Recording Business Transactions

The Cash and Accrual Bases of Accounting

Chapters 2 and 3

The Basic Accounting Equation Assets = Liabilities + Equity

Accounting transaction Any event that causes a change in the basic

accounting equation

Double-entry bookkeeping Any transaction must affect at least two accounts

if the equation is to remain in balance

The Cash Basis of Accounting

Revenues are recorded when cash is received

Expenses are recorded when cash is paid

Transactions are only recorded if they increase or decrease cash

Not acceptable for financial reporting purposes Violates the matching concept

The Accrual Basis of Accounting Any transaction affecting the basic

accounting equation is recorded

Revenues are recorded when earned, expenses are recorded when incurred Timing of the cash receipts or payments is not

relevant

Allows us to match expenses to the revenues they help produce

Adjusting Entries

Adjustments must be made to record certain revenues and expenses in the proper periods

Accruals Revenue is earned, or expense is incurred, before

the cash changes hands Interest, wages, taxes, utilities, etc.

Accrued revenues require the recording the revenue and a related asset (receivable)

Accrued expenses require the recording of the expense and a related liability (payable)

Adjusting Entries Deferrals

Cash changes hands before the revenue is earned or the expense incurred Depreciation, supplies, prepaid items, customer

deposits, subscriptions, etc. Deferred revenues

Initial entry includes a receipt of cash and a liability Adjusting entry records the revenue and reduces the

liability Deferred expenses

Initial entry includes an asset and a payment of cash Adjusting entry records the expense and reduces the

asset

Financial Statement Formats

Income statement Single-step format

All revenues are listed first, then all expenses Total revenue – total expenses = net income

Multi-step format Revenues and expenses are categorized as “operating”

or “other” to emphasize the main activities of the business

Provides more useful information than the single-step method

Sales 500,000$ Interest income 500 Gain on sale of assets 1,700 Total revenues 502,200$ Expenses:

Cost of goods sold 278,000$ Salary expense 84,000 Rent expense 36,000 Utility expense 18,000 Maintenance expense 5,000 Depreciation expense 12,000 Interest expense 2,000 Income tax expense 20,000

Total expenses 455,000 Net income 47,200$

Example CompanyIncome Statement

For the Year Ended December 31, 2004

Sales 500,000$ Cost of goods sold 278,000 Gross margin 222,000$ Operating expenses:

Salary expense 84,000$ Rent expense 36,000 Utility expense 18,000 Maintenance expense 5,000 Depreciation expense 12,000

Total operating expenses 155,000 Income from operations 67,000$ Other revenues and expenses:

Interest expense (2,000)$ Interest income 500 Gain on sale of assets 1,700

Net other revenues and expenses 200 Income before income taxes 67,200$ Income tax expense 20,000 Net income 47,200$

Example CompanyIncome Statement

For the Year Ended December 31, 2004

Financial Statement Formats Classified balance sheet

Categorizes assets and liabilities by their characteristics Current assets

Items expected to be consumed or converted into cash within one year or one operating cycle, whichever is longer

Cash, accounts receivable, inventory, short-term notes receivable, prepaid items, etc.

Investments Investments which are not considered current assets

Stocks, bonds, etc.

Financial Statement Formats

Property, plant and equipment Long-lived assets and the related accumulated

depreciation

Land, buildings, equipment, vehicles, furniture, etc.

Intangible assets Assets with no physical substance

Copyrights, trademarks, patents, etc.

Other assets Assets which do not fit into one of the previous categories

Financial Statement Formats

Current liabilities Liabilities expected to be satisfied within one year or one

operating cycle, whichever is longer, and will be satisfied with current assets

Accounts payable, wages payable, taxes payable, short-term notes payable, current maturities of long-term debt, unearned revenue, warranty liabilities, etc.

Long-term liabilities Liabilities which will not be satisfied within one year or an

operating cycle, or will not be satisfied with current assets

Long-term debt, pension obligations, etc.

Financial Statement Formats

Stockholders’ equity Contributed capital

Capital stock and other amounts received from investors

Retained earnings

Treasury stock

Stock repurchased from investors

Negative stockholders’ equity item

Current assets: Current liabilities:Cash 25,000$ Accounts payable 7,000$ Accounts receivable 18,000$ Wages payable 2,000 Less: allowance for bad debts (1,000) 17,000 Short-term note payable 10,000 Inventory 23,000 Unearned revenue 3,000 Prepaid rent 1,000 Total current liabilities 22,000$

Total current assets 66,000$ Long-term liabilities:Investments: Long-term note payable 30,000$

XYZ Company stock 7,000 Mortgage payable 20,000 Property, plant and equipment: Total long-term liabilities 50,000

Land 11,000$ Total liabilities 72,000$ Building 69,000$ Stockholders' equity:Less: accumulated depreciation (14,000) 55,000 Capital stock 25,000$ Equipment 33,000$ Retained earnings 67,000 Less: accumulated depreciation (12,000) 21,000 Total stockholders' equity 92,000

Total property, plant and equipment 87,000 Intangible assets:

Patents 4,000 Total assets 164,000$ Total liabilities and stockholders' equity 164,000$

ASSETS

As of December 31, 2004Balance Sheet

Example Company

LIABILITIES AND STOCKHOLDERS' EQUITY

Financial Statement Formats Statement of cash flows

Operating activities Direct method

Cash received from customers

Cash paid for operating activities

Indirect method Start with net income and adjust for changes in current

assets and liabilities (accruals and deferrals)

Investing activities

Financing activities

Financial Statement Formats

Reconciliation of net income to cash flow from operating activities Required if direct method is used

Net income is adjusted for the effects of accruals, deferrals and non-cash items Begin with net income

Add back depreciation expense (and other non-cash expenses)

Subtract (add) increases (decreases) in current assets

Add (subtract) increases (decreases in current liabilities

Operating activities:Cash received from customers 475,000$ Cash paid to suppliers (290,000) Cash paid for operating expenses (181,000)

Cash flow from operating activities 4,000$ Investing activities:

Purchase of land (6,000)$ Sale of equipment 1,000

Cash flow from investing activities (5,000) Financing activities:

Issuance of long-term debt 20,000$ Issuance of capital stock 6,000 Repayment of long-term debt (5,000) Payment of dividends (1,000)

Cash flow from financing activities 20,000 Net increase in cash 19,000$ Cash balance, January 1, 2004 6,000 Cash balance, December 31, 2004 25,000$

For the Year Ended December 31, 2004Statement of Cash Flows

Example Company