CHAPTER 4 The Mechanics of Financial Accounting

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1 CHAPTER 4 The Mechanics of Financial Accounting SYNOPSIS This chapter covers the mechanics underlying preparation of financial statements and how they help to ensure that a company s transactions are accurately and completely accounted for. After completing this chapter, students should be able to construct financial statements from economic events. The author discusses economic events and the criteria necessary before such events can be reflected in the financial statements. The author describes the fundamental accounting equation and explains its relationship to the economic events that are reflected in the financial statements. The author explains the use of journal entries and T-accounts to capture the effects of economic events on the accounting equation and the financial statements. The author also describes how and why periodic adjustments to financial statements are made to reflect economic events that are not represented by transactions. Some of the reporting issues faced by multinationals are discussed. This chapter covers the mechanics of the financial accounting process from an economic consequences perspective, emphasizing that managers must understand the mechanics that link their choice of transactions to the financial statements. Appendix 4A further covers the mechanics from a financial statement user s perspective, explaining how managers in their role as users can infer from financial statements the events and transactions that occurred during the accounting period. Appendix 4A describes how the statement of cash flows can be prepared by using of T-account analysis. The ethics vignette addresses the subjectivity involved in decisions to capitalize or expense costs. The Internet research exercise explores accounting for the United States federal government. The following key points are emphasized in Chapter 4: 1. Two criteria necessary for economic events to be reflected in the financial statements. 2. The accounting equation and how it relates to the balance sheet, income statement, statement of shareholders equity, and statement of cash flows. 3. Journal entries (and T-accounts) and how they express the effect of economic events on the basic accounting equation and the financial statements. 4. Why managers need to understand how economic events affect the financial statements. 5. Why the financial statements are adjusted periodically to reflect certain economic events.

2 TEXT/LECTURE OUTLINE The mechanics of financial accounting. I. Economic events must be both relevant and objectively measurable to be included in the financial statements. A. Relevant means that the event has economic significance to the company. B. Objectively measurable means that parties with differing incentives reach agreement on the value of the event and that those events are backed by documentary evidence which can be audited. II. The fundamental accounting equation. A. Assets = Liabilities + shareholders' equity. B. Business transactions, the accounting equation, and the financial statements. 1. Transactions and the accounting equation. 2. The accounting equation and the financial statements. III. The journal entry. A. A journal entry records the economic event in a journal that thereby enters the event in the company's accounting records. B. The double entry system. 1. Debit is defined as the left-hand side. 2. Credit is defined as the right-hand side. C. All journal entries have three components: 1. The accounts affected. 2. The direction of the effect. 3. The dollar value of the transaction. D. T-accounts are useful for keeping running tallies of balances for each account. E. Financial statements can be prepared from T-accounts. IV. Recognizing gains and losses. V. Periodic adjustments. A. Periodic adjustments are necessary because not all economic events that occur during the accounting period are captured by an exchange transaction in the same accounting

3 period. Accrual accounting requires that all economic events that have occurred during the accounting period be recognized to achieve a proper matching of revenues and expenses. B. Periodic adjustments take one of three forms. 1. Accruals. a) Accrue means to build up gradually. Accrual adjustments recognize economic events that have occurred in the current accounting period but have not yet been captured in an exchange transaction. b) Accrued expenses. (1) Accrued expenses are expenses that have been incurred but not yet paid. (2) The appropriate journal entry would be to debit an expense account and credit a liability account. c) Accrued revenues. (1) Accrued revenues are revenues that have been earned but cash collection has not yet occurred. (2) The appropriate journal entry would be to debit a receivable account and credit a revenue account. 2. Deferrals (or cost expirations). a) Asset capitalization and the matching principle. b) Expense or capitalize examples. c) Current assets. (1) Supplies inventory. (2) Merchandise inventory. (3) Prepaid expenses. (4) Unearned (deferred) revenues. (5) Property, plant and equipment. (6) Intangible assets (7) Capitalizing and matching: examples 3. Revaluation adjustments. VI. Reporting difficulties faced by multinational companies.

4 VII. T-Account analysis and preparing the statement of cash flows (Appendix 4A). A. Operating items. B. Non-operating items. C. Indirect form of presentation. VIII. Review problem. IX. Ethics in the real world. X. Internet research exercise. LECTURE TIPS 1. Particular attention should be given to helping students in deciding whether an economic event has accounting significance and should be recorded. It would be worthwhile to spend some time covering the concepts of relevant and objectively measurable. Further, discussing different economic events that would be recorded (such as purchasing inventory) or would not be recorded (such as signing a new union contract) in a journal entry would be worthwhile. 2. Often students need extra help understanding how to record economic events. In particular, students need help to understand (1) which accounts have debit and credit balances and (2) how debits and credits affect particular accounts. A useful approach is to break the recording process down into two distinct steps. The first step is to have students record economic events on the accounting equation (similar to Figure 4 2) expanded to include revenue, expense, and dividend accounts. This step prepares them (1) to work with revenue, expense, and dividend accounts, which are difficult for many students to grasp, and (2) to address which accounts