Doxpara: Notes for Accounting 1

Thus far covered: Chapters 3, 4, 5, 7. 6 coming soon, error correction not yet begun. Everyone, send me patches(comments/flames/grunts)and win fame, fortune...well, as much as you'd get from any dot-com nowadays ;-)

WARNING: The notes contained herein could be completely and utterly wrong. I'm serious. No joke, do *not* presume I'm right about any of this stuff. These are notes culled from "Financial Accounting: A Decision Making Approach", and there's a very large number of very interesting questions about exactly what something like this page portends. But heh, live fast, hack young, and help people pass their tests!

Ch.4:

MEASURING QUALITY OF INFORMATION
Relevance:

        Explains the past or predicts the future
        Available when needed
        Representative of recent events (timeliness)
Reliability:
        Reflects real world
        Honest; Free of bias
        Independantly verifiable
Understandability:
        Assumes no reader knowledge beyond basic accounting principals
Comparability:
        Standardized structure throughout industry
        Able to be examined relative to competitors
Consistency:
        Standardized structure throughout history of company
        Able to examined relative to previous fiscal years
Materiality:
        Significant enough to justify causing it to be noted

FINANCIAL ACCOUNTING INFORMATION MODEL

Transaction Occurs
Supporting Documents (i.e. Invoices or Receipts) record the Transaction financially.
The Journal aggregates all Supporting Documents into one financial sequence of events.
Ledger accounts segregate the Journal into multiple relevant streams of financial events.
1. "Phones sold", "Uniforms Purchased", etc.
Financial Statements summarize the ledger accounts into consistent and comparable information.

FINANCIAL ACCOUNTING INFORMATION MODEL: MTV EDITION Transactions Occur
Documents Record
The Journal Aggregates
Ledger Accounts Segregate
Financial Statements Summarize

ACCOUNTING ENTITIES: The Short Form
--If a parent company owns many smaller companies, all those companies have to share a single "consoldated" financial statement. This means the good work of one subsidiary might be wiped out by the total destruction of another. Many companies will choose to restructure themselves, absolving the profitable divisions/subsidiaries from the bills of the unprofitable ones.

ELEMENTS OF FINANCIAL STATEMENTS:

Financial Positions
1. Assets: Valuable stuff. May be physical(land, inventory), monetary(cash, bonds), or even completely imaginary("goodwill", "eyeballs", "internet").
2. Liabilities: Bills. May be due sometime in the future, present, or even past.
3. Equity: How much stuff we have left after paying bills.
Change in Financial Positions
1. Revenues: Assets received as payment for what the business does (operations)
2. Expenses: Liabilities incurred so the business can do whatever it does
3. Gains: Profit made "on the side", i.e. not through primary business operations
4. Losses: Assets lost "on the side".
5. Net Income:Overall change in the equity of a company.
Owner Transactions:
1. Investment by Owners: An increase in equity due to owners contributing assets to the company.
2. Distribution to Owners: A decrease in equity due to owners receiving assets from the company.

MISCELLANEOUS ACCOUNTING CONCEPTS

Objectivity
1. Recording only that information that may possibly be verifiable.
2. Land is often recorded at "historical cost", even when actual sale value is many times higher, because the only way to verifiably learn how expensive something would really be on the open market is to sell it.
Going-Concern
1. Assets are valued presuming the company was to stay in business
2. Some assets are worth more if they are to be sold, rather than to be continually used by the company.
Periodicity
1. Providing financial statements according to a fixed schedule (quarterly, yearly, etc.)
Disclosure
1. Revealing extra information that would contradict or modify the expectations of the financial statement user
2. "If an earthquake destroys your factory after the fiscal year ends, you still have to disclose the catastropic loss of assets, even though you owned those assets at the end of the fiscal year."
3. Responsibility of the management and independant auditor
Conservatism
1. Financial Paranoia and Pessimism-- "The piggy bank is half empty"
2. It is better to presume bad numbers and need to adjust upwards than to presume good numbers and need to adjust downwards
3. Example: Inventory is valued at either original cost or presumed sale cost, whichever is lower.

