Financial Accounting 2301

Midterm Exam Study Guide

Chapter 1
Purposes of and differences between financial accounting/management accounting/tax accounting.
Financial acct the area of acct that refers to providing info to support external investment and credit

decisions; provides information about the financial resources, obligations, and activities of an economic entity
that is intended for use primarily by external decision makersinvestors and creditors
Management Accounting area of acct that refers to providing info to support internal management decisions;
information is primarily used by internal management in decision making required to run the business
Tax Accounting a specialized field within accounting; tax returns are based on financial accounting
information, but the information often is adjusted or reorganized to conform with income tax reporting
requirements; it results from a different system and complies with specialized legal requirements that relate to a
company's responsibility to pay an appropriate amount of taxes.
Nature of accounting systems - consists of the personnel, procedures, technology, and records used by an

organization (1) to develop accounting information and (2) to communicate this information to decision makers.
In developing information about the activities of a business, every accounting system performs the following
basic functions:
1. Interpret and record the effects of business transactions.
2. Classify the effects of similar transactions in a manner that permits determination of the various totals and
subtotals useful to management and used in accounting reports.
3. Summarize and communicate the information contained in the system to decision makers.
Whether for a large or small business, the basic purpose of the accounting system remains the same: to meet the
organization's needs for information as efficiently as possible
Purpose and objectives of Generally Accepted Accounting Principles (GAAP) acct principles that
provide the framework for determining what information is to be included in financial statements and how the
info is to be prepared and presented; includes broad principles of measurement and presentation, as well as
detailed rules that are used by professional accountants in preparing accounting information and reports; refers

to the accounting concepts in use in the United States

Purposes/Authority of Securities and Exchange Commission (SEC) and Financial Accounting
Standards Board (FASB)
SEC govt agency that has the legal power to establish acct principles and financial reporting requirements
for publicly held co in the US; generally adopts the recommendations of the FASB (discussed below), rather

than develop its own set of accounting principles. Thus, accounting principles continue to be developed in the
private sector but are given the force of law when they are adopted by the SEC.
FASB a private sector org that establishes generally accepted acct standards in the US; works closely w/
SEC; has compiled all of its standards, and those of its predecessors, in an Accounting Standards Codification;

it is part of the private sector of the economyit is not a governmental agency.

Nature of Sarbanes Oxley Act/Purpose of Public Company Accounting Oversight Board

SOX - A landmark piece of securities law, designed to improve the effectiveness of corporate financial reporting

through enhanced accountability of auditors, boards of directors, and management. Public co must:
1. issue a yearly report indicating whether they have an effective system of internal control over financial
reporting
2. management must indicate whether the entity's internal control system provides reasonable assurance
that financial statements will be prepared in accordance with laws and regulations governing financial
reporting
3. the company's external auditor must issue its own report as to whether the auditor believes that the
company's internal control system is effective
4. to ban auditors from providing many nonaudit services for their audit clients on the assumption that
those services interfere with the objectivity
Among the more important provisions of Sarbanes-Oxley is the creation of the Public Company Accounting
Oversight Board
PCAOB a quasi-governmental body charged with the oversight of the public acct profession; sets auditing
standards for audits of publicly traded companies; was created as a result of the Sarbanes-Oxley Act of 2002
and began operations in the spring of 2003.
Purpose of audited financial statements and financial reporting to insure against deficiencies that may
lead to violation of securities law; provides a complete and reliable picture of an orgs financial position;
determines fairness (reliable and complete)
Chapter 2
3 primary financial statements, nature of and reporting periods/dates covered by each

