Introduction

If you are currently enrolled in an accounting course (which I sure hope you are because most people don’t browse my site for fun) you’ve probably heard some pretty terrible things about accounting. I remember when I took my first accounting course. I was scared to death before I walked in the door.

The textbooks certainly don’t help. My first accounting book was over 1,000 pages. The book was filled with lots of small text and complicated charts. Today’s accounting textbooks are certainly prettier but I’m not sure the text has gotten any more interesting or understandable. My goal is to help guide you through your accounting classes in an easy straightforward manner. In order to do that, we need to discuss what accounting is and what it is not.

What is accounting?

I would argue that accounting is the most important business class you will take. It doesn’t matter how great your product or service is if you can’t make the numbers work. Accounting is the language of business. It lets businesses communicate with investors, creditors and other stakeholders so they can make decisions about the business. Knowing this language makes you a powerful player in the business community.

There are two major branches of accounting: financial and managerial.

Financial accounting is what most people think of when they think of accounting. Financial accounting is based on communicating information to external users (users who are outside the company). This includes investors, creditors, customers, suppliers and various government agencies. Financial accounting is all about following the rules. It deals mostly with historical information.

Managerial accounting, also called cost accounting, deals with compiling information to allow managers to make decisions and plan for future business needs. In managerial accounting, we frequently deal with “what if” scenarios. There are very few rules in managerial accounting, but there are lots of best practices. It deals mostly with the present and future.

Accounting is NOT a math class

I can’t stress this enough. Accounting is not a math class. It may look like a math class because there are numbers, but the numbers are just part of the language.

Many students get instantly discouraged because they see numbers and think “Oh but I’m terrible at math.” At that instant, the brain switches off. I have had plenty of students who were “terrible at math” do extremely well in my classes. They lived by the mantra “accounting is not a math class.” The most complicated math you will encounter in financial or managerial accounting is division. I usually require my students to purchase a basic four function calculator like the one shown here because that is about as complicated as it gets.

It’s true. Accounting really is a language and you should try to learn it in the same way you would approach a language class. The biggest mistake students make is ignoring the terminology in the course. They focus on formulas but without the conceptual understanding of the terminology, they don’t know when to use the formulas. It’s like trying to write a sentence in Spanish without knowing any of the vocabulary. You may know that the adjective goes after the noun, but without knowing any nouns you can’t write a sentence.

On the flip side, I have students who had such a good conceptual understanding of the terminology, they didn’t need to know the formulas because the calculations came naturally once the concepts were known. That is actually how I learned accounting. With a thorough knowledge of the concepts, I did not memorize a single formula.

How to study for your financial accounting course

There are three areas you should focus on when learning new material in a financial accounting course:

  1. The terminology and concepts – This includes the account names and types. This is critical to your ability to do well in the course.
  2. Structure – similar to learning sentence structure when learning a language, there is a lot of structure in financial accounting. Journal entries have a particular structure, as do trial balances and financial statements. Learning the structure and what goes where is extremely important.
  3. Calculations – Notice that I put this last. This really is the least important of the three. If you can add, subtract, multiply, and divide you have all the math skills you need. When you understand the terminology, concepts, and structure you will barely notice the calculations.

For the account names and types, I recommend flashcards. I know it it seems old school but it really works. For each account, create a card. This is what I put on my cards:

flashcard

On the front, I have the name of an account. On the back, I put the type of account it is and if the normal balance is a debit or credit. On some cards, I put a description for the account. Some students confuse accounts receivable and accounts payable, so it might be a good idea to put a description to make the difference between the two accounts more clear. Each time you encounter a new account, create a card for it.

After you have completed each chapter in the course, take a single sheet of printer paper and make yourself a page of notes. You should be able to boil down each chapter into a single page of notes. the accounts are already covered with your flash cards. The notes page should contain key terms and examples of journal entries. This quick reference guide will save you time when completing assignments or just to refresh your knowledge when needed,

Having the flash cards and the single page of notes will make studying for each exam so much easier. Whatever you do, do NOT reread the chapters. Studies show you only retain about 20% of what you read. Your best bet is to do more problems and study your flash cards and quick notes.