ACCRUAL ACCOUNTING:

Method of Recognizing Financial Activity
1. Recognition: The process of choosing when and how to record a financial transaction
Compared to Cash Based
1. Cash: "How much stuff do we have?"
2. Accrual: "How much will we have, and how much will we still owe?"
3. Cash is more objective, but Accrual reflects the actual state of the business
Matching Concept
1. "Single most important concept in accounting"
2. Businesses incur costs so they can receive benefits
3. Matching means associating all benefits with the costs required to bring them about, when the benefit occurs.
  1. If the benefits stretch past one period, the costs are divided among the periods.
4. Process
  1. How much will it cost: Determine amount of cost (liability)
  2. How much will we make: Determine expected benefits (assets)
  3. When will we make it: Determine when period benefits are to be realized
  4. This is when we'll "pay" for it: Recognize cost as an expense (liability) then
5. Conservative Recognition [mentioned in chapter 5, important to note]
  1. Nothing may be recognized until costs are completed
  2. One records transactions that have occured, not that are in the process of occuring.
  3. If a sale is "made", but that sale is contingent upon some non-guaranteed event occurring, no transaction has occured.
  4. Even if a contract is signed, guaranteeing money will be paid, if the costs of fulfilling that contract aren't expended yet(example: Cell Phones with yearly contracts; they still need to maintain the cell net for that whole year), the full transaction cannot be recorded.
  5. One may only record revenues that have been fully earned.
6. Examples
  1. Cost of Salaries -> Benefit of Employee Labor.
    1. Costs incurred as soon as employees work, even if they're not actually paid until later.
    2. The received benefit(employee labor) is immediately matched with what it took to make it happen(waving dollar bills, mock options, and free cans of Mountain Dew in front of the employee).
  2. Cost of Goods Sold -> Benefit of Sales Revenue.
    1. Costs incurred once goods are actually sold(this of course presumes goods will sell).
    2. The received benefit(sales revenue) forces the company to register the costs needed to make those sales happen(marketing, production, payola, etc.)
  3. Cost of Rent -> Benefit of Office Space
    1. Costs are spread throughout the period of the lease, as the benefit(shelter) is spread out over time.
    2. Example: One year lease at $100,000/year, four quarterly reports. Each report will report $25,000 of Office Space received for a cost of $25,000.
  4. Cost of Sleep -> Benefit of Actually Being Conscious
    1. Value of sleep not recognized until one realizes they're not being an entranced zombie, struggling to pay attention.
    2. Human difficulty of recognizing a negative("Gee, I'm not lime green this morning") combined with the availability of lime green sodas(Mountain Dew) makes this transaction rarer than it should be among college students.
      1. OK, me.

CLASSIFYING COSTS

Unexpired Costs: Representing Future Benefits
1. Costs that have not yet had their benefit received
2. Examples: Prepaid Rent before you've moved in, supplies before they're used
3. Are classified as assets
Expired Costs: Representing Past Benefits
1. Costs that have had their benefit received
2. Examples: Prepaid Rent after the lease expires, supplies once they're used up
3. Are classified as expenses/liabilities
Depreciation: Representing Present Benefits
1. Costs that are in the process of expiring
2. Examples: Prepaid Rent while you're still there, supplies when there's still some left
3. The idea is to match how much of the total benefit was received with how much of the total cost was paid. If half the benefit was received, half the cost should be recognized.
Writeoffs: Representing NO Benefits (Mentioned in passing)
1. If no benefit will ever be received from the costs incurred, all costs are immediately expired. After all, all benefits have been received.
2. Example: You spend many millions starting an MP3 sharing service. You are sued for Two Hundred And Fifty Billion Dollars. You shut down before you can start charging a subscription fee, and all your costs are expired.
  1. (You however, get one hell of an attitude. You're right up there with the tobacco companies, and they're killing people.)

CURRENT VS. LONG TERM

Current Assets will be used/"expired" within one year
Current Liabilites must be paid/"satisfied" within one year

ELEMENTS OF BALANCE SHEETS [this may not be necessary, but included for completeness]

Assets = Liabities + Equity
1. "You've got whatever you own, plus whatever is still sucking you dry via your credit card."
2. You have assets, which are either flat out yours(equity) or will be(liabilities).
[a decent breakdown of terminology is on p.141 of the accounting book. I can't do better.]