Income statement - reports the profitability of the firm; it is made up of revenues and expenses and the
difference b/t these numbers shows the firms profitability. This bottom line number, the net income or net
loss is later used to prepare the balance sheet which is why the income statement is prepared first. An activity
statement that subtracts from the enterprises revenue those expenses required to generate the revenues,
resulting in a net income or a net loss; it is a summarization of the company's revenue and expense
transactions for a period of time, and explains how the company's financial position changed between the
beginning and ending of that period.
Statement of financial position (balance sheet) made up of two parts which must equal each other; 1st is
assets (all of the productive resources of a firm) and 2nd is liabilities (all the money owed by the firm) and OE
(all the money invested in the firm or that has been earned by the firm) it is a position statement that shows
where the company stands in financial terms at a specific date; gives a static look in financial terms of
where the company stands; the income statement and the statement of cash flowscover the intervening
period of time between the two balance sheets and help explain important changes that occurred during the
period. (shows value not worth)
Statement of cash flows -explains the enterprises change in cash in terms of its operating, investing, and
financing activities; summarizes cash transactions during an acct period and helps users evaluate a
companys ability to have enough cash (an important signal to investors and creditors about the prospects of
future cash flows)
Nature of Assets, Liabilities, Equity, Revenue and Expenses.
Assets - An enterprise's resources are often referred to as assets, are economic resources that are owned by a

business and are expected to benefit future operations (land, buildings, inventory, AR, furniture, equipment,
investment in other firms).

Liabilities money that the firm owes others are financial obligations or debts. They represent negative future
cash flows for the enterprise (such as notes & bonds payable, accounts payable, salaries payable, and unearned
revenues) and are usually listed in the order in which they are expected to be repaid
Equity what the firm has earned or is expected to earn; made up of paid-in capital (owner investments) and
retained earnings (all of the accumulated net income) represents the owners' claims on the assets of the
business. If you are the owner of a business, you are entitled to assets that are left after the claims of creditors
have been satisfied in full. Therefore, owners' equity is always equal to total assets minus total liabilities
Increases in Owners' Equity comes from two primary sources:
1. Investments of cash or other assets by owners.
2. Earnings from profitable operation of the business.
Decreases in Owners' Equity caused in two ways:
1. Payments of cash or transfers of other assets to owners.
2. Losses from unprofitable operation of the business.
Revenue results from the sale of goods or provision of services The price of goods and services charged to

customers for goods and services rendered by a business; increases in the company's assets from its profitdirected activities, and they result in positive cash flows; revenues incr assets and OE.
Expenses result from costs necessary to carry on current operations The costs of the goods and services used
up in the process of obtaining revenue; Past, present, or future reductions in cash required to generate
revenues; decreases in the company's assets from its profit-directed activities, and they result in negative cash
flows; exp decr assets and OE
Impact of financial transactions on individual balance sheet accounts as well as Total Assets,
Liabilities and Equity.
Owner investment - I assets, NE liabilities, I OE
Cash purchase decr cash but also incr assets so NE on A, L, OE
Credit purchase I assets, I liabilities, NE OE
Returned items bought on credit but not yet paid for - D assets, D liabilities, NE OE
Sale of asset at cost incr cash but also decr assets so NE on A, L, OE
Sale of asset above cost I cash, D liabilities, I OE (represents a gain)
Collection of AR incr cash, decr in AR so NE on A, L, OE
Payment of a liability D cash, D AP, NE OE

Earning rev I cash, NE liabilities, I OE (A & OE incr equally)

Payment of exp D cash, NE liabilities, D OE (A & OE decr equally)
Borrowed $ - I assets, I liabilities, NE OE
Application of the Accounting Equation Assets = Liabilities + OE (the bal sheet is a detailed expression of
this)
Underlying theories of the Cost principle, Objectivity principle, and Going-Concern assumption.
Computation of Net Income.
Cost principle assets should be represented at cost (historical)
Objectivity principle another reason for using cost to record assets is the need for a definite factual and
objective basis for valuation that can be verified by independent experts (b/c market values chg)

Going-concern assumption another reason assets are not recorded at market value is they were acquired for
use not for resale; so acct use the assumption that a business will operate in the foreseeable future (unless
evidence suggest otherwise) in valuing assets at cost
3 forms of business organizations and primary differences between them.

