MSE608C – Engineering and Financial Cost Analysis

Accounting Rules and Closing the Books

Financial Accounting Rules

• Financial Accounting– Measures financial activities and summarizes them into

reports and financial statements • Objective and Consistent Rules and Conventions

– Generally Accepted Accounting Principles (GAAP)• Basic Assumptions of Accounting

• Specific Rules of Accounting

• Understand the Compromises and Conventions

Basic Assumptions of Accounting (Riggs)

• Expression in Monetary Terms• Separate Entity• Going-Concern• Conservatism• Realization• Consistency• Materiality

Basic Assumptions of Accounting

• Expression in Monetary Terms– Only events that can be expressed in monetary terms will be

recorded– This ensures consistency in reporting financial activities– Not all important business events can be expressed in monetary

terms.– The monetary unit must be a stable currency and account for the

effects of inflation

• Separate Entity– The finances of the owners and the business must not co-mingle – The specific business entity must be clearly delineated.

Basic Assumptions of Accounting

• Going-Concern– The business entity will have an indefinite life and it is not

expected to terminate operation in the foreseeable future.– Assets are valued on their present use and future revenues.– This assumption is not longer valid if the business ceases

operation.

• Conservatism– When there is reasonable doubt in valuing assets and liabilities, be

conservative.– The lower value for assets; the higher value for liabilities.– Revenues will not be recorded until they are earned.

Basic Assumptions of Accounting

• Realization– Determination if a cash basis or accrual method is used

to recognize revenues and expenses.

– Must be applied consistently in all transactions and financial statements

– The method used to realize revenues and liabilities must be clearly footnoted on the financial statements.

Basic Assumptions of Accounting

• Consistency– Accounting transactions must be recorded in the same

manner from period to period.– Any changes in accounting procedures must be

identified in footnotes on financial statements and their impact must be estimated.

• Materiality– It is only important to record transactions if they are

large enough to affect the quality of the information provided outside the organization

– Estimates can be used when appropriate.

Specific Rules of Accounting

• Important Institutions– Professional accounting associations– Securities and Exchange Commission (SEC)– Internal Revenue Service (IRS)

Professional Accounting Associations

• Accounting Principles Board (APB)– The APB was superseded in 1973 by the Financial

Accounting Standards Board– Published

• Opinions and Statements of the Accounting Principles Board • Accounting Research Bulletins, • Accounting Terminology Bulletins and • Code of Professional Ethics and Accounting Interpretations.

• Financial Accounting Standards Board (FASB)– Seven member board– Publishes

• Statement of Financial Standards and • Financial Accounting Concepts.

Professional Accounting Associations

• American Institute of Certified Public Accountants (AICPA)– Association of professional Certified Public Accountants

(CPA)– Publications include:

• Accounting Research Bulletins (ARB), • Industry Audit and Accounting Guides, • Statements of Position,• Practice Bulletins• Accounting Interpretations• Issues Papers• Technical Practice Aids

GAAP Hierarchy

Accounting literature from a variety of sources

Level CAICPA Accounting Interpretations

Questions and answers published by the FASB staffIndustry practices widely recognized and prevalent

Level BFASB Technical Bulletins

AICPA Industry Audit and Accounting GuidesAICPA Statements of Position

Level AFASB Statements of Financial Standards

FASB InterpretationsAPB Opinions and AICPA Accounting Research Bulletins

Generally Accepted Accounting Principles(GAAP)

Government Regulatory Agencies

• Securities and Exchange Commission (SEC)– responsibility to establish, monitor, and enforce accounting rules

for publicly traded investment securities, which includes stocks and bonds

– establishes standardized procedures and rules for preparing and issuing financial statements to public shareholders

• Internal Revenue Service (IRS)– administers the Internal Revenue Code

– responsible to collect income taxes from business and individuals

– establishes guidelines and rules regarding the treatment of financial statements that affect taxable income

Role of the Auditor

• Verify that:– General and specific accounting rules are followed

• Random sample of transactions and accounting operations• Test the accounting system for reliability• Check unusual transactions• An other checks that seem prudent

– Financial statements fairly represents the company’s position and condition.

