those that result from revenues or investments by owners

• Losses:Losses:Decreases in equity from peripheral or incidental transactions of a firm and from other transactions and events affecting the firm except those that result from expenses or distributions to owners


Income Statement: Cramer Corporation


Critical Thinking

• Discussion: If financial statements were not presented with commonly accepted elements, what problems might arise for financial statement users?

• Each financial statement contains certain key elements that users of financial data expect to find and analysts rely upon. Without these elements, users would not be able to compare like figures between companies and between different fiscal periods for the same company.


Concepts Underlying the Income Statement

Periodicity Assumption

Accrual Accounting

Revenue Recognition Principle

Matching Principle

Conservatism

Full Disclosure


Periodicity Assumption

• A firm’s activities should be measured in terms of arbitrary time periods even though the firm’s life is considered to be indefinite

• The firm’s operating cycle may differ from these arbitrary time periods

• Periodic financial statements are published


Accrual Accounting

• Practice of recording transactions in the period in which they occur rather than in the period in which cash or other form of payment is received

• Differs from cash basis of accounting in which revenues are recorded when cash is received and expenses are recorded when cash is paid


Revenue Recognition Principle

• Governs when revenue should be recognized and recorded in records

• Record revenue when the amount and timing of revenue are reasonably determinable AND when the earnings process is complete or virtually complete


Matching Principle

• Expenses should be reported in the same accounting period as the revenues to which they are related

• Supports accrual accounting and the practice of depreciation, in which the cost of an asset is allocated over its useful life


Conservatism

• Guides the valuation of assets and liabilities and influences the recognition of revenues and expenses, gains and losses

• Dictates that accountants should select accounting methods that are least likely to overstate net income and the financial position of the firm


Full Disclosure

• Requires that financial statements and related notes include any information that is significant or material enough to change the decisions of financial statement users

• Details of complicated transactions, such as leases, interest swaps, and stock options, are usually disclosed in the notes to the financial statements


Statement of Changes in Stockholders’ Equity

• Summarizes the adjustments to stockholders’ equity accounts over an accounting period

Capital Stock Accounts

Paid-in Capital Accounts

Retained Earnings


Statement of Changes in Stockholders’ Equity


Statement of Cash Flows

• Shows the amount of cash collected and paid out by a firm over an accounting period

Cash Flows from Operating Activities

Cash Flows from Investing Activities

Cash Flows from Financing Activities


Statement of Cash Flows


Check Your Understanding

Q Which financial statement provides information about the financial position of a firm at a specific point in time?

A The balance sheet



Q What are the primary elements found on the income statement?

A Revenues, expenses, gains, and losses



Q What three categories of cash flows are found on the statement of cash flows?

A Cash flows from investing, financing and operating activities



• The balance sheet is supported by the assumption that a firm will continue to operate indefinitely. What is the name of this assumption?

A Going Concern Assumption


Section B: Double-Entry Accounting System and the Accounting Cycle

• Every transaction has a dual effect on the accounting equation

ACCOUNTING EQUATION

Assets =

Liabilities +

Stockholders’ Equity


Rules for Debiting and Crediting Accounts


The Accounting Cycle

Step 1: Identify and gather information about transactions and economic events

Step 2: Analyze and record each transaction

Step 3: Post journal entries to the general ledger

Step 4: Prepare an unadjusted trial balance

Step 5: Record and post the adjusting journal entries and prepare an adjusted trial balance

Step 6: Prepare the financial statements

Step 7: Record and post closing entries and prepare a post-closing trial balance


Step 1: Identify and Gather Transaction Information

• Use source documents like invoices, purchase orders, sales invoices, and register printouts for external transactions

• Use source documents like memos or depreciation schedules for internal transactions


Step 2: Analyze Transactions and Record in a Journal

• Determine the dollar amounts and accounts involved.

• To journalize the transaction, enter the date of the transaction and the debited account title and amount. On the next line, indent and enter the credited account title and amount. On the third line, enter the description of the transaction.

Date Account Title & Explanation

Post Ref Debit Credit

July 1 Land $300,000

Cash $300,000

To record the purchase of land for cash


Analyzing and Recording: Sample Transaction 1

• On September 1, 2006, Nancy and John form a corporation, Kettle and Wolf, Inc., by filing with the State of Illinois. They each invest $5,000 in the business in exchange for common stock.

2006

Sept. 1 Cash $10,000

Common Stock $10,000

To record the issuance of common stock



• On September 1, Kettle and Wolf sign a note at the local bank for $3,000 due in two years at 12 percent annual interest.

