Accounting Basics for Community Financial Institutions Chapters 1 & 2

Presented by: Richard Rowe, Jr., CPA EVP and Treasurer Scituate Federal Savings Bank [email protected]

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Schedule of Assignments September 7, 2006 Chapter 1 Basic Accounting Chapter 2 The GAAP Self-Regulatory Framework September 14, 2006 Chapter 3 Accounting Uniqueness in Community Financial Institutions Chapter 4 Basic Business Functions and Risks of Community Financial Institutions Chapter 5 Internal Controls in Community Financial Institutions September 21, 2006 Chapter 6 Typical Financial Statements of a Community Financial Institutions Chapter 7 Left-Hand Side of the Balance Sheet Chapter 8 Right-Hand Side of the Balance Sheet September 28, 2006 Chapter 9 Ratio Analysis Chapter 10 Accounting Issues of Particular Concern to Community Financial Institutions Chapter 11 Future Accounting Possibilities

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Polling Question #1

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Throughout this course….. I will refer to both the Microsoft PowerPoint slides and the textbook, Accounting Basics. Please make sure you find a comfortable environment, which will allow you to maneuver back and forth from the PowerPoint presentation to the textbook.

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Polling Question #2

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Chapter 1 Basic Accounting

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Review Chapter 1 Objectives Before we jump into the material, let’s take a moment and review the objectives established for Chapter 1.











Define accounting State the fundamental accounting equation Differentiate among types of accounts: assets, liabilities, equity, revenue and expense Explain the double-entry bookkeeping system Distinguish between the balance sheet and the income statement Summarize the accounting cycle activities

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What is accounting? Accounting is a field of business that records, classifies, and interprets the economic transactions of a business enterprise. This definition of accounting sounds important enough, yet it might not clearly explain the purpose. So what then is the purpose of accounting? To communicate relevant information about a business to interested parties as an aid in decision making. The key word is COMMUNICATE.

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Two Broad Categories of Users There are two broad categories of users:



Internal External

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And why does accounting matter? Accounting provides information that every business needs to attain the goals of profitability and liquidity.

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So how does this “accounting” thing work?

Accounting uses a method of capturing transaction data that is more commonly called the accounting system.

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The accounting system involves three major steps:


First, the system manually or electronically records the dollar amounts of completed transactions. Examples of a completed transaction are the sale of a product and payment of rent.

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The accounting system involves three major steps, cont:







It then classifies those transactions into logical categories called accounts. Finally the logically classified transactions are summarized into reports called financial statements.

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OK, before we can move forward … It is necessary to understand the following concepts:




types of accounts the fundamental accounting equation double entry bookkeeping

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An Account An account is a device for grouping additions and subtractions that apply to items included in the financial statements.

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Individual accounts are grouped into the following types:








assets – permanent or real accounts for what the business owns liabilities – permanent or real accounts for what the business owes equity – permanent or real account for the initial infusion of cash into the business plus accumulated profits and losses of the business

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Individual accounts are grouped into the following types, cont.:







revenues – temporary accounts for the value of the goods or services sold expenses – temporary accounts for the amounts the organization spends or incurs to run the business

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Questions? Select *1 now to ask a live question through the phone or Type your question into the chat box in the lower left corner of the screen and click on the “Send” button located right below the box.

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Polling Question

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Double Entry Bookkeeping Every transaction has at least one debit and one credit. And for every transaction, the total debits (left-side amounts) equal the total credits (right-side amounts).

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Polling Question To begin, a “T” account illustrates how an account is used to record transactions and determine the balance. The left side is always the debit side and the right side is always the credit side.

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The fundamental accounting equation is:

Assets = Liabilities + Equity

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Polling Question

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Debits and Credits It usually takes a while to become comfortable with analyzing a transaction.

Debits and credits, at first, seem to be confusing, really confusing. How debits and credits affect different accounts is illustrated in Figure 1.3 on page 8 in the textbook.

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Polling Question Once again consider the fundamental accounting equation: Assets = Liabilities + Equity If you accept [sorry, you have no choice] that assets are increased by a debit, then those accounts on the opposite side of the equal sign, liabilities and equity, are increased by a credit.

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Revenues and expenses are in need of some explanation. As mentioned earlier equity is affected by: • the initial infusion of cash into the business • the accumulated net profits and losses. The net profits and losses are determined for each accounting period by closing the revenue accounts and expense accounts to an account called Income Summary. The income summary is only used during the closing process and will never appear on a financial statement.

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Income Statement & Balance Sheet Relationship The financial statements are easier to understand when we recognize how the income statement and balance sheet are related. The balance sheet shows the amount of owner’s equity as of the balance sheet date. The income statement explains the change in owner’s equity resulting from the operations of the business, as measured by the revenue and expense accounts.