Related Video:

Introduction to Financial Accounting: Objectives and Overview

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It could be argued that the statement of cash flow is the most important of all the financial statements. It is also the least understood. Understanding the purpose of the statement of cash flow is the key. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier.

Most people have a difficult time understanding the concept of accrual accounting. I believe this is because most people live in a cash basis world. As individuals, we do not consider income when it is earned. We recognize our income when it is paid. We recognize expenses when they are paid. It is important to remember that most businesses do not operate that way. Most businesses recognize income when the work is done, whether or not the job has been paid for. These businesses recognize expenses when the cost is incurred, regardless of payment status. In business, we are frequently recording income and expenses when no money has changed hands.

This causes a problem for many people looking at the financial statements. Individuals think in terms of cash so when an individual sees a company with a profit of $500,000, he or she may think that there is an additional $500,000 worth of cash sitting in the bank at the end of the year. Cash might have only increased slightly. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement.

The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. If there was a $500,000 profit, the statement of cash flow explains why the increase in cash is not also $500,000. The statement begins with net income. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.

Every source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities.

Operating Activities

These are activities related to operations or the income statement. In other words, these are items related to income and expenses. There are two main types of operating activities: noncash and those related to current assets and current liabilities.

Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. The most common noncash item is depreciation. Think about the entry recorded for depreciation.

CF1

The entry creates an expense, which appears on the income statement but no cash changes hands. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. This leads to one of the differences between net income and change in cash.

Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. Adding it back removes it from net income, helping us get closer to the change in cash.

Other noncash items include amortization, gains and losses. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. The gain or loss on the transaction is considered to be a noncash part of the transaction. It is essentially there to balance the transaction.

CF2

Notice that $5,000 in cash was received, not $2,000. We eliminate the $2,000 gain in the operating section. Later, we will see what happens to the $5,000.

Any noncash item that is added on the income statement, a gain for example, is subtracted on the statement of cash flows to remove it. Noncash items that are subtracted on the income statement are added back on the statement of cash flows.

Changes in current assets and current liabilities are the second type of operating item. Think of some common current assets and current liabilities: accounts receivable and accounts payable. Both of these items are linked to the income statement.

Current Assets and Changes in Cash

Accounts receivable is created when a company does work and creates revenue. The work has not yet been paid for. However, the income appears on the income statement. This could create a difference between net income and the change in cash. When trying to determine if there is an effect on the change in cash, we need to look at how much accounts receivable has changed. Let’s look at three different scenarios.

Example #1

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

If Accounts Receivable was $230,000 at the end of 2012 and is still $230,000 at the end of 2013, that means that $3,000,000 worth of sales were collected in 2013.

CF3

The amount of sales and the amount of cash collected are equal. Therefore, no timing difference exists. There difference between net income and cash is not affected by accounts receivable.

Example #2

2012 ending balance in Accounts Receivable was $330,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

In this example, Accounts Receivable decreased by $100,000. Let’s see how this decrease affects the amount of cash collected.

CF4

The company reported $3,000,000 in sales on the income statement but actually collected $3,100,000 in cash related to sales. The decrease in accounts receivable results in an increase in cash. That makes sense because when accounts receivable balances are paid (and the balance decreases), the company receives cash.

The $100,000 difference creates a positive change in cash. You could also say that the $100,000 decrease in accounts receivable is a $100,000 source of cash.

Example #3

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $330,000
Sales were $3,000,000

Now we have a $100,000 increase in accounts receivable. What effect do you think this has on cash? If accounts receivable is increasing, the company doesn’t have the cash. Let’s look at the calculation.

CF5

Only $2,900,000 was collected over the course of the year but sales of $3,000,000 appear on the income statement. The $100,000 creates a negative change in cash. My change in cash in this case is less than net income because the company did not collect those funds.

