Review: Accounting Cycle Basics Flashcards
What is an accounting transaction?
An accounting transaction occurs when assets, liabilities, or shareholders’ equity items change as a result of some economic event.
Not all events are recorded in the financial statements—only those that affect the financial position of the company (i.e., assets, liabilities, or shareholders’ equity) are considered accounting transactions.
What types of events require recording as accounting transactions?
Examples of events that require recording include:
Purchase of a computer by a company.
Payment of rent.
Sale of goods or services.
Events that do not change the company’s financial position, such as discussing a potential transaction with a customer, do not require recording.
How do you determine if an economic event should be recorded as an accounting transaction?
You should ask: “Is the financial position (assets, liabilities, or shareholders’ equity) of the company changed?”
Yes: If the answer is yes, then the event should be recorded as an accounting transaction.
No: If the answer is no, then the event should not be recorded.
What is the significance of the criterion “Is the financial position of the company changed?” in accounting transactions?
This criterion is crucial because it determines whether an economic event has a measurable impact on the company’s financial status, thus requiring it to be recorded in the accounting records.
This ensures that only relevant financial information is included in financial statements, providing an accurate picture of the company’s financial health.
What is the basic accounting equation?
The basic accounting equation is:
**
Assets=Liabilities+Shareholders’Equity**
This equation must always balance, and every transaction affects the equation in a way that maintains this balance.
What is transaction analysis?
Transaction analysis is the process of identifying the specific effects of economic events on the accounting equation.
Every transaction has a dual effect, meaning if one asset increases, another asset, liability, or equity must change to keep the equation balanced.
What happens in the accounting equation when a company purchases equipment by paying part cash and signing a note for the balance?
For example, if a company purchases equipment for $10,000 by paying $6,000 in cash and signing a note for $4,000:
Equipment (an asset) increases by $10,000.
Cash (an asset) decreases by $6,000.
Notes Payable (a liability) increases by $4,000. This keeps the accounting equation balanced:
Assets = Liabilities + Shareholders’ Equity
+10,000 - 6,000 = +4,000
What does the expanded accounting equation include?
Assets = Liabilities + Shareholders’ Equity
Where:
Shareholders’ Equity is further broken down into:
Common Shares
Retained Earnings
Retained Earnings is affected by:
Revenues (which increase Retained Earnings)
Expenses (which decrease Retained Earnings)
Dividends (which decrease Retained Earnings)
What happens when shareholders invest cash into the business?
When shareholders invest cash into the business, for example, $10,000:
Cash (an asset) increases by $10,000.
Common Shares (part of Shareholders’ Equity) increases by $10,000. The accounting equation remains balanced:
Assets = Liabilities + Shareholders’ Equity
+10,000 = +10,000
What is the effect of borrowing cash through a note payable?
When a company borrows cash through a note payable, for example, $5,000:
Cash (an asset) increases by $5,000.
Notes Payable (a liability) increases by $5,000.
The accounting equation remains balanced:
Assets = Liabilities + Shareholders’ Equity
+5,000 = +5,000
How does purchasing equipment for cash affect the accounting equation?
When a company purchases equipment by paying cash, for example, $5,000:
Equipment (an asset) increases by $5,000.
Cash (an asset) decreases by $5,000.
The total amount of assets remains the same, so the accounting equation is balanced.
What happens when cash is received in advance from a customer?
When a company receives cash in advance from a customer, for example, $1,200:
Cash (an asset) increases by $1,200.
Unearned Revenue (a liability) increases by $1,200 because the service has not yet been performed.
The accounting equation remains balanced:
What is the effect of performing services for cash on the accounting equation?
When a company performs services for cash, for example, $10,000:
Cash (an asset) increases by $10,000.
Service Revenue (part of Retained Earnings in Shareholders’ Equity) increases by $10,000.
The accounting equation remains balanced:
How does the concept of “revenue recognition” affect the timing of when revenue is recorded in the accounting equation?
Revenue is recognized when the work is performed, not when cash is received.
If cash is received before the service is performed, it is recorded as a liability (Unearned Revenue) until the service is completed.
Once the service is performed, the liability is reduced, and revenue is recorded, increasing shareholders’ equity.
How does the payment of rent affect the accounting equation?
When a company pays rent, for example, $900:
Effect on Assets: Cash decreases by $900
Effect on Shareholders’ Equity: Rent Expense (which reduces Retained Earnings) increases by $900
Assets = Liabilities + Shareholders’ Equity
-900 = -900
What is the effect of purchasing an insurance policy for cash?
When a company purchases an insurance policy, for example, $600:
Effect on Assets:
Cash decreases by $600
Prepaid Insurance (an asset) increases by $600
Accounting Equation:
Assets = Liabilities + Shareholders’ Equity
-600 + 600 = 0
How does purchasing supplies on account affect the accounting equation?