The income statement therefore provides the “link” between the prior and current balance sheets.

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Polling Question

Therefore, assets and expenses have a normal or expected debit balance, whereas, liabilities, equity and revenues have a normal or expected credit balance.

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Questions? Select *1 now to ask a live question through the phone or Type your question into the chat box in the lower left corner of the screen and click on the “Send” button located right below the box.

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The accounting cycle consists of eight steps: Let me emphasize that these steps are typical for a manual system, however, they describe the process embedded in any system. 1. Recording transactions in a journal. 2. Posting transactions from the journal to ledger accounts [a formal “T” account]. 3. Preparing a trial balance to ascertain whether the debits equal the credits.

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The accounting cycle consists of eight steps, cont.: 4. Preparing end-of-period adjustments to record transactions needed but not yet journalized. 5. Preparing the financial statements. 6. Preparing and posting correcting entries, if any. 7. Closing the books. 8. Preparing a post-closing trial balance.

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Accounting Cycle In nearly all instances and for every business, the accounting cycle is completed each month.

Every transaction is first analyzed and then recorded in the journal, the book of original entry, in chronological order.

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Accounting Cycle, cont. The account titles for the accounts used are available from a chart of accounts.

Refer to: Page 9, Figure 1.4, General Journal Entries and Page 18, Figure 1.8, Revenue and Expense Journal Entries.

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Accounting Cycle, cont. Once the journal entries for the accounting period have been journalized they are posted to the respective ledger accounts. After each posting a balance is determined.

Refer to: Page 11, Figure 1.5, Journal Entries Posted to Ledger Accounts Page 19, Figure 1.9, Revenue and Expense Ledger Entries.

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Trial Balance After all the transactions for the month have been journalized and posted a trial balance is prepared.

The accounts and balances appearing on the trial balance are listed in order of assets, liabilities, equity, revenues and expenses.

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Polling Question The sole purpose of the trial balance is to ensure that the total debits equal the total credits.

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Trial Balance, cont. Mistakes, such as unintentional mathematical errors, improper postings or misapplications of GAAP [Generally Accepted Accounting Principles], may still exist. The business must make correcting entries to remove the errors in order to prepare proper financial statements. Refer to: Page 10, Figure 1.6, Trial Balance.

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At this point, the accounts are in balance… …however, it is necessary to determine that all

revenue earned and expenses incurred have been recorded.

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Adjusting entries consist of one or more of the following:


Costs that must be allocated to one or more accounting period. An example is recording depreciation for property, plant and equipment.




Revenue collected in advance. An example is collecting fees or revenue in advance of providing a service. The unearned fees or revenue are credited to a liability account with a similar account title. If any or all of the unearned fees are earned an adjusting entry is needed.

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Adjusting entries consist of one or more of the following, cont.:


Unrecorded expenses. An example is wages incurred but not yet paid. Typically at the end of the month there are one or more days of unpaid wages due to the payroll period.




Unrecorded revenue. An example is a company that has provided a service but hasn’t collected or billed the customer.

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Adjustments Adjustments are needed to take the accounts from a cash basis and put them on an accrual basis, which is required by GAAP.

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Let’s take a moment and review accrual accounting: • Revenue is recorded in the period earned regardless of when the cash is collected, and • Expenses are recorded in the period incurred regardless of when the cash is paid.

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Polling Question

The first four steps in the accounting cycle must be completed before the financial statements are prepared.

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Accounting Cycle Reminder The first four steps in the accounting cycle must be completed before the financial statements are prepared. 1. Recording transactions in a journal. 2. Posting transactions from the journal to ledger accounts [a formal “T” account]. 3. Preparing a trial balance to ascertain whether the debits equal the credits. 4. Preparing end-of-period adjustments to record transactions needed but not yet journalized.

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Accounting Cycle Fact Up through this point in the accounting cycle,

no one other than the accounting department cares about steps 1-4.. However, everyone [particularly the owner(s)] is interested in the financial statements!

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Polling Question

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The Balance Sheet

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The Balance Sheet While the balance sheet is the first financial statement presented, it is important to note that the income

statement is the first financial statement prepared. The balance sheet is prepared as of a point in time, not for a period of time. The balance sheet is generally prepared in a classified format.

Refer to: Pages 14-17, Figure 1.7, Balance Sheet.

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Assets Assets are either current, meaning already in the form of cash or will be converted to cash or consumed within one year (or the operating cycle, if longer), or noncurrent.

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Liabilities Similarly, liabilities are either current, meaning amounts the business owes that it expects to liquidate using current assets or the creation of other current liabilities, or noncurrent.

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Equity consists of…



investments by the owners accumulated earnings [the summary of the monthly net profits and losses].

When stock companies pay dividends [from accumulated earnings], equity is reduced.

