Chapter 2 accounting in detail – Flashcards

Asset Assets are resources owned or controlled by a company, and those resources have expected future benefits. Most accounting systems include (at a minimum) separate accounts for the assets described here.

Asset A Cash account reflects a company's cash balance. All increases and decreases in cash are recorded in the Cash account. It includes money and any medium of exchange that a bank accepts for deposit (coins, checks, money orders, and checking account balances).

Asset Accounts receivable are held by a seller and refer to promises of payment from customers to sellers. These transactions are often called credit sales or sales on account (or on credit). Accounts receivable are increased by credit sales and billings to customers, but are decreased by customer payments. A company needs a separate record for each customer, but for now, we use the simpler practice of recording all increases and decreases in receivables in a single account called Accounts Receivable.

Asset A note receivable, or promissory note, is a written promise of another entity to pay a definite sum of money on a specified future date to the holder of the note. A company holding a promissory note signed by another entity has an asset that is recorded in a Note (or Notes) Receivable account.

Asset Prepaid accounts (also called prepaid expenses) are assets that represent prepayments of future expenses (expenses expected to be incurred in one or more future accounting periods). When the expenses are later incurred, the amounts in prepaid accounts are transferred to expense accounts. Common examples of prepaid accounts include prepaid insurance, prepaid rent, and prepaid services (such as club memberships). Prepaid accounts expire with the passage of time (such as with rent) or through use (such as with prepaid meal tickets). When financial statements are prepared, prepaid accounts are adjusted so that (1) all expired and used prepaid accounts are recorded as expenses and (2) all unexpired and unused prepaid accounts are recorded as assets (reflecting future use in future periods). To illustrate, when an insurance fee, called a premium, is paid in advance, the cost is typically recorded in the asset account titled Prepaid Insurance. Over time, the expiring portion of the insurance cost is removed from this asset account and reported in expenses on the income statement. Any unexpired portion remains in Prepaid Insurance and is reported on the balance sheet as an asset.

Asset Supplies are assets until they are used. When they are used up, their costs are reported as expenses. The costs of unused supplies are recorded in a Supplies asset account. Supplies are often grouped by purpose—for example, office supplies and store supplies. Office supplies include stationery, paper, toner, and pens. Store supplies include packaging materials, plastic and paper bags, gift boxes and cartons, and cleaning materials. The costs of these unused supplies can be recorded in an Office Supplies or a Store Supplies asset account. When supplies are used, their costs are transferred from the asset accounts to expense accounts.

Asset Equipment is an asset. When equipment is used and gets worn down, its cost is gradually reported as an expense (called depreciation). Equipment is often grouped by its purpose—for example, office equipment and store equipment. Office equipment includes computers, printers, desks, chairs, and shelves. Costs incurred for these items are recorded in an Office Equipment asset account. The Store Equipment account includes the costs of assets used in a store, such as counters, showcases, ladders, hoists, and cash registers.

Asset Buildings such as stores, offices, warehouses, and factories are assets because they provide expected future benefits to those who control or own them. Their costs are recorded in a Buildings asset account. When several buildings are owned, separate accounts are sometimes kept for each of them.

Asset The cost of land owned by a business is recorded in a Land account. The cost of buildings located on the land is separately recorded in one or more building accounts.

Liabilities are claims (by creditors) against assets, which means they are obligations to transfer assets or provide products or services to others. Creditors are individuals and organizations that have rights to receive payments from a company. If a company fails to pay its obligations, the law gives creditors a right to force the sale of that company's assets to obtain the money to meet creditors' claims. When assets are sold under these conditions, creditors are paid first, but only up to the amount of their claims. Any remaining money, the residual, goes to the owners of the company. Creditors often use a balance sheet to help decide whether to loan money to a company. A loan is less risky if the borrower's liabilities are small in comparison to assets because this means there are more resources than claims on resources. Common liability accounts are described here.

Liability Accounts payable refer to oral or implied promises to pay later, which usually arise from purchases of merchandise. Payables can also arise from purchases of supplies, equipment, and services. Accounting systems keep separate records about each creditor. We describe these individual records in Chapter 5.

Liability A note payable refers to a formal promise, usually denoted by the signing of a promissory note, to pay a future amount. It is recorded in either a short-term Note Payable account or a long-term Note Payable account, depending on when it must be repaid. We explain details of short- and long-term classification in the next two chapters.

Liability Unearned revenue refers to a liability that is settled in the future when a company delivers its products or services. When customers pay in advance for products or services (before revenue is earned), the revenue recognition principle requires that the seller consider this receipt as unearned revenue. Examples of unearned revenue include magazine subscriptions collected in advance by a publisher, rent collected in advance by a landlord, and season ticket sales by sports teams. The seller would record these in liability accounts such as Unearned Subscriptions, Unearned Rent, and Unearned Ticket Revenue. When products and services are later delivered, the earned portion of the unearned revenue is transferred to revenue accounts such as Subscription Fees Revenue, Rent Revenue, and Ticket Revenue.1

Liability Accrued liabilities are amounts owed that are not yet paid. Examples are wages payable, taxes payable, and interest payable. These are often recorded in separate liability accounts by the same title. If they are not large in amount, one or more ledger accounts can be added and reported as a single amount on the balance sheet. (Financial statements often have amounts reported that are a summation of several ledger accounts.)

The owner's claim on a company's assets is called equity or owner's equity. Equity is the owner's residual interest in the assets of a business after deducting liabilities. Equity is impacted by four types of accounts as follows: Equity = Owner's capital − Owner's withdrawals + Revenues − Expenses. We show this visually in Exhibit 2.3 by expanding the accounting equation. We also organize assets and liabilities into subgroups that have similar attributes. An important subgroup for both assets and liabilities is the current items. Current items are usually those expected to come due (either collected or owed) within the next year. The next two chapters explain this in detail. At this point, know that a classified balance sheet reports current assets before noncurrent assets and current liabilities before noncurrent liabilities.

When an owner invests in a company, it increases both assets and equity. The increase to equity is recorded in an account titled Owner, Capital (where the owner's name is inserted in place of "Owner"). The account titled C. Taylor, Capital is used for FastForward. Any further owner investments are recorded in this account.

When an owner withdraws assets for personal use it decreases both company assets and total equity. The decrease to equity is recorded in an account titled Owner, Withdrawals. The account titled C. Taylor, Withdrawals is used for FastForward. Withdrawals are not expenses of the business; they are simply the opposite of owner investments. (Owners of proprietorships cannot receive company salaries because they are not legally separate from their companies; and they cannot enter into company contracts with themselves.)

The inflow of net assets from providing products and services to customers increases equity through increases in revenue accounts. Examples of revenue accounts are Sales, Commissions Earned, Professional Fees Earned, Rent Revenue, and Interest Revenue. Revenues always increase equity.

The outflow of net assets in helping generate revenues decreases equity through increases in expense accounts. Examples of expense accounts are Advertising Expense, Store Supplies Expense, Office Salaries Expense, Office Supplies Expense, Rent Expense, Utilities Expense, and Insurance Expense. Expenses always decrease equity. The variety of revenues and expenses can be seen by looking at the chart of accounts that follows the index at the back of this book. (Different companies sometimes use different account titles than those in this book's chart of accounts. For example, some might use Interest Revenue instead of Interest Earned, or Rental Expense instead of Rent Expense. It is important only that an account title describe the item it represents.)