When a company purchases supplies on account, for example, $2,500:
Effect on Assets:
Supplies (an asset) increases by $2,500
Effect on Liabilities:
Accounts Payable increases by $2,500
Assets = Liabilities + Shareholders’ Equity
+2,500 = +2,500
What is an account in accounting?
An account is an individual accounting record of increases and decreases in a specific asset, liability, shareholders’ equity, revenue, or expense item.
An account typically consists of three parts:
The title of the account
A left or debit side
A right or credit side
What is a T-account?
A T-account is a basic form of an account that resembles the letter “T.” It has a title at the top, with the left side representing debits (Dr.) and the right side representing credits (Cr.).
What do debits and credits indicate in accounting?
Debit (Dr.): Indicates the left side of an account.
Credit (Cr.): Indicates the right side of an account.
They do not mean increase or decrease. Whether a debit or credit indicates an increase or decrease depends on the type of account.
What is a debit balance and a credit balance?
Debit Balance: Occurs when the total of the debit amounts exceeds the credits in an account.
Credit Balance: Occurs when the credit amounts exceed the debits in an account.
How do you record increases and decreases in cash?
Increases in cash: Recorded as debits (left side).
Decreases in cash: Recorded as credits (right side).
What is the double-entry system in accounting?
The double-entry system is a method where each transaction is recorded in at least two accounts, with debits equaling credits.
This system ensures the accounting equation remains balanced and helps detect errors.
How do debits and credits affect assets and liabilities?
Assets:
Debit increases assets.
Credit decreases assets.
Liabilities:
Debit decreases liabilities.
Credit increases liabilities.
Normal balances:
Asset accounts normally show a debit balance.
Liability accounts normally show a credit balance.
What is the normal balance for assets and liabilities?
Assets: Debit for increase, Credit for decrease.
Liabilities: Debit for decrease, Credit for increase.
This indicates how increases and decreases in the account are recorded.
How do debits and credits affect the Common Shares account?
Debits: Decrease Common Shares.
Credits: Increase Common Shares.
Normal Balance:
Common Shares account normally has a credit balance.
What are Retained Earnings and how do debits and credits affect this account?
Retained Earnings represent the net income retained in the business, which is accumulated in the shareholders’ equity through profitable operations.
Debits: Decrease Retained Earnings (e.g., by net loss).
Credits: Increase Retained Earnings (e.g., by net income).
Normal Balance:
Retained Earnings account normally has a credit balance.
What effect do dividends have on Retained Earnings?
Dividends are distributions by a corporation to its shareholders, reducing shareholders’ claims on retained earnings.
Debits: Increase in Dividends (which decreases Retained Earnings).
Credits: Decrease in Dividends.
Normal Balance:
Dividends account normally has a debit balance.
How do revenues and expenses affect shareholders’ equity?
Revenues: Increase shareholders’ equity. They are increased by credits and decreased by debits.
Expenses: Decrease shareholders’ equity. They are increased by debits and decreased by credits.
Normal Balances:
Revenue accounts: Normally show credit balances.
Expense accounts: Normally show debit balances.
Why is it important to understand the normal balances of accounts in accounting?
Understanding the normal balances of accounts helps identify errors and ensures that transactions are recorded correctly.
For example, an asset account should normally show a debit balance.
If it shows a credit balance, it may indicate an error unless it’s an exceptional case. Similarly, knowing the normal balances helps ensure that debits and credits are applied appropriately in the double-entry system, keeping the accounting equation balanced.
How are the subdivisions of shareholders’ equity reported in the financial statements?
Common Shares and Retained Earnings: Reported in the shareholders’ equity section of the balance sheet.
Dividends: Reported on the statement of retained earnings.
Revenues and Expenses: Reported on the income statement.
Changes in any of these items affect shareholders’ equity as they are eventually transferred to retained earnings at the end of the period.
How do the income statement, statement of retained earnings, and balance sheet interrelate?
Income Statement: Calculates net income or net loss (Revenues - Expenses).
Statement of Retained Earnings: Starts with beginning retained earnings, adds net income, subtracts dividends, and results in ending retained earnings.
Balance Sheet: Lists assets, liabilities, and shareholders’ equity, which includes common shares and retained earnings (affected by net income and dividends).
What are the key debit/credit rules summarized for each type of account?
Assets:
Debit increases (+)
Credit decreases (-)
Liabilities:
Debit decreases (-)
Credit increases (+)
Common Shares:
Debit decreases (-)
Credit increases (+)
Retained Earnings:
Debit decreases (-)
Credit increases (+)
Revenues:
Debit decreases (-)
Credit increases (+)
Expenses:
Debit increases (+)
Credit decreases (-)
Dividends:
Debit increases (+)
Credit decreases (-)
Why is it important to understand the relationships between the income statement, retained earnings statement, and balance sheet?
Understanding these relationships is crucial because they provide a comprehensive view of a company’s financial performance and position.
