LEGAL ACCOUNTING OUTLINE
Exam: Thurs, May 6 from 2:00pm – 4:00pm
1. See notebook page for final exam review stuff
I. How to approach Basic Accounting Problems (from Prof):
1. How to determine the correct journal entry?
a. Remember that for almost all transactions, there are only four possible “cubbyholes” into which debits and credits will fall: assets, liabilities, expenses, and revenues
Balance sheet income statement
b. For each journal entry, the debits and credits must be equal
c. Assets, liabilities, expenses, and revenues act in very limited and predictable ways (you must know and understand the following.
i. Assets (normally) have a debit balance (left hand side of the balance sheet). Thus, if there is an increase in an asset, it will be a debit; if there is a decrease in an asset, it will be credit.
ii. Liabilities have a credit balance (right hand side of the balance sheet). Thus, if there is an increase in a liability, it will be a credit; if there is a decrease in a liability, will be a debit.
iii. Expenses have a debit balance (left hand side of the income statement). Thus, if there is an expense, it will be a debit. Because of the nature of the income statement, expenses do not decrease (no credits to expense).
iv. Revenues have a credit balance (right hand side of the income statement). Thus, if there is revenue, it will be a credit. Because of the nature of the income statement, revenues do not decrease (no debit to revenue).
d. Strategy suggestion: when you are creating a journal entry, begin with the easiest half of the entry. For example, if the problem involves the movement of cash, is it cash in (a debit) or cash out (a credit).
e. If common stock is being issued or if you are closing the income statement, then the journal entry will involve the equity portion of the balance sheet (usually via a credit).
f. Note whether “performance” has occurred. If the revenue has not been earned or the expense not incurred, then the income statement will not be involved in the journal entry.
II. Class: Jan. 19 (Assignment: Bradford, Ch. 1, 2, and 5; Herwitz & Barrett, chapter I, pp. 1-13 (bottom of page); problem 1.1A (pp 23-24))
1. Balance sheet (shows a business’s assets, liabilities, and equity at a particular moment in time):
a. Assets: (what a business owns)
i. Three requirements: the business must
(1) control of the resource
(2) reasonably expect the resource to provide a future benefit
(3) have obtained the resource in a past transaction
(1) purchase of office computer qualifies as an asset
(2) a business owner’s great personality is not an asset (didn’t purchase in transaction)
(3) business spending money to send secretary to training session on using software for the computer is not an asset (unless business and secretary signed an employment contract, an at-will employee can quit anytime)
iii. Historical cost:
(1) accountant record assets at historical cost (price at which property was brought); thus, note that the balance sheet usually does not show assets at their fair market value.
b. Liabilities (what a business owes; duties or responsibilities to provide economic benefits to some other accounting entity in the future):
(1) Liabilities arise from borrowing of cash, purchases of assets on credit, breaches of contracts or commissions of torts, receipts of services, or passage of time.
ii. The underlying debt or obligation must possess three requirements:
(1) involves a present duty or responsibility
(2) obligates entity to provide a future benefit
(3) arose in a transaction which has already occurred
(1) if Tutt accepts delivery of the computer on Aug. 1 and agrees to pay for it in full on Oct. 1, this is a liability (a transaction that has already occurred has legally bound Tutt to pay $2,000 to the seller)
(2) if Tutt order law books worth $200, but the seller has not yet delivered the books, this is not a liability (transaction does not become complete until delivery takes place—only then must Tutt pay for the supplies for return them)
(3) if Tutt accepts a $300 retainer from one of her clients to prepare and file an articles of incorporation in advance of rendering legal service, this is a liability (Tutt has an obligation to deliver legal services worth $300 to the client; if she can’t provide the service she must refund client’s payment; she’s incurred a legal obligation and a transaction has already occurred)
(4) the balance sheet does not list “negatives” which could adversely affect the business—for e.g., poor management, labor problems, unsatisfied customers, or poor reputation does not appear on the balance sheet
c. Equity (net worth)
(1) The arithmetic difference between an entity’s assets and its liabilities. In other words, if the company sold its assets, and satisfied its liabilities, for the amounts shown on the balance sheet, we call the remainder equity b/c the owners could claim that residual amount
(2) Equity increases when the owners invest assets into the business; equity decreases when the owners withdraw from the business.
(3) Balance sheet’s equity section in each of these different forms of business organization:
(i) sole proprietorship: the residual ownership interest in a sole proprietorship is known as proprietorship
(ii) partnership → partners’ equity (note: keep separate equity accounts for each partner)
(iii) corporations → shareholders’ equity (note: do NOT keep separate equity accounts for each shareholder)
(iv) limited partnership → partners’ equity (note: keep separate equity accounts for each partner, whether general or limited)
(v) limited liability company → members’ equity (keep separate equity accounts for each member)
(vi) limited partnership → partners’ equity (keep separate equity accounts for each partner)
uity” (note—done for each partner)—Herwitz p44-45.
g. Example of corporation issuing stocks:
i. Corporation issues 1 share for $100
D Cash 100
C Common stock 100
ii. Corporation issues $1 par value stock for $100
D Cash 100
C Common stock (par value $1) 1
C Additional paid in capital 99
iii. Delta pays its employees w/ shares: 1 share worth $100
D Employee compensation expense 100
C Credit common stock 100
Note: the common stock goes directly on the balance sheet; the employee compensation goes onto the income statement as an employee expense; which then gets tabulated then goes to the balance sheet
IV. Classes Feb 1 and 2, 2010: (Assignment: For accrual accounting material: read Bradford, ch. 8; Herwitz, p 50-52, skim pp 52-58 (“assumptions”), and then read pp 67-72 (“accrual of expense and income”); do practice problem starting on p.75 (write down your proposed journal entries before looking at the book’s answers; problem 1.4A (p 72); For depreciation, read Bradford p. 43-44 (up to “methods”) of chapter 9; Herwitz p. 62-63, (“depreciation accounting“)
1. Accrual accounting
a. Recognizes revenue when earned and expenses when incurred, without regard to actual cash receipts or payments
b. Accrual and Deferral:
i. Accrual of revenue example: In Dec. 2008, Tutt performs legal work and billed the customer for the agreed charge of $500; customer didn’t pay by the end of the year, but paid in 2009; the $500 will be recognized as revenue in 2008 by creating an Accounts Receivable account (an asset) and add the $500 to that account
(1) Dec. 2008: D Accounts Receivable 500
C Professional Income 500
(2) When customer pays bill in Jan 2009:
D Cash 500
C Accounts Receivable 500
ii. Accrual of expense example: Tutt rented an office in 2008, but did not pay the $7000 bill until 2009; the $7000 will be recognized as an expense in calculating 2008 income, so $7000 is added to the Rent Expense Account, the offsetting entry is added to a liability account—Rent Expense Payable
(1) 2008: D Rent Expense $7000
C Rent expense payable $7000
(2) 2009 (when actually paid):
D Rent expense payable $7000
C Cash $7000
iii. Deferral of revenue example: Tutt received $500 in 2008 for work it has not yet performed (does work in 2009); since $500 has not been earned, it must be deferred to a later accounting period; receipt of cash increases cash by $500, which is offset by adding $500 to deferred revenue
(1) 2008 (work not yet completed): D Cash $500