You might be concerned at this point because this seems like a lot of work to do for every line of the cash flow statement. This is just to illustrate what happens. If accounts receivable increases, the change in cash decreases by the same amount. If accounts receivable decreases, the change in cash increases by the same amount.

When completing the statement of cash flow, calculate the change in the account balance. Ask yourself who has the money resulting from that change. Go back to example #2. Accounts receivable decreased by $100,000. Who has the $100,000? The company does because customers paid the additional $100,000. This results in an increase in cash. In example #3, the customers had the $100,000 because they had not paid their bills. This results in a decrease in cash for the company. This method works for all current assets and current liabilities.

All assets behave like accounts receivable. If the balance in prepaid expenses increases, more cash is trapped in that account, resulting in a decrease in cash. If the balance in inventory decreases, the company used up some of the previous inventory rather than spending cash to purchase more. Cash increases because of this.

Current Liabilities and Changes in Cash

Current liabilities, like accounts payable, react the opposite way that assets do. Again, we are examining the differences in current liabilities to determine how these changes affect the change in cash. Let’s run through a few examples just to get the hang of it.

Example #4

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $105,000
Expenses were $2,500,000

Accounts payable decreased by $45,000. Why did accounts payable decrease? Because the company paid all the current expenses and paid off some of last year’s balance. The company paid down debt. This has a negative impact on the change in cash. Let’s look at the full calculation to confirm.

CF6

The company paid $45,000 more in cash than it recorded in expense. This causes a decrease in cash. It can also be said that the decrease in accounts payable is a use of cash.

Example #5

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $175,000
Expenses were $2,500,000

Now, accounts payable is increasing. The company charged more to accounts payable over the course of the year than the company paid off. The $25,000 difference is a source of cash. The company was able to write off expenses that it has not yet paid for.

CF7

The company’s income statement shows expenses of $2,500,000 but the company only spent $2,475,000. It kept the $25,000. Because of the $25,000 increase in accounts payable, the change in cash increased by $25,000.

All current liabilities behave like accounts payable. When accounts payable decreases, cash decreases because cash was used to pay down the liability. When accounts payable increases, cash increases as well because the company used debt rather than cash to finance its activities.

Steps to Complete the Operating Section

  1. First calculate the change in the account balance.
  2. Ask yourself who has the cash from that change. If the company has the cash, it is an increase in cash.  If someone else has the cash, customers or vendors for example, it is a decrease in cash.
  3. Don’t forget to look for noncash items as you work your way down the balance sheet: depreciation, amortization, gains and losses.

Investing Activities

In this section, we are concerned with investments that the company has made. What do companies invest in? Long-term assets that will help with company increase revenue. This includes buildings, machinery, intangible assets, investments in other companies and other long-term investments.

In the investing section, we are not allowed to explain a difference in an account balance by listing “change in fixed assets.” The investing section requires us to explain each change. Let’s look at an example.

Example #1

2012 ending balance in Vehicles was $250,000
2013 ending balance in Vehicles was $235,000
In 2013 the company sold a vehicle which was originally purchased for $35,000 for $5,000. The vehicle had $33,000 of accumulated depreciation recorded at the time of sale.

When dealing with assets, we may not have all the transactions listed, but we will always have all the information we need to do the calculation. Let’s start with the beginning balance and run through the information we have so far.

CF8

This does not make sense because the account balance was $235,000. Clearly, something else happened which was not listed in the information. What would cause the balance in the vehicles account to increase? The company must have purchased another vehicle. How much was the new vehicle? It must have been $20,000.

CF9

Now that we have identified all the activity in the vehicles account and were able to reconcile the change in the balance. We now must figure out what we need to record. We must forget for a moment the vehicles and turn our attention to the cash that changed hands.

The company sold a vehicle. How much cash was received? $5,000. It does not matter that the vehicle originally cost $35,000. Now we are only concerned with cash. The company also purchased a vehicle. How much cash was paid? $20,000. On the statement of cash flow, we would record these two items.