The income statement affects retained earnings, which in turn affects shareholders’ equity on the balance sheet.
Errors in one statement can cascade and cause inaccuracies in the others, leading to a misrepresentation of the company’s financial health.
What are the basic steps in the recording process?
The recording process involves three basic steps:
Analyze each transaction in terms of its effect on the accounts.
Enter the transaction information in a journal.
Transfer the journal information to the appropriate accounts in the ledger.
This process typically begins with a source document (such as a sales slip, cheque, bill, or cash register document), which provides evidence of the transaction. The information from the source document is analyzed, then recorded in the journal, and finally posted to the ledger.
What are the three significant contributions of the journal to the recording process?
The journal makes three significant contributions to the recording process:
It discloses in one place the complete effect of a transaction.
It provides a chronological record of transactions.
It helps to prevent or locate errors by allowing the debit and credit amounts for each entry to be readily compared.
What is the process of journalizing?
Journalizing is the process of entering transaction data in the journal.
Each transaction is recorded in chronological order, showing the debit and credit effects on specific accounts.
What features should be included in a journal entry?
A journal entry should include:
Date of the transaction in the Date column.
Account to be debited is listed first, at the left. The credited account is listed on the next line, indented.
Amounts for debits and credits are recorded in the Debit and Credit columns, respectively.
Brief explanation of the transaction to clarify the nature of the transaction.
It is important to use correct and specific account titles in journalizing to ensure accuracy in financial statements.
What is a trial balance?
A trial balance lists accounts and their balances at a given time, prepared at the end of an accounting period to ensure that the total debits equal the total credits, proving the mathematical equality of debits and credits after posting.
What are the steps for preparing a trial balance?
The steps for preparing a trial balance are:
List the account titles and their balances.
Total the debit column and total the credit column.
Verify the equality of the two columns.
What is the order of presentation in a trial balance?
The order of presentation in a trial balance is:
Assets
Liabilities
Shareholders’ equity
Revenues
Expenses
What are the limitations of a trial balance?
A trial balance does not prove that all transactions have been recorded or that the ledger is correct. It may balance even when certain errors are present, such as:
A transaction not being journalized.
A correct journal entry not being posted.
A journal entry being posted twice.
Incorrect accounts being used in journalizing or posting.
Offsetting errors in recording the amount of a transaction.
What is the significance of the trial balance in accounting?
The trial balance is significant because it verifies the equality of debits and credits after posting.
It is useful in the preparation of financial statements and may uncover errors in journalizing and posting.
Why is the trial balance still useful despite its limitations?
Despite its limitations, the trial balance is a useful screen for finding errors and is frequently used in practice.
What is the periodicity assumption in accounting?
The periodicity assumption divides the economic life of a business into artificial time periods, typically a month, a quarter, or a year.
What is the revenue recognition principle?
The revenue recognition principle requires that companies recognize revenue in the accounting period in which the performance obligation is satisfied, regardless of when the cash is received.
What is the expense recognition principle?
The expense recognition principle, also known as the matching principle, dictates that efforts (expenses) should be matched with the results (revenues) they help to generate.
How does the expense recognition principle apply to expenses related to revenue generation?
Under the expense recognition principle, expenses should be reported in the same period as the revenues they help to generate, even if the payment for those expenses occurs in a different period.
What is the relationship between the revenue recognition principle and the expense recognition principle?
Both the revenue and expense recognition principles are guided by the periodicity assumption and ensure that revenues and expenses are recognized in the appropriate accounting periods according to generally accepted accounting principles (GAAP).
What is accrual-basis accounting?
Accrual-basis accounting means that transactions that change a company’s financial statements are recorded in the periods in which the events occur, even if cash was not exchanged.
Revenues are recognized when services are performed, and expenses are recognized when incurred.
What is cash-basis accounting?
Cash-basis accounting records revenue when cash is received and records expenses when cash is paid.
It often produces misleading financial statements and is not in accordance with generally accepted accounting principles (GAAP).
How does accrual-basis accounting differ from cash-basis accounting?
Accrual-basis accounting recognizes revenue when the performance obligation is satisfied and expenses when incurred, while cash-basis accounting recognizes revenue when cash is received and expenses when cash is paid, regardless of when the obligation or expense occurred.
Why is cash-basis accounting often considered misleading?
Cash-basis accounting can be misleading because it fails to record revenue in the period that a performance obligation is satisfied and may not reflect the true financial performance of the company, especially when there are delays in cash transactions.
What are the financial impacts of using accrual-basis accounting as shown in the example of Fresh Colours?
In 2019, Fresh Colours recognized $80,000 in revenue and $50,000 in expenses, resulting in a net income of $30,000.
If using cash-basis accounting, the revenue would not be recognized until 2020, leading to a misleading net loss of $50,000 in 2019 and a net income of $80,000 in 2020, misrepresenting the company’s financial performance.