Ch.5:

THE NATURE OF INCOME

Net Income
1. Change in owner's equity, positive or negative
2. Does not include additional investments or withdrawls
3. Computed as: Revenues - Expenses
  1. Revenue: This period's new assets
  2. Expenses: This period's new (satisfied) liabilites
4. Sometimes referred to as "net earnings" or "profit"
Net Assets
1. Assets - Liabilities
2. Equivalent to Owner's Equity

THE INCOME STATEMENT: "SIMPLE FORM"
(WARNING: The book is moderately inconsistent about whether Income Statements should reflect expenses using parenthesis' or not. Look for the words 'costs', 'charges', 'expenses', or 'liabilities'--if they're there, subtract the value. Of course, if the entire category is something like 'total costs', add everything together--the subtraction is occuring on a category level. Comparability indeed!)

Net Sales: How much was made by selling stuff
1. Operating Expenses: How much it cost to sell that stuff
  1. Revenue benefits trigger recognition of costs needed to get those sales(production/marketing).
Operating Income: Net Sales - Operating Expenses
1. Nonoperating Expenses: That the business is still operating triggers recognition of costs required to operate the business (payment of interest)
2. Nonoperating Income: That the business is still operating also triggers recognition of benefits received by the business continuing to exist (earning of interest).
Earnings Before Income Taxes: Operating Income + Nonoperating Income - Nonoperating Expenses
1. Income Taxes: That the business has an income means it's going to be taxed on it.
  1. Businesses are taxed on revenue they think they'll make, not cash they've actually received!
Net Earnings: Earnings Before Income Taxes - Income Taxes
Earnings Per Share: Net Earnings / Number Of Shares Outstanding

A MEASURE OF CONTRIBUTION TO SOCIETY

this space left intentionally blank

MISCELLANEOUS NOTES

Internal Users of Income Statements
1. Owners/Managers (Tracking quality of employees, areas of improvement, etc.)
2. Employees/Unions (Tracking job stability, fair pay)
External Users of Income Statements
1. Owners/Investors (Tracking company profitability, future disbursements, relative performance to rest of industry)
2. Creditors (Tracking ability to pay interest/principle, promised income levels)
3. Vendors (Tracking stability of customer, predict future sales)
4. IRS/Regulatory Agencies/Public Interest Groups(Evaluate taxability, legitimacy)
Revenue: Assets received during period
1. Only comes from company's primary activity
2. No internal/cross-department sales qualify
3. No one-time gains (too misleading)
4. Recorded as "Net Sales"
Expenses: Liabilities incurred during period
1. Similar limitations as Revenue
Gains and Losses: Ostensibly rare one time events that increase/decrease net income
1. Book Value / Carrying Amount: The recorded value of a given asset in the accounting books. A one-time disaster that destroys a warehouse causes a loss of the book value of the warehouse.
Non-op Income/Expenses: Temporary or non-primary streams of money (leasing unused space, reorganizing business, etc.)

[WARNING: PAINFUL REDUNDANCY FOLLOWS. I'm doing what I can to filter it.]

CASH ACQUISITION TIMINGS

Sale and cash collection in same period
1. Retail sales--I sell you a cashmere sweater, you give me cash.
Sale before cash collection
1. Commercial sales--I sell you a bunch of cashmere-sweater spawning goats, you give me cash a few months later.
Sale after cash collection
1. Airline Sales--I sell you a ticket to fly to Aspen in five months, and you pay me immediately. (You wear a cashmere sweater on the plane.)

CASH ACCOUNTING

Almost completely objective
1. I could refuse payment until next quarter, or demand payment in advance, to tweak how much money I have on hand now.
Cash coming in = Revenue
Cash going out = Expenses
Debts don't exist until they're paid
Future income doesn't exist until its in the bank

ACCRUAL ACCOUNTING 2: JUDGEMENT DAY
[this is horribly, HORRIBLY written in the book.]

