1 chapter 5 the accounting system: concepts and applications

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CHAPTER 5

THE ACCOUNTING SYSTEM: CONCEPTS AND APPLICATIONS

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Chapter Overview Why do managers, investors, creditors,

and others need information about a company’s operations?

What are the basic concepts and terms that help identify the activities that a company’s accounting system records?

What do users need to know about the accounting equation for a company?

Why are at least two effects of each transaction recorded in a company’s accounting system?

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What are revenues and expenses, and how

is the accounting equation expanded to

record these items?

What are the accounting principles and

concepts related to net income?

What are the end-of-period adjustments

necessary?

Chapter Overview

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Using Financial Statements

What are the components of revenue and

expenses? How was net income

generated? What

resources has the

company invested in to generate

profits?

What financial resources has the company raised for the business?

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Financial Statements Need Uniformity

Making good business decisions based on

financial statement information assumes there is

agreement about what is included in the

statements and how the amounts are measured.

Generally accepted accounting principles

(“GAAP”) provides the guidelines and rules that a

company must follow when financial statements

are prepared.

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Several basic concepts help identify the activities that a company’s accounting process records:

1. Entity concept.

2. Transactions.

3. Source documents.

4. Monetary unit concept.

5. Historical cost concept.

Basic GAAP Concepts

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Entity Concept

The entity concept states that an entity is considered to be separate from its owners and from any other company.

Each company is an entity and has its own accounting system and records. Only transactions that affect that particular company are recognized.

An owner’s personal financial activities are not included in the accounting records unless the activity has a direct effect on the company.

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Transactions A transaction is an external transaction, in

which an exchange of property or service occurs with another entity. For example, when Sweet Temptations purchases storefront equipment for its shop, a transaction occurs.

Purchases $2,200 in storefront cabinets

Sweet Temptations Sells $2,200

of storefront cabinets

Ace EquipmentCompany

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A source document is a business record used as evidence that a transaction has occurred, such as a company check, a sales receipt, a supplier’s bill, a customer’s bill, a payroll time card, or a log of miles driven in the company delivery truck.

Source Documents

Ace Equipment Co.Invoice 4857310 storefront cabinets @ $220 each, sold to Sweet Temptations $2,200

This invoice becomes the source document for Sweet Temptations to record the transaction in its accounting system.

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Monetary Unit Concept The monetary unit concept states that transactions

are recorded in terms of money, providing a quantifiable basis for recognizing a transaction.

In the U.S., the monetary unit is the dollar; U.S.-based companies show financial statements in dollars.

Monetary unit depends on the national currency of a company’s country; Sony uses the Japanese yen and Benetton uses the European Union euro.

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Historical Cost Concept The historical cost concept states that a company records its transactions

based on the dollars exchanged (the cost) at the time the transaction occurs.

This provides the most objective evidence to record the transaction.

If a company purchases land for $100,000 in 2002, this is the cost recorded by the company (the acquisition cost). If the land increases in value to $130,000 in 2003, the appreciation is not recorded.

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The Accounting Equation

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Assets Assets are economic resources that will provide future benefits to a company. A

company may own many assets.

Some assets are physical in nature such as land, buildings, and inventory.

Other assets are intangible in nature for the legal rights (benefits) conveyed, such as accounts receivable (the amounts owned to a company by customers) or the prepaid insurance (the right for future insurance protection.

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Liabilities

Liabilities are the economic obligations (debts) of a company. The external parties to whom a company owes the debts are referred to as creditors.

Liabilities include items such as accounts payable (the amounts owned to suppliers for credit purchases) or wages payable (amounts owned to employees for work they have done).

Legal documents are often evidence of liabilities that establishes a creditor’s claim.

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Owners’ Equity

Owners’ Equity is the owners’ current investment in the assets of the company. Corporations call this stockholders’ equity.

Owners’ Equity is often referred to as residual equity because creditors have first legal claim to a company’s assets; owners’ are entitled to what remains after creditors have been paid.

Owners’ Equity represents the total resources provided by owners.

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Accounting for BusinessTransactions

Transaction 1: Anna Cox starts her business on December 15, 2003 by writing a $15,000 personal check and depositing it in a checking account she opened for Sweet Temptations.

Cash (assets) and A. Cox, Capital (owners’ equity) increase for the $15,000 cash investment into the business.

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Transaction 2: To open Sweet Temptations at the Westwood Mall, Anna signed, in the company’s name, a rental agreement with the mall’s manager, paying 6 months of rent ($1,000 each month) in advance.

Prepaid Rent (assets) increase and Cash (assets) decrease for the $6,000 rent paid in advance.

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Transaction 3: On December 17, 2003, Sweet Temptations purchases $700 of office and store supplies from City Supply Company by writing a check for $700.

Supplies (assets) increase and Cash (assets) decrease for the $700 in supplies purchased.

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Transaction 4: On December 20, 2003, Sweet Temptations purchases $1,620 of candy (360 boxes @ $4.50 each) on credit from Unlimited Decadence Corporation.

Inventory (assets) and Accounts Payable (liabilities) increase for the $1,620 in merchandise purchased on credit.

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Transaction 5: On December 29, 2003, Sweet Temptations purchases store equipment for $2,200, $1,000 cash down and issuing a note to pay the remaining $1,200 (plus interest of $240) at the end of 3 months.

Store Equipment (assets) increase for $2,200 and then Cash (assets) decrease for $1,000, a net increase of $1,200; Notes Payable (liabilities) then increase for the $1,200 note issued for the balance due.

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Transaction 6: On December 30, 2003, Sweet Temptations sells an extra desk, recently purchased for $400, to The Hardware Store, another store in the mall, for the same amount.

