Chapter3.doc

Chapter 3 THE ACCOUNTING CYCLE: INTRODUCTION The accounting cycle is the process of entering transaction and economic event data into an accounting system and then processing, organizing, and using it to produce information, such as financial statements. Panel A, provides an overview of an accounting system's role in capturing raw data, processing it,and producing financial statements and other financial information. Panel A Overview of an Accounting Information System An accounting system is designed to capture relevant economic events affecting the entity. A relevant event must be entered into the accounting system in some wayit does not happen automaticallyand judgment is required to decide if, when, and how the event is recorded. ACCRUAL ACCOUNTING Accrual accounting provides more relevant information to stakeholders than cash accounting does. Contrasting the two methods is a good way to explain accrual accounting. With cash accounting an economic event is recorded only when cash is exchanged: a sale is recorded when the customer pays cash, an expense when cash is paid to a supplier. Cash doesn't have to be exchanged when an economic event is recorded Accrual accounting: inventory purchased on credit is recorded as an asset, and the obligation to pay the supplier is recorded as a liability. With accrual accounting, revenues and expenses can be recorded before, after, or at the same time cash changes hands. (**revenue is economic benefits earned by providing goods or services to customers, and expenses are economic sacrifices made or costs incurred to earn revenue.) A key concept in accounting is revenue recognitionthe point in time when revenue is recorded in the accounting system and reported in the income statement Relationship between Revenue and Expense Recognition and Cash Flow Delivery of goods to customers is typically (but not always) the economic event that triggers revenue recognition under accrual accounting. With cash accounting the sale would be recognized when cash is received, which is at a different time in each of the three situations. Under accrual accounting, accountants try to match expenses to revenue. With matching, expenses are recognized (recorded) in the same period as the revenue they helped earn is recognized Matching is an important concept of accrual accounting. Associating economic benefits (revenues) and economic costs (expenses) is necessary if profit is to be a meaningful measure of performance. While accrual accounting may provide more relevant information to stakeholders in many situations, it also requires judgment, which is subjective. With cash accounting its obvious when a sale should be recognizedcash is received. The Accounting Equation Spreadsheet and Journal Entries In an accounting equation spreadsheet transactions and economic events are recorded to reflect their impact on the accounting equation. 1. Which elements of the accounting equation are affectedassets, liabilities, and/or owners' equity, including revenues and expenses? 2. How are the accounts affecteddoes the amount of each element increase or decrease? 3. By how much has each element increased or decreased? EXAMPLE - Sells shares to investors for $50,000 cash. - Purchases inventory and promises to pay the supplier $3,000 in 30 days. - Provides services to a customer worth $1,100. The customer agrees to pay in 60 days. - Collects $500 owed by a customer. - Pays $2,000 owed to a supplier. - Receives $2,500 from a customer for goods that will be delivered next month. 1. Cheticamp sells shares to investors for $50,000 cash. Explanation: Cheticamp received $50,000 from the investors so cash, an asset, increases. By purchasing shares the investors have made an equity investment in Cheticamp so owners' equity increases. 2. Cheticamp purchases inventory and promises to pay the supplier $3,000 in 30 days. Explanation: Cheticamp has received some inventory, which is an asset because it can be sold in the future to earn revenue. It didn't pay cash but promised to pay in 30 days so there is a liability to pay the supplier. 3. Cheticamp provides services to a customer worth $1,100. The customer agrees to pay in 60 days. Explanation: Services are provided to a customer, which represents an increase in revenue and an increase in owners' equity. The customer has agreed to pay in 60 days, which is an asset because it represents the right to receive the customer's money. 4. Cheticamp collects $500 owed by a customer. Explanation: This transaction converts one asset into another. The entity received cash from a customer so assets increase. But assets also decrease because the customer has fulfilled its obligation to pay Cheticamp, which decreases asset accounts receivable. 5. Cheticamp pays $2,000 owed to a supplier. Explanation: Cheticamp has fulfilled an obligation to a supplier by paying an amount owing so accounts payable decrease. The obligation is paid in cash so cash decreases. 6. Cheticamp receives $2,500 from a customer for goods that will be delivered next month. Explanation: Cheticamp has received cash in advance for providing goods to the customer. Cash increases since the cash was paid, but since the goods haven't been provided to the customer it's not appropriate in most cases to recognize revenue. Instead, Cheticamp has a liability to provide $2,500 of goods and services to the customer in the future. In practice, an entity creates separate categories called accounts to reflect the different types of assets, liabilities, and owners' equity it has. A journal entry describes how a transaction or economic event affects the accounting equation. Account names in a journal entry correspond to the column headings on the spreadsheet. The terms debit and credit indicate whether the balance in the account has increased or decreased. THE ACCOUNTING CYCLE: TRANSACTIONAL ANALYSIS The double-entry bookkeeping system in which each transaction or economic event is recorded in at least two places in the accounts. This system is necessary to keep the accounting equation in balance. Depreciation Depreciation (or amortization) allocates the cost of a capital asset to expense over its useful life. It's also another example of matching. Since property, plant, and equipment (PPE) help an entity earn revenue, its cost should be matched to the revenue it helps earn. Therefore, accountants or managers estimate how long capital assets will be used (useful life) and choose a method for depreciating the cost. Depreciation provides no information whatsoever about the change in the market value of capital assets. It's just the allocation of the cost to expense.