CF10

Notice, we listed each item separately. We need to explain to the reader what happened.

You might have noticed that there was a gain on the sale of the vehicle. The vehicle had a book value of $2,000 ($35,000 cost – $33,000 accumulated depreciation). If $5,000 was received, there was a $3,000 gain. Remember when we discussed noncash items in the operating section. This gain would be listed in the operating section and subtracted from net income.

You should follow this procedure for all noncurrent assets on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. This activity must be an asset purchase. Calculate how much the asset purchase was.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Financing Activities

In our analysis of the balance sheet, we have covered current assets, current liabilities and long-term assets. The only items remaining are long-term liabilities and equity. Both of these items go into the financing section.

The financing section is similar to the investing section. We must explain what happened, not just list the changes in each account balance.

Example #1

2012 ending balance in Notes Payable was $95,000
2013 ending balance in Notes Payable $75,000
The company borrowed $35,000 in additional loans

Looking at this example, it is clear that there is information missing. The company borrowed additional money but the Notes Payable balance decreased. That just doesn’t make sense with the information we are given. There are two ways to work this calculation. we can reconcile the balance, similar to the method used in the investing section.

CF11

What is causing the balance to be $55,000 less than anticipated? Think about the reason that the balance in Notes Payable would decrease. Debts decrease when they are repaid. The company must have repaid $55,000 on the debt.

Here is how we would list this on the statement of cash flow in the financing section:

CF12

You should follow this procedure for all noncurrent liabilities on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. Calculate the amount you are off and the reason for the change.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Completing the Statement of Cash Flows

Whenever I am working on a cash flow statement, I use the balance sheet as a guide.

First, calculate how much each account has changed from the previous year.

Starting at the top of the balance sheet, I work my way through each account. The first account should be cash. We can skip that one since the purpose of the statement of cash flow is to match the change in cash. The next account is most likely accounts receivable. Determine which section accounts receivable would go into: operating, investing or financing (if you said operating, you are correct). Then ask yourself if the change in the balance is a source of cash or a use of cash. Add it to your statement.

Use this same procedure, explaining all the differences and adding them to the correct section of the cash flow statement. When you have explained all the differences, total each section and then add all three sections together to calculate your change in cash. The change in cash you calculate should equal the difference between your beginning and ending cash balance.

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When to Recognize Revenue

Revenue recognition is one of the most important concepts in accounting. Deciding when to record revenue and expenses can have a huge impact on the financial statements. Incorrectly recording revenue that has not been earned can inflate profits and give potential investors or lenders incorrect information about the company’s future profitability.

Revenue should be recorded when it is earned, essentially when the work is done. For some businesses, this is fairly simple. When I complete a tax return for a client, I have earned revenue. When a retailer sells a product, revenue is earned. It does not matter when payment is received; the work is completed and therefore the revenue should be recorded. Payments do not affect the recognition of revenue.

When deciding how to record transactions involving revenue, there are two important questions you should ask yourself:

  1. Did the company do the work?
  2. Did the company get paid?

The following chart should help guide you through the process of determining if revenue should be recognized.

 Rev1

Notice the first question is regarding the work. This is the most important factor. Once we have determined it work has been done, then we can look at payment information to determine what the debit should be in the entry.

Let’s look at some examples.

K’s Bounce House Adventures rents bounce houses to individuals and corporations for parties. K’s has the following transactions during the month of February. Record the necessary journal entries.

Feb 2 – K’s agrees to provide a bounce house for a corporate function on February 10 for $300. The companies sign a contract stating that payment will be made on the date of the function.

Feb 4 – K’s provides a bounce house for a birthday party and gets paid at the end of the party, $250.

Feb 5 – K’s provides two bounce houses for a town picnic, $700. K’s must bill the town and will receive payment within 30 days.

Feb 7 – K’s signs a contract to provide a bounce house for a birthday party on Feb 20 for $350. The contract requires the customer to pay 50% of the balance today and the rest the day of the party.