To record the issuance of a long-term note payable

2006

Sept. 1 Cash $3,000

Long-Term Notes Payable $3,000



• On September 1, Kettle and Wolf sell 800 newsletters for $3 each as one-month subscriptions.

To record the sale of 800 one-month subscriptions

2006

Sept. 1 Cash $2,400

Subscription Revenue $2,400


Step 3: Post Journal Entries to the Ledger

To record the issuance of common stock

Cash Common Stock

Posting to T-accounts (for illustrative purposes):

9/1 10,000 10,000 9/1

2006

Sept. 1 Cash $10,000

Common Stock $10,000


Post Journal Entries to the Ledger

To record the issuance of a long-term note payable

Cash Long-Term Notes Payable


9/1 10,000

9/1 3,000

3,000 9/1

2006

Sept. 1 Cash $3,000

Long-Term Notes Payable $3,000


Post Journal Entries to the Ledger

To record the sale of 800 one-month subscriptions

Cash Subscription Revenue


9/1 10,000

9/1 3,000

9/1 2,400

2,400 9/1

2006

Sept. 1 Cash $2,400

Subscription Revenue $2,400


Step 4: Prepare an Unadjusted Trial Balance

• After all transactions are recorded in the journal and posted to the ledger, prepare the unadjusted trial balance

• Compares total debit and credit balances in the ledger to verify that they are correct before preparing the adjusting entries

[Insert Illustration 1.13, Unadjusted Trial Balance]


Step 5: Record and Post Adjusting Entries and Prepare Adjusted Trial Balance

Accruals:Accruals:

• Recognized when an economic event occurs before cash is exchanged

Deferrals:Deferrals:• Recognized when

cash is exchanged before an economic event occurs

• Prepare adjusting entries to record the financial effects of transactions or events that cover more than one period and to make estimates and other changes necessary to bring the accounts to their true balances


Accrual Entries

• Accrue revenue to ensure that all revenues for that period are recorded in the period, even though related cash may not yet be received

• Accrue expenses to ensure that all expenses incurred during period are recorded even though they have not yet been paid


Deferral Entries

• Defer revenue when a firm receives cash or assets prior to earning the revenue associated with the transaction

• Examples: Advance deposits or professional services retainers

• Defer expenses when cash has been paid before the related expense has been incurred

• Examples: Supplies and prepaid expenses


Other Adjusting Entries

• Adjust accounts to their true balances due to estimates of future events that affect the current period’s financial statements

• Estimates that may need review and adjustment include bad debt expense, warranty expense, pension costs, and postretirement benefits


Adjusting Entry: Illustration

• On September 31, Kettle and Wolf should recognize one month of accrued interest on the $3,000 long-term note payable at 12 percent.

2006

Sept. 31 Interest Expense 30

Interest Payable 30

To record interest expense for the current period


Step 6: Prepare Financial Statements

• Income Statement

• Statement of Changes in Stockholders’ Equity

• Balance Sheet

• Statement of Cash Flows


Step 7: Prepare and Post Closing Entries and Prepare Post-Closing Trial Balance

1. Close all revenue accounts to Income Summary.

2. Close all expense accounts to Income Summary.

3. Close Income Summary to Retained Earnings.

4. Close the Dividends account to Retained Earnings.


Sample Closing Entries for Kettle and Wolf

Subscription Revenue 3,400 Income Summary 3,400

To close Revenue account to Income Summary

Income Summary 855 Salaries Expense 400 Interest Expense 30 Depreciation Expense 125 Supplies Expense 100 Website Expense 200

To close expense accounts to Income Summary

Income Summary 2,545 Retained Earnings 2,545

To close Income Summary to Retained Earnings


Prepare Post-Closing Trial Balance

• Post-closing trial balance should contain only permanent accounts (all temporary accounts have been closed)

• Final check to ensure that total debits equal total credits



Q Under the rules of debit and credit in a double-entry accounting system, describe the change represented by a debit to an asset account, to a liability account, and to a stockholders’ equity account.

A Debit to an asset account represents an increase; a debit to a liability account or to a stockholders’ equity account represents a decrease.



Q Why are adjusting entries needed?

A Adjusting entries record the financial effects of transactions and events that cover more than one accounting period and to make the estimates and other changes necessary to bring the accounts to their actual balances.



Q List the four basic closing entries required at the end of an accounting period.

A Close all revenue accounts to Income Summary. Close all expense accounts to Income Summary. Close the Income Summary account to Retained Earnings. Close the Dividends account to Retained Earnings

Documents

Chapter One Accounting Foundations. Copyright © Houghton Mifflin Company.All rights reserved.1 - 2 Reliability of QUALCOMM Financial Statements Auditor’s