• The auditor is:– Independent of their client while providing a service.– Obligation to investors, creditor and regulatory agencies

How Good Are The Concepts and Rules

• Financial statements reflect best-estimates of the financial picture of an organization.

• Be skeptical; financial statements cannot reflect the absolute truth.

Source Documents

• Types of Source Documents– Sale of a product or service

– An expense is incurred

– A cash receipt

– A cash disbursement

• There are checks-and-balances for source documents designed into the accounting system– Source documents must be matched before payments are made.

– Checks are sequentially numbers with an attached register.

Source Documents

• Sale of a product or service– Invoice

• An expense is incurred– Purchase Order

– Invoice

– Time Card

Source Documents

• A cash receipt– Checks

– Cash register receipts

• A cash disbursement– Checks

– Petty cash receipt

The Journal (Register)

• Smaller business’ will use a single journal while larger ones have multiple, specialized journals.– Payroll - Sales - Cash Receipts

– Expense - Cash Disbursement

The Ledger (T-account)

• Smaller business’ will use a single Ledger while larger ones have multiple, Subsidiary Ledgers.

• Journal entries are commonly “posted” to the Ledger monthly.

• Entries to the Ledger include a reference to the Journal.

• Error are never erased; they are “reversed”.

Preparing the Financial Statements

1. Prepare a Trial Balance

2. Adjustments to the Trial Balance

3. Prepare the Financial Statements• Balance Sheet• Income Statement• Cash Flow Statement

4. Close the books

The Trial Balance

The trial balance sequence1. List all ledger accounts and their balances in

numeric order (from Chart of Accounts)

2. Sum all the debits and credits

3. The sum of Debits must equal the sum of Credits; If they do not add up, find the errors.

4. Update accounts that have changed value (adjusting entries)

Preparing a Trial BalanceMatador Company Trial Balance 'December 31, 2004

Debit CreditCash $3,900Supplies on Hand 100Furniture 2,000Accounts Payable $800Invested Capital 4,000Owner Withdrawls 400Sales Revenue 2,500Rent Expense 500Salaries Expense 200Supplies Expense 200

$7,300 $7,300

Adjustment Entries

• One-time entries to appropriate accounts that brings accounts up to date

• Three Generic Adjusting Entries :– Corrections– Prepaid (Cash flows occur BEFORE the revenue or expense is

recognized)– Accrual (Cash flows occur AFTER the revenue or expense is

recognized)

• They match Revenues and Expenses to the period they actually occurred

• These are Internal accounting events.

Adjusting Entries

Date Acct # Description Debit Credit12/31/05 5003 Depreciation Expense 125

1052 Accumulated Depreciation 125

12/31/05 5012 Uncollectible Debts Expense 1003044 Allowance for Uncollected Debts 100

12/31/05 5020 Salaries Expense 1,0003010 Salaries Payable 1,000

Closing the Temporary Accounts

• Performed after the financial reports are completed

• Temporary Accounts are defined as all Revenue and Expense Accounts.

• Sequence for Closing1. Add debits and credits to Revenue and Expense accounts to bring their

balance to zero.2. Add corresponding debit and credit entries to the Retained Earnings

account.

• Revenues and Expenses are zeroed start “fresh” for next accounting period

Closing Entries

Date Acct # Description Debit Credit12/31/04 6001 Sales Revenue 2,500

7001 Expense and Income Summary 2,500

12/31/04 7001 Expense and Income Summary 9005005 Rent Expense 5005020 Salaries Expense 2005025 Supplies Expense 200

12/31/04 7001 Expense and Income Summary 16008000 Retained Earnings 1600

Assessment

• Where do the rules for Accounting come from?

• What is the role of the Auditor

• What is the purpose of Source documents?

• What is the sequence for Closing the Books?