Revenue must be realized and earned
1. Realization: The process of converting non-cash(land, accounts receivable) into cash.
  1. Related to "An Exchange Must Take Place"
  2. Forces the exchange to be recorded in cash terms
  3. Verifiability: The agreed exchange amount provides objective evidence of mutual value of the transaction
2. Earning: The process of surpassing a "critical event", past which the sale is considered completed/established/unlikely to be reneged on.
  1. Related to "The earnings process must be substantially complete."
  2. Critical event differs between types of businesses
    1. Sales of Goods: When goods delivered and customer agrees to pay
    2. Sales of Services: When services are rendered and customer is billed
    3. Leasing of Assets: While the asset is being leased and the customer is billed according to contract terms
  3. The business must exhaust its obligations for the given transaction before it may recognize the revenue (though it may accrue that recognition)

GROSS VS. NET SALES

Sales Returns and Allowances: Sales that were cancelled after being completed
Net Sales = Gross Sales - Sales Returns and Allowances

COST OF GOODS SOLD

Includes costs directly involved in the production(not promotion) of goods
Example: Hard drives, memory, monitors, keyboards, DVD drives purchased for the construction of a laptop computer.
Net Sales - Cost Of Goods Sold = Gross Profit / Gross Margin

MORE EXPENSES

Promotion
Administration
Interest
Other(litigation, currency exchange, etc.)

GAINS AND LOSSES

if they define this again i am going to scream
no really

A TINY SET OF FACTS ABOUT PREFERRED STOCK

Usually receive more dividends, preference in case of corporate liquidation
Usually receive less/no voting rights

SECRETS OF THE INCOME STATEMENT: THE FOX SPECIAL

Several elements are explicitly disclosed if and when they occur
1. Discontinued Operations
  1. A division or product line is shut down
  2. The division's income for the period(as well as presumably liquidation proceeds) are marked as gains, not standard revenue. This is because they're not expected to recur.
  3. The division's writeoffs from being forced to deny future benefit from a possibly high cost operation are marked as losses, not standard expenses.
2. Extraordinary Items
  1. Anything miscellaneous that wouldn't have been predicted in the past and isn't expected to recur in the future
  2. Flood damage, riots on the factory floor, Slashdot Effect
3. Changes in Accounting Principles
  1. If the company redefines the way it recognizes revenue, it must adjust for its previous "error"
  2. Cause no change in actual cash flow; merely reflects a reorganization that changes the total assets or liabilities.
  3. Changing the "critical event" that the company uses to recognize a sale would cause previously recognized revenue to dissipate into the "still in progress" state, forcing a change in income.
Comprehensive Income
1. All "random noisy" information goes here
2. Pension Adjustments, some foreign currency oddities, gains and losses from holding instead of selling investments.

Ch. 7:

JOURNAL ENTRIES AND LEDGER ACCOUNTS

The Journal aggregates all Supporting Documents into one financial sequence of events.
"Ledger accounts segregate the Journal into multiple relevant streams of financial events." --Ch. 4
Ledgers are represented as a T account

...BECAUSE SOMETIMES YOU NEED MORE THAN ALOE[this isn't in the book. but it's true, and it's useful, so damnit it's goin in :-)]

"If the business wants more of it, it's an asset. If the business wants less of it, it's a liability. If the business is it, it's owner's equity!"
Corrolary to this: "If the business if forced to give it up, it's an asset being negated. If the business is happy to give it up, it's a liability being negated. If the business is worth less because of it, it's owner's equity being negated."

PUT ANOTHER WAY: IS IT AN ASSET OR A LIABILITY?

Assets: Things we've got.
Liabilities: Things we've got...to pay for.
Owner Equity: Value of what we've got.
Accounts Receivable is Cash We're Gonna Get, which is something valuable to have.
Notes Payable is Cash We've Gotta Pay, which is something we'd rather not have.

JOURNAL ENTRIES: THE NO MISERY WAY

Builds off of "Assets = Liabilities + Owner's Equity"
An increase to the assets causes an increase to the left side of the equation, which must be reflected equally in an increase on the right side of the equation. +$100 in Assets means either +$100 in Liabilities or +$100 in Owner's Equity(or some mix, but lets not nitpick). Journal entries simply reflect this--throw everything into an A=L+OE equation, see what's on the left side, see what's on the right, and imagine that any negative values get exchanged to the opposite side.