Sole proprietorship - An unincorporated business owned by a single individual; the business and its owner
are not regarded as separate entities so the owner is personally liable for the debts of the business. If the
business encounters financial difficulties, creditors can force the owner to sell his or her personal assets to pay
the business debts. While an advantage of the sole proprietorship form of organization is its simplicity, this
unlimited liability feature is a disadvantage to the owner.
Partnership - An unincorporated form of business organization in which two or more persons voluntarily
associate for purposes of carrying out business activities. Partnership owners are personally responsible for all
debts of the business. From an accounting standpoint, a partnership is viewed as a business entity separate from
the personal affairs of its owners.5 A benefit of the partnership form over the sole proprietorship form is the
ability to bring together larger amounts of capital investment from multiple owners.
Corporation - A business organized as a separate legal entity and chartered by a state, with ownership
divided into transferable shares of capital stock. Is a type of business organization that is recognized under the
law as an entity separate from its owners so the owners are not personally liable for the debts of the business
(owners can lose no more than the amounts they have invested in the businessa concept known as limited
liability) Ownership is divided into transferable shares of capital stock, and the owners are called stockholders
Chapter 3
Nature of debits/credits, impact on assets, liabilities, equity, revenue, and expenses - In simple terms,

debits refer to the left side of an account, and credits refer to the right side of an account:
Debit - entered on the left side of a ledger account. A debit is used to record an increase in an asset or a
decrease in a liability or in owners equity, or a debit entry.
Credit - entered on the right side of a ledger account. A credit is used to record a decrease in an asset or an
increase in a liability or in owners equity, or a credit entry.
Asset accts have debit balances so incr are recorded on the left and decr are recorded on the right; asets
include
Liability and OE accts have credit balances so incr are recorded on the right and decr are recorded on the left

Revenue money coming in; debit cash, credit AR (always incr OE)
Expenses buying a shovel; debit equip, credit cash or AP (always decr OE)
Recording journal entries The journal entry is a tool for analyzing and describing the impact of various
transactions on a business entity; double entry acct is used to keep debits and credits equal thus remaining in
balance; entires are 1st posted in the general journal then transferred to the ledger

Underlying theories of accrual accounting, the matching concept, revenue realization principle, and
expense recognition rule.

Accrual accounting - The policy of recognizing revenue in the accounting records when it is earned and
recognizing expenses when the related goods or services are used is called the accrual basis of accounting
The effect of events on the business is recognized as services are rendered or consumed rather than when
cash is received or paid.. The purpose of accrual accounting is to measure the profitability of the economic
activities conducted during the accounting period.
Matching principle - The most important concept involved in accrual accounting is the matching principle.
Revenue is offset with all of the expenses incurred in generating that revenue, thus providing a measure of the
overall profitability of the economic activity. A significant relationship exists between revenue and expenses.
Expenses are incurred for the purpose of producing revenue. In the measurement of net income for a period,
revenue should be offset by all the expenses incurred in producing that revenue.
Revenue Realization Principle - The generally accepted accounting principle that determines when revenue
should be recorded in the accounting records; indicates that revenue should be recognized at the time goods are
sold & delivered or services are rendered. The price of goods sold & service rendered in an acct period incr OE
Expense recognition rule timing diff b/t cash flow and revenue to ensure that appropriate amounts of rev and
exp are measured and reported; links expense to the revenue it helped to create. Costs of goods and services
used up in the process of earning revenue decr OE
Nature of Retained Earnings The portion of stockholders (owners) equity resulting from profits earned

and retained in the business; the Retained Earnings account appears in the stockholders' equity section of the
balance sheet. The balance in the Retained Earnings account represents the total net income of the corporation
over the entire lifetime of the business, less all of the dividends to its stockholders. In short, retained earnings
represent the earnings that have been retained by the corporation to finance growth. Earning net income
causes the balance in the Retained Earnings account to increase; RE = assets-liabilities-capstock; RE is
distributed to owners in the form of dividends.
Impact of Net Income on owners equity and individual accounts affected net income is the incr in OE
from profitable business operations. As net income is earned either an asset in incr or a liability is decr and it
always results in an incr in OE
Nature of double-entry system of accounting - A system of recording every business transaction with equal

dollar amounts of both debit and credit entries. As a result of this system, the accounting equation always
remains in balance; in addition, the system makes possible the measurement of net income and also the use
of error-detecting devices such as a trial balance. The phrase double-entry refers to the need for both debit
entries and credit entries, equal in dollar amount, to record every transaction. the double-entry system allows
us to measure net income at the same time we record the effects of transactions on the balance sheet
accounts.
Proper format for preparing journal entries in chronological order, showing each transaction as a debit
and a credit
Rationale for Revenues being credit balance accounts and Expenses being debit balance accounts
Revenue incr OE so revenue is recorded by credits; expenses decr OE so exp are recorded as debits; this is
just the debit/credit rule: incr in OE is recorded by credits, decr in OE is recorded by debits
Chapter 4

