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Receivables and Sales Chapter 2 Review of the Accounting Process Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The purpose of this chapter is to review the fundamental accounting process used to produce the financial statements. This review establishes a framework for the study of the concepts covered in intermediate accounting. This accounting process identifies, analyzes, records, summarizes, and then reports any economic event that affects a company’s financial position. We describe and illustrate a manual accounting information system to provide an overview of the basic model that underlies the computer software programs actually used to process accounting information. 1 Economic Events The Basic Model External Events Internal Events Involve an exchange transaction with another entity Do not involve an exchange transaction with another entity Cause changes in the financial position of the company LO2-1 02-02 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The first objective of any accounting system is to identify the economic events that can be expressed in financial terms by the system. An economic event for accounting purposes is any event that directly affects the financial position of the company. Recall from Chapter 1 that financial position comprises assets, liabilities, and owners’ equity. Broad and specific accounting principles determine which events should be recorded, when the events should be recorded, and the dollar amount at which they should be measured. Economic events can be classified as either external events or internal events. External events involve an exchange between the company and a separate economic entity. Examples are purchasing merchandise inventory for cash, borrowing cash from a bank, and paying salaries to employees. In each instance, the company receives something (merchandise, cash, and services) in exchange for something else (cash, assumption of a liability, or both). On the other hand, internal events directly affect the financial position of the company but don’t involve an exchange transaction with another entity. Examples are the depreciation of equipment and the use of supplies. As we will see later in the chapter, these events must be recorded to properly reflect a company’s financial position and results of operations in accordance with the accrual accounting model. 2 Underlies the process used to capture the effect of economic events: The Accounting Equation LO2-1 Assets Liabilities Owners’ Equity = + Total Economic Resources Total Claims Each event, or transaction, has a dual effect on the accounting equation 02-03 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The accounting equation underlies the process used to capture the effect of economic events. The accounting equation portrays the equality between the total economic resources of an entity (its assets)—shown on the left side of the equation—and the total claims against the entity (liabilities and equity)—shown on the right side. The equation also implies that each economic event affecting this equation will have a dual effect because resources always must equal claims. 3 An attorney invested $50,000 to open a law office. An investment by the owner causes both assets and shareholders’ (owners’) equity to increase. Accounting Equation—Owner Investment LO2-1 Assets = Liabilities + Shareholders’ Equity + $50,000 (Investment by owner) + $50,000 (Cash) 02-04 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Now, let’s understand how each transaction or event is analyzed to determine its effect on the equation and on the specific financial position elements. Consider the first transaction where an attorney invested $50,000 to open a law office. The investment made by the attorney increases cash, an asset, in the company. This also increases the shareholders’ (owners’) equity by the same amount. Note that the transaction has a dual effect on the accounting equation and that the equation is in balance. 4 2. $40,000 was borrowed from a bank and a note payable was signed. This transaction causes assets and liabilities to increase. A bank loan increases cash and creates an obligation to repay it. Accounting Equation—Borrowing Money from the Bank LO2-1 + $40,000 (Cash) + $40,000 (Notes Payable) Assets = Liabilities + Shareholders’ Equity 02-05 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. In the second transaction, $40,000 was borrowed from a bank and a note payable was signed. The loan granted by the bank increases cash by $40,000 while creating an obligation to repay it. This increases both assets and liabilities by the same amount. 5 3. Supplies costing $3,000 were purchased on account. Buying supplies on credit also increases both assets and liabilities. Accounting Equation—Supplies Purchased on Account LO2-1 + $3,000 (Supplies) + $3,000 (Accounts Payable) Assets = Liabilities + Shareholders’ Equity 02-06 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. This transaction states that supplies costing $3,000 were purchased on account. The purchase increases supplies by $3,000. However, the purchase was made on credit increasing a liability for the same amount. 6 4. Services were performed on account for $10,000. Revenues and gains describe inflows of assets, causing shareholders’ equity to increase. Accounting Equation—Services Performed on Account LO2-1 + $10,000 (Accounts Receivable) + $10,000 (Revenue) Assets = Liabilities + Shareholders’ Equity 02-07 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Recall that revenues and expenses (and gains and losses) are events that cause shareholders’ equity to change. Revenues and gains describe inflows of assets, causing shareholders’ equity to increase. Expenses and losses describe outflows of assets (or increases in liabilities), causing shareholders’ equity to decrease. The transaction states that services were performed on account for $10,000. Service revenue recognized increases shareholders’ equity by $10,000. Since the amount is yet to be received for the service performed, accounts receivable increases by the same amount. 7 5. Salaries of $5,000 were paid to employees. Expenses and losses describe outflows of assets (or increases in liabilities) causing shareholders’ equity to decrease. Accounting Equation—Salaries Paid to Employees LO2-1 − $5,000 (Cash) − $5,000 (Expense) Assets = Liabilities + Shareholders’ Equity 02-08 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. This transaction states that the company paid salaries of $5,000 to employees. This is an expense to the entity thus reducing shareholders’ equity and decreasing cash by $5,000. 8 6. $500 of supplies were used. *Expenses and losses describe outflows of assets (or increases in liabilities) causing shareholders’ equity to decrease. Accounting Equation—Supplies Used LO2-1 − $500 (Supplies) − $500 (Expense*) Assets = Liabilities + Shareholders’ Equity 02-09 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The company used $500 of supplies that were purchased earlier. Assets, supplies, decrease by $500 and shareholders’ equity, supplies expense, also decreases. 9 7. $1,000 was paid on account to the supplies vendor. This transaction causes assets and liabilities to decrease. Accounting Equation—Payment on Account LO2-1 − $1,000 (Cash) − $1,000 (Accounts Payable) Assets = Liabilities + Shareholders’ Equity 02-10 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. The transaction involves a payment made on account to the supplies vendor for $1,000. The cash payment decreases assets, cash, by $1,000 and a liability, accounts payable, is reduced by the same amount. 10 Accounting Equation for a Corporation LO2-1 + Paid-In Capital + Retained Earnings + Revenues + Gains — Expenses — Losses — Dividends 02-11 Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Copyright © 2020 McGraw-Hill Education. All rights reserved. No reproduction or distribution without prior written consent of McGraw-Hill Education. Since owners of a corporation are its shareholders, the owners’ equity for a corporation can also be referred to as shareholders’ equity. Shareholders’ equity for a corporation arises primarily from two sources: (1) amounts invested by shareholders in the corporation and (2) amounts earned by the corporation (on behalf of its shareholders). These are reported as paid-in capital and retained earnings