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The Balance Sheet is used to:










determine the liquidity of the business assess the business’s financial flexibility provide information about returns on investment evaluate the financial structure of the business review the financial health of the business in accordance with GAAP

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Polling Question

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The Income Statement

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Income Statement The income statement is prepared for a period of time, not as of a point in time like the balance sheet. The period of time may be for a month, quarter, semiannual, year, etc. Refer to: Page 20, Figure 1.11, Income Statement.

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Polling Question

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Income Statement, cont. Some users consider the income statement as a company’s report card. Readers of the income statement typically want to know how a company performed: • in the current accounting period • compared to the previous period • compared to the budget • compared to companies in its peer group or in a similar industry.

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Polling Question

Refer to: Page 21, Figure 1.12, Revised Balance Sheet. The equity section illustrates the change in equity that results from the net income.

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Income Statement Formats The income statement can be presented in any of the following three formats: • Single-step • Multiple-step • Condensed

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Single-step A single-step income statement displays both revenues and expenses to arrive at the net income or loss for the accounting period. Refer to: Page 27, Appendix A for an example of the single-step income statement.

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Multiple-step The multiple-step income statement displays information in a more helpful format. Operating transactions are separated from nonoperating transactions to provide the reader pertinent information about the operations. Refer to: Page 28, Appendix B for an example of the multiple-step income statement.

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Condensed The condensed income statement displays revenues and expenses by group, such as, selling and administrative expenses. Refer to: Page 29, Appendix C for an example of the condensed income statement.

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Chapter 2 The GAAP Self-Regulatory Framework

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Chapter 2

Chapter 2 introduces a lot of terminology [yawn].

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Generally Accepted Accounting Principles

(GAAP) Generally Accepted Accounting Principles (GAAP) is a technical term that encompasses the conventions, rules and procedures necessary to define acceptable accounting practice at a particular time. These principals have evolved over time.

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The Cornerstone of GAAP The cornerstone on which the conceptual framework of GAAP is built consists of the following principles: • • • •

revenue recognition expense recognition accruals deferrals

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Nine Basic Concepts that underlie GAAP:





entity – the transactions of a business entity are accounted for separately from the owners personal transactions. going concern – in the absence of contrary evidence, a business is assumed to continue forever.

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Nine Basic Concepts that underlie GAAP: cont.





Stable monetary unit – all transactions are recorded at cost, ignoring inflation. Consistency/comparability – the same accounting principles are applied from period to period [consistency], while the information appearing in the financial statements is displayed in the same manner [comparability].

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Nine Basic Concepts that underlie GAAP: cont.





Revenue realization/recognition – revenue is recorded in the accounting period earned. Cash receipt is not a requirement. Doctrine of conservatism – gains or profits are not recognized until realized, whereas, losses when probable and estimable are recognized.

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Nine Basic Concepts that underlie GAAP: cont.


Matching/Materiality – expenses incurred to produce revenue are recorded in the same accounting period as the revenue [matching]. Financial statements should not include a dollar misstatement or omission that would adversely influence the financial statement reader [materiality].

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Nine Basic Concepts that underlie GAAP: cont.


Asset valuation – assets initially recorded at cost and then adjusted to reflect proper accounting values.

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Nine Basic Concepts that underlie GAAP: cont.


Fair presentation/full disclosure – a complete set of financial statements and all appropriate disclosures be presented to the users [fair presentation]. The financial statements should include sufficient information for readers to make knowledgeable decisions about the company [full disclosure].

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Time for the Rule Makers


Securities and Exchange Commission [SEC] – a federal agency that administers the Securities Exchange Act of 1934. The SEC is the “watchdog” over the integrity of financial reporting for publicly traded companies.

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Time for the Rule Makers


(cont.)

Companies that issue securities to the public or are listed on a stock exchange are required to file annual, audited financial statements with SEC. The SEC also prescribes the accounting practices and standards that publicly owned companies must follow; yet has relegated its duty to the private sector.

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Time for the Rule Makers


(cont.)

American Institute of Certified Public Accountants [AICPA] – the national professional organization of CPAs, and a significant contributor in the development of GAAP.

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Time for the Rule Makers


(cont.)

Financial Accounting Standards Board – created by the AICPA in 1973, in part to avoid governmental rule making. FASB has its own staff of professionals and has a mandate to establish and improve standards of financial accounting and reporting.

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Questions? Select *1 now to ask a live question through the phone or Type your question into the chat box in the lower left corner of the screen and click on the “Send” button located right below the box.

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Your feedback is important to us! Don’t forget to complete the seminar survey. 1. Simply click on the “Seminar Survey” in the LINKS area to the left of this slide. 2. From the drop-down box at the top of the survey, choose the “Accounting Basics” series. 3. Complete the survey and click on “Submit” to send us your responses

This concludes the first of four sessions. Thank you for your participation.

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