Purpose of adjusting entries and accounts that are affected by adjusting entries needed whenever
transactions affect the revenue or expenses of more than one accounting period to record; these entries assign

revenues to the period when they were earned and expenses to the period when related goods and services are
used. Only made at the end of each accounting period to make certain that appropriate amounts of revenue and
expense are reported in the company's income statement (Entries made at the end of the accounting period for
the purpose of recognizing revenue and expenses that are not properly measured as a result of journalizing
transactions as they occur) based upon accrual acct
Accts that are affected: prepaid exp like insurance premiums, depreciation, interest, and unpaid expenses like
unbilled revenue, salaries payable, unused supplies, taxes
4 Types of adjusting entries and preparing adjusting entries
Convert assets to expenses - cash is paid prior to expense being incurred
Ex: prepaid expenses, depreciation NOTE: for depr, you credit a contra-asset account
Transaction: debit asset acct (deferral), credit cash (18000 for annual insurance)
AE: debit exp acct, credit asset acct (18000 * 1/12 = 1500 per month)
this transfers the portion of the asset that was used up during the month
Converting liabilities to revenue cash is received b/f revenue is earned
Creates a liability called unearned or deferred revenues which are not paid, but worked off
Ex: customer pays in advance
Transaction: debit cash, credit liability acct (unearned revenue) (9000 recd for 3 mo rent)
AE: debit liability acct, credit revenue earned (9000/3 = 3000 per mo)
Accruing unpaid expenses exp incurred b/f cash is paid
Ex: salaries, interest, light bill
Transaction: debit cash, credit notes payable (4000 borrowed @9% for 3 mo)
AE: debit interest exp, credit interest payable (4000*9%*1/2 = 30 per mo)
Accruing uncollected revenue rev earned b/f cash is received
Ex: money earned but not billed/collected
AE: debit asset acct, credit rev acct (1500 due over 2 mo is 1500 * = 750 per mo)
Transaction: debit cash, credit AR AND repair rev (this entry is made when amt is collected)
Accruing tax exp to record tax liability
AE: debit inc tax exp, credit inc tax payable

Theory of the Realization principle governs the timing of revenue recognition; that revenue should be
recognized in the period it was earned
Nature of accumulated depreciation- shown as a deduction from the related asset account in the asset

section of the balance sheet; depreciation taken throughout the useful life of an asset is accumulated in a contraasset account (An account with a credit balance that is offset against or deducted from an asset account to

produce the proper balance sheet amount for the asset) called accumulated depreciation because (1) it has a
credit balance, and (2) it is offset against an asset account (Building) to produce the book value for the asset.

Accountants often use the term book value (The net amount at which an asset appears in financial statements.
For depreciable assets, book value represents cost minus accumulated depreciation. Also called carrying value)