So, for example, a $1000 car paid with cash becomes: ($1000 Car)-($1000 Cash)+A=L+OE

We're losing cash, so our cash value is negative. We flip the negative cash entry to the other side, so:

        Car Asset       $1000
        Cash            -$1000

        Becomes:

        Car Asset       $1000
                Cash            -$1000

And that's it. Just plug everything into the A=L+OE equation, and flip the negatives, and you've got your journal entries. You can SOMETIMES think of it as "the right side pays off the left side, even if it does it with debt." A few more examples:

A $10,000 Loan is taken out for cash. This becomes: ($10,000 Cash Asset)+A=($10,000 Loan)+L+OE

        Cash            $10,000
                Loan            $10,000

The loan is a liability that will need to be paid later, so it shows up on the right side. There are no negatives, so no side flipping needed to take place. In english--the $10,000 in cash was paid for by a $10,000 Loan, which will need to be repaid.

Lets repay it: (-$10,000 Cash Asset)+A=(-$10,000 Loan)+L+OE

        Loan            $10,000
                Cash            $10,000

Look--both were negative, so both negatives needed their sides flipped. The Asset on the left flew to the right, and the Liability on the right flew to the left. You just don't need to remember mind-numbingly redundant lists like on p.249--just remember, "left side is paid for by right side."

Of course, loans aren't generally interest free. We might end up with something like a $10,000 Loan with $1000 in interest due, and only have $5000 on hand in cash. So, we get another loan for $6000 and do:

(-$5000 Cash Asset)+A=(-$10,000 Original Loan Liability)+(-$1000 Interest Liability)+($6000 New Loan Liability)+OE

Cash goes to the right, Original Liability goes to the left, Interest Liability goes to the left, and the New Loan stays where it is:

        Original Loan           $10,000
        Original Interest       $ 1,000
                Cash                    $5000
                New Loan                $6000

(Note: We generally use standard terms like "Notes Payable" to describe things, but I'm trying to actually make sense here.)

Of course, it's generally nice to have some "metadata"(or data about data) to help us know when and where everything happened. So we generally tack on the following structure:

        DATE            ACCT#           ACCOUNT TITLES          DR / CR
==================|=================|======================|=======|=========|
12-Feb-2001       |              911|Cash                  |$1000  |         |
                  |             1000|   Accounts Recievable|       |$1000    |
==================|=================|======================|=======|=========|

This means that, on Feb 12, $1000 less was receivable from accounts because someone coughed up the cash--which we immediately deposited in our swiss bank account. Sveet.

DEBITS AND CREDITS: NO, REALLY, WE NEED TO KNOW

Increases in assets are debits, decreases in assets are credits
Increases in liabilities or owner equities are credits, decreases in assets or owner equities are debits
Simple way to remember: Debits are on the left, Credits are on the right. If, after flipping negatives, the entry is on the right, it's a Credit. If it's on the left, it's a Debit.
This utter stupidity is all part of a conspiracy to make people pay accountants far too much. Really.

T ACCOUNTS

Stacks of Journal Entries related to a single category

Suppose we have a secret slush fund with cash we buy random properties with. We end up with a list of transactions:


DATE                   ACCT#           ACCOUNT TITLES           DR / CR
==================|=================|======================|=======|=========|
01-Apr-2000       |              911|Cash                  |$110000|         |
                  |                1|   Cash               |       |$110000  |
==================|=================|======================|=======|=========|
15-Feb-2001       |              101|Land                  |$85000 |         |
                  |              911|   Cash               |       |$85000   |
==============================================================================
16-Feb-2001       |              102|Land                  |$15000 |         |
                  |              911|   Cash               |       |$15000   |
==============================================================================
16-Feb-2001       |              911|Cash                  |$30000 |         |
                  |                1|   Cash               |       |$30000   |
==============================================================================
17-Feb-2001       |              103|Land                  |$40000 |         |
                  |              911|   Cash               |       |$40000   |
==============================================================================