Accounts Receivable (assets) increase and Store Equipment (assets) decrease for the $400 desk sold.

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The Components ofOwners’ Equity

Owners’ Equity includes two very important components of an owners’ investment in the business: (1) the owners investments and withdrawals, and (2) the profits earned (net income).

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Principles and ConceptsRelated to Net Income

Accounting periods

Earnings and recording revenues

Matching principle

Accrual accounting

Several additional accounting principles and concepts are important to understanding how net income is reported.

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2002

Annual Accounting Periods

Accounting Period

An accounting period is the time span for which a company reports its revenues and expenses, usually a twelve-month accounting period.

2003 2004 2005

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Earnings and Recording Revenues

A company records revenues during the accounting period in which they are earned and are collectible.

In June, 2003, customer pays for goods purchased

in May, 2003

$2,000 in goods are sold to a customer on

account in May, 2003

$2,000 in revenue is earned in May, 2003

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Matching Principle

The matching principles states that a company must “match” expenses with the revenues produced during the current period.

In June, 2003, when the pay period ends,

employees are paid

$1,500 in wages are earned by employees during the last week

of May, 2003

$1,500 in wages expense has been incurred in May, 2003

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Accrual Accounting

Accrual accounting is related to both the recording of revenue and the matching of expenses to produce revenues.

To accrue means to accumulate or add revenues and expenses.

Under this concept, revenues are recorded when earned and expenses are recorded when incurred (or consumed), regardless of when cash is received or paid.

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Transaction 1: On January 2, 2004, Sweet Temptations opens for business, selling 30 boxes of candy for cash, at $10 a box. Each box of candy cost Sweet Temptation’s $4.50.

Cash (assets) and Revenues (owners’ equity) increase for the $300 received on the sale.

Cost of goods sold increases (which decreases (owners’ equity) and inventory decreases (assets) for the $135 cost of inventory sold.

Recording Daily Transactions:

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Transaction 2: On January 3, Sweet Temptations pays for the inventory it purchased in December on credit.

Cash (assets) and accounts payable (liabilities) decrease for the $1,620 paid.


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Transaction 3: On January 4, the company purchases 960 additional boxes of chocolates at $4.50 per box on credit.

Inventory (assets) and accounts payable (liabilities) increase for the $4,320 credit purchase.


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Recording Daily Transactions

Transaction 4: On January 6, Sweet Temptations sells 10 boxes of candy for $100 on credit to Bud Salcedo, owner of the flower shop next door. Each box of candy cost Sweet Temptation’s $4.50.

A/R (assets) and Revenues (owners’ equity) increase for the $100 credit sale.

Cost of goods sold increases (which decreases (owners’ equity) and inventory decreases (assets) for the $45 cost of inventory sold.

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Transaction 5: Sweet Temptations receives a check for $400 from The Hardware Store on January 7, 2004 for the equipment sold in December.

Cash (assets) increase and accounts receivable (assets) decrease for the $400 received.

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Transaction 6: Anna Cox withdraws $50 cash from the business for personal use on January 20, 2004, writing a $50 check to herself from the Sweet Temptation’s bank account.

Cash (assets) and owners’ capital (owners’ equity) decrease for the $50 cash withdrawal.

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Transaction 7: Sweet Temptations hires the Dana Design Group to produce Valentine’s Day ads. The design group presents the ad on January 25, 2004 and Sweet Temptations pays the $200 due.

Cash (assets) decrease and expenses increase (which decreases owners’ equity) for the $200 consulting expense paid.

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Transaction 8: On January 25, the company pays $300 to run an advertisement in the mall promotional flyer at the end of January.

Cash (assets) decrease and expenses increase (which decreases owners’ equity) for the $300 advertising expense paid.

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Transaction 9: On January 29, 2004, Sweet Temptations purchases an additional candy display case for $200, writing a company check.

Cash (assets) decrease and store equipment (assets) increase for the $200 purchase.

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Transaction 10: On January 31, 2004, Sweet Temptations pays its employees $2,050 for service performed during January.

Cash (assets) decrease and expenses increase (which decreases owners’ equity) for the $2,050 salaries expense paid.

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Transactions 11: On January 31, 2004, Sweet Temptations pays the telephone bill ($60) for January.

Cash (assets) decrease and expenses increase (which decreases owners’ equity) for the $60 telephone expense paid.

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Recording Daily Transactions Transactions 12: On January 31, 2004, Sweet

Temptations pays the utilities (heat, light, and water, $190) for January.

Cash (assets) decrease and expenses increase (which decreases owners’ equity) for the $190 utilities expense paid.

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Recording Daily Transactions: Transaction 13: Cash sales of candy for January 3

through January 31 totaled $7,700. The candy cost Sweet Temptation’s $3,465.

Cash (assets) and Revenues (owners’ equity) increase for the $7,700 received on sales.

Cost of goods sold increases (which decreases (owners’ equity) and inventory decreases (assets) for the $3,465 cost of inventory sold.

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End-of-Period Adjustments

Transactions 14: During January, Sweet

Temptations used $30 of the $700 in supplies

purchased at the beginning of January.

Transaction 15: Due to the passage of time,

the rent prepaid for January has now been

consumed (used).

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End-of-Period Adjustments

Transaction 16: Depreciation of $15 is recorded on the

$1,800 of store equipment purchased in early January,

a process of allocating the cost of a physical asset to

expense over the time period the asset is used.

Transaction 17: Due to the passage of time, Sweet

Temptation is now obligated to recognize $8 of the $24

in interest the company agreed to pay on the store

equipment note.

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Effect of January Transactions on the Accounting Equation

A summary of the effect of Sweet Temptation’s January transaction is as follows:

+=