Chapter 5
The income statement is prepared first (after adjusting entries are made) then statement of RE, and then
balance sheet
Determining net income after adjusting journal entries have been made revenue expenses = income b/f
taxes income tax exp = net income
Roll forward of Retained Earnings after inc statement has been prepared, an statement of RE is prepared
to reflect: BOY RE + Net inc dividends = EOY RE. This amt is rolled forward to the balance sheet
Nature of dividends and their effect, if any, on the various financial statements a dividend is not an
expense, it reduces RE. When dividends are paid a liability account called dividends payable comes into
existence; when a dividend is declared and discharged the dividend is paid by debiting RE, crediting dividends,
thus the dividend is not included in the computation of net income
Purpose of closing entries and accounts which are affected to bring temp acct balances to zero.
1. Transfer all rev/exp acct balances to the inc summary
2. Transfer inc summary and dividends acct to RE
Preparing closing entries
1. Close a rev acct: debit rev acct, credit inc summary (transfers credit bal of rev)
2. Close an exp acct: debit inc summary, credit exp acct (transfers debit bal of exp)
3. Close inc summary: debit inc summary (rev-exp amt), credit RE (incr RE)
4. Close dividend acct: debit RE, credit div (decr RE)
5. After all of this, an after closing trail bal is prepared (only for bal sheet accts) to ensure accts are in bal
and ready for new acct period
Trial bal Adj TB inc statement RE bal sheet prepare closing entries in general journal after
closing trial bal
Nature of current assets and current liabilities current assets are cash and other assets that can be
converted to cash or used up in one year or less; current liabilities are obligations that are expected to be
satisfied using current assets in one year or less (these are grouped together as separate bal sheet subtotals);
these are useful when evaluating a co ability to pay its debts as they come due
Computing working capital and the working capital ratio (current ratio)

Chapter 6
Inventory when purchased, it is recorded as an asset on the BS as it is sold the asset is converted to an
expense called costs of goods sold (cost is transferred from the BS to the inc statement)
Merch co inc statement: sales COGS = gross profit other expenses = net income
Periodic versus Perpetual Inventory systems and how cost of goods sold and ending inventory are
determined under each system
Periodic inv for many sales or manual acct; (an alternative to the perpetual inventory system that

eliminates the need for recording the cost of goods sold as sales occur. However, the amounts of inventory
and the cost of goods sold are not known until a complete physical inventory is taken at year-end) no effort is
made to keep up-to-date records of either the inventory or the cost of goods sold. Instead, these amounts are
determined only periodicallyusually at the end of each year.
Merch is purchased: debit inv purchase (asset acct), credit AP or cash
Merch is sold: an entry is made to recognize rev but not entry is made to record COGS or reduce bal of inv acct
Ending Inventory is determined by an EOY physical count
COGS is calculated: BOY inv + purchases of goods (inv) EOY inv
Since inv is not updated as transactions occur, no subsidiary inv ledger is needed
Perpetual inventory system (A system of accounting for merchandising transactions in which the Inventory
and Cost of Goods Sold accounts are kept perpetually up-to-date) all transactions involving costs of
merchandise are recorded immediately as they occur. The system draws its name from the fact that the
accounting records are kept perpetually up-to-date.
Merch is purchased: debit inv, credit AP or cash
Merch is sold: debit AR or cash, credit sales rev (to record sale) AND
Debit COGS, credit inv (to update COGS and inv)
Ending inventory inv acct is continuously updated then when a physical inv is taken, inv is updated to reflect
shrinkage by debiting COGS, credit inv
COGS is kept perpetually up to date
Computing Gross Profit and the gross profit percentage (gross profit margin)

Purpose of subsidiary ledgers - A ledger containing separate accounts for each of the items making up the

balance of a control account in the general ledger. The total of the account balances in a subsidiary ledger
are equal to the balance in the general ledger control account; contain information about specific control
accounts in the company's general ledger. (not needed for periodic)
Journal entries necessary to record a sale under a perpetual inventory system - When merchandise is

sold, two entries are necessary: one to recognize the revenue earned and the second to recognize the related cost

of goods sold. This second entry also reduces the balance of the Inventory account to reflect the sale of some of
the company's inventory.
Journal entry necessary to reconcile ending inventory per the books and ending inventory
per the physical counts under a perpetual inventory system (i.e. recording shrinkage)
Perpetual - adjust inv records to reflect results of EOY physical inv: debit COGS, credit inv