Feb 10 – K’s provides the bounce house for the contract signed on Feb 2 and is paid.

Feb 13 – K’s provides a bounce house for a function booked in January. The customer paid the entire amount of the contract, $275, when the function was booked.

Feb 20 – K’s provides the bounce house for the contract signed on Feb 7 and is paid the remaining balance.

Feb 25 – K’s receives the payment from the town event on Feb 5.

For each of the transactions, ask yourself the two questions above. The solutions are listed below with explanations. Try working through the transactions before looking at the solutions. Take notes on the transactions you had trouble identifying. Usually there is a pattern. Find your weaknesses and work on them. Write your own transactions for those types of entries.

Click here for the solutions to the transactions.

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Basic Journal Entries, Part 2

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K’s Bounce House Adventures rents bounce houses to individuals and corporations for parties. K’s has the following transactions during the month of February. Record the necessary journal entries.

Feb 2 – K’s agrees to provide a bounce house for a corporate function on February 10 for $300. The companies sign a contract stating that payment will be made on the date of the function.

Feb 4 – K’s provides a bounce house for a birthday party and gets paid at the end of the party, $250.

Feb 5 – K’s provides two bounce houses for a town picnic, $700. K’s must bill the town and will receive payment within 30 days.

Feb 7 – K’s signs a contract to provide a bounce house for a birthday party on Feb 20 for $350. The contract requires the customer to pay 50% of the balance today and the rest the day of the party.

Feb 10 – K’s provides the bounce house for the contract signed on Feb 2 and is paid.

Feb 13 – K’s provides a bounce house for a function booked in January. The customer paid the entire amount of the contract, $275, when the function was booked.

Feb 20 – K’s provides the bounce house for the contract signed on Feb 7 and is paid the remaining balance.

Feb 25 – K’s receives the payment from the town event on Feb 5.

Rev2 Rev3

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The trial balance is a list of all the accounts a company uses with the balances in debit and credit columns. There are three types of trial balances: the unadjusted trial balance, the adjusted trial balance and the post- closing trial balance. All three have exactly the same format.

The unadjusted trial balance is prepared before adjusting journal entries are completed. This trial balance reflects all the activity recorded from day-to-day transactions and is used to analyze accounts when preparing adjusting entries. For example, if you know that the remaining balance in prepaid insurance should be $600, you can look at the unadjusted trial balance to see how much is currently in the account.

The adjusted trial balance is completed after the adjusting entries are completed. This trial balance has the final balances in all the accounts and is used to prepare the financial statements.

The post-closing trial balance shows the balances after the closing entries have been completed. This is your starting trial balance for the next year. We will discuss the post-closing trial balance in the post regarding closing entries.

Accounts in the trial balance are listed in a specific order to aid in the preparation of the financial statements. Accounts should be listed in the following order:

  • Assets
  • Liabilities
  • Equity
  • Revenue
  • Expenses

Assets and liabilities should be listed in order from most liquid to least liquid. Liquidity refers to how quickly an asset could be converted to cash and how quickly a liability will be paid off with cash. The most liquid asset is cash, because it has already been converted to cash (who knew?). Typically, the next most liquid asset is accounts receivable because most companies collect their receivables within 30 days.

You can also think of assets and liabilities in terms of current and long-term. A current asset is one that will most likely be used up in less than 12 months. A current liability is one that will be paid off in less than 12 months. Long-term assets and liabilities are those that will be on the trial balance for more than 12 months.

Using the Adjusted Trial Balance

TB

Here is a sample adjusted trial balance. Notice the accounts are listed in the order described above. You might be wondering why it is such a big deal to organize the trial balance in this manner. The purpose of the trial balance is to make your life easier when preparing financial statements. Look what happens when we divide the trial balance by statement.

FS1
This is the same trial balance but I have color coded it. The orange section is for the accounts that will be used on the balance sheet, the blue is the statement of retained earnings and the green is the income statement. Because we took the time to organize the accounts, the preparation of the financial statements will be so much easier.

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