T Accounts are a Ledger implementation, so they aggregate lots of events related to the same account. All we have to do to create a T Account is stack entries by the times they occur. So:

Lets take the ledger for our secret account:


    ACCT911:  Sekret Offshore Slurpy Cash Fund
=================================================
            (increases)|(decreases)
                 bal. 0|
                $110000|
                       |$85000
                 $30000|$15000
                       |$40000
=================================================
                 bal. 0|

DOUBLE ENTRY ACCOUNTING

All that we see above. Essentially, keep matching A=L+OE. They've been doing it for 500 years

ACCOUNT TYPES:

Permanent Accounts
1. Reported in the balance sheet
2. "Official numbers"
3. Carry over from one period to the next
4. Ex: A, L, OE
Temporary Accounts
1. Reported in Income Statement or Retained Earnings Statement
2. Relative only to a specific accounting period
3. Ex: Revenues, Expenses, Gains, Losses, Dividends
After each period, remaining balances in all temporary accounts become Retained Earnings, which is owner equity.

RETAINED EARNINGS EQUATION:

Final Retained Earnings = Original Retained Earnings + Net Income - Dividends
"Amount of value the owners now possess in the company is equal to what they did possess, plus the amount the company didn't spend, minus the amount the company gave to those owners."
Yeah, I can't figure out how retained earnings are put into journal entries either.

ADJUSTMENT ENTRIES

Basic rule: "What is there--now what should be there, by accrual? Adjust."
Essentially handle the Cash-Based Oddities
Accrual Adjustments: Goods before Cash
Deferred Adjustments: Cash before Goods
Accrued Income
1. Revenue is earned, but not yet due or available for collection
2. Ex: Landlord's Unpaid Rent--it was earned(the room was rented) but not paid for.
```
                Rent Recievable         $3000
                        Rental Income           $3000
```
3. Ex: Certificate of deposit--half the time has passed since the CD was purchased, so half the value has been earned. But the CD can't be cashed yet, so the money is locked away.
```
                Accrued Interest        $10000
                        CD Interest             $10000
```
Accrued Expenses
1. Expenses are incurred, but we don't have to pay them yet.
2. Ex: Tenant's Unpaid Rent--he occupied the room, but didn't pay for it.
```
                Rental Expense          $3000
                        Rent Payable            $3000
```
  "The Expense is being covered by 'the need to pay'."
3. Ex: Certificate Of Deposit, From The Bank's Perspective--half of the value of the CD may be owed to the customer, but that value may only be recovered by the customer when the CD is due. Until then, the bank doesn't have to pay--and won't, not without a significant penalty.
```
                Interest Expense        $10000
                        Interest Payable        $10000
```
Deferred Income
1. Expenses aren't yet incurred, even though we've already been paid for what they'll spawn.
2. Also called Unearned Income
3. Ex: Magazines sell a year subscription in advance, will defer recognition of that income that hasn't yet resulted in a published issue.
```
                Cash                    $3
                        Deferred Income         $3
```
4. Amount deferred is proportional to amount still remaining to be earned; as Cash is recognized by delivery of an issue, the amount remaining to be recognized is dropped. So if a year subscription costs $12, and this is a quarterly report, $3 may be recognized, leaving $9 deferred.
Deferred Expenses
1. Revenues(inflow of assets, not just cash!) aren't yet received, even though we've already paid the expense for them.
2. Also called Prepaid Expenses
3. Ex: Magazine subscribers purchase a year subscription in advance, but could defer recognition of that expense until they've actually received some portion of the issues.
  "I haven't gotten my value yet, so I might as well have not paid for it yet--in the grand scheme of things!"
```
                Magazine Expense                $3
                        Prepaid Magazine                $3
```
  (Question: Would one say "Deferred Magazine Expense?" instead of Prepaid Magazine? I don't exactly know.)
```
        
```
Depreciation
1. A special kind of deferred expense
2. "We spent $100K on something that'll last us ten years; we'll defer recognizing the expense on this purchase evenly over the course of the next ten years."
```
                Depreciation Expense            $10,000
                        Accumulated Depreciation        $10,000
```
  "We prepaid the cost of the thing, and will subtract each quarter's depreciation against the total value we paid."