A merchandising business with a perpetual inventory system makes closing entries that parallel those of a
service-type business. The Sales account is a revenue account and is closed into the Income Summary account
along with other revenue accounts. The Cost of Goods Sold account is closed into the Income Summary account
in the same manner as the other expense accounts.
Periodic One approach is to create a Cost of Goods Sold account with the proper balance as part of the

closing process. Once this account has been created, the company can complete its closing procedures in the
same manner as if a perpetual inventory system had been in use.
A Cost of Goods Sold account is created with two special closing entries. The first entry creates the new
account by bringing together the costs contributing toward the cost of goods sold. The second entry adjusts the
Cost of Goods Sold account to its proper balance and records the ending inventory in the Inventory account.
The costs contributing to the cost of goods sold include (1) beginning inventory and (2) purchases made during
the year. These costs are brought together by closing both the Inventory account (which contains its BOY
balance) and the Purchases account into a new account entitled COGS. This year-end closing entry is:

debit COGS, credit inv AND purchase (This entry closes inv and purchase acct into COGS acct)

debit inv (EOY balance) , credit COGS (transfers merch on hand out of COGS into inv acct)
Record shrinkage under perpetual

Once the quantity of merchandise on hand has been determined by a physical count, the per-unit costs in the
inventory ledger accounts are used to determine the total cost of the inventory. The Inventory control account
and the accounts in the inventory subsidiary ledger then are adjusted to the quantities and dollar amounts
indicated by the physical inventory.
To illustrate, assume that at year-end both the Inventory control account and inventory subsidiary ledger of
Computer City show an inventory with a cost of $72,200. A physical count, however, reveals that some of the
merchandise listed in the accounting records is missing; the items actually on hand have a total cost of $70,000.
Computer City would make the following adjusting entry to correct its Inventory control account:

Computing net sales - net sales is the most widely used measure of dollar sales volume; usually the first

figure shown in an income statement. It is calculated by: total sales revenue minus sales returns and
allowances and minus sales discounts.

Nature of sales discounts and sales returns & allowances sales discounts are offered to encourage
customers to make early pymts for purchases on acct (it is a contra revenue acct).
Sales Returns allow customers to get a refund by returning merchandise (also a contra revenue acct)

Most merchandising companies allow customers to obtain a refund by returning any merchandise considered to
be unsatisfactory. Under the perpetual inventory system, two entries are needed to record the sale of
merchandise: one to recognize the revenue earned and the other to transfer the cost of the merchandise from the
Inventory account to Cost of Goods Sold. If some of the merchandise is returned, both of these entries are
partially reversed.
debit sales returns, credit cash or AR (to show the goods have been unsold)
debit inv, credit COGS (to show goods have been returned)
Journal entry to record sales discounts Gross method: To the seller, the cost associated with cash discounts is not the discounts lost when payments

are delayed, but rather the discounts taken by customers who do pay within the discount period.

initial entry records full price: debit inv, credit AP

When paid early record discount: debit cash AND purchase discount taken, credit AR
Net method: Most well-managed companies have a policy of taking advantage of all cash discounts available

on purchases of merchandise.4 These companies initially record purchases of merchandise at the net costthat
is, the invoice price minus any available discount. After all, this is the amount that the company expects to pay.

for an item purchased for 10,000 on 2/10, n 30 (10,000 * 2% = 200 off, 10000-200=9800)
Deciphering Credit Terms and purpose of cash discounts Manufacturers and wholesalers normally sell

their products to merchandisers on account. The credit terms are stated in the seller's bill, or invoice.
net 30 days, or n/30 - full payment is due in 30 days
10 eom - payment is due 10 days after the end of the month in which the purchase occurred.
2/10, n/30 - full payment is due in 30 days, but that the buyer may take a 2 percent discount if payment is made
within 10 days
Cash discounts are given to encourage buyer to make pymt early. Most well-managed companies have a policy

of taking advantage of all cash discounts available on purchases of merchandise.4 These companies initially
record purchases of merchandise at the net cost
Journal entry to record purchases under the net method (see above)
Nature of Operating Cycles - The series of transactions through which a business generates its revenue and its

cash receipts from customers is called the operating cycle.

The operating cycle of a merchandising company consists of the following basic transactions:

(1) purchases of merchandise;

(2) sales of the merchandise, often on account; and
(3) collection of the accounts receivable from customers.
Operating cycle of a merchandising co purchase of merch sale of merch collection of AR (a food store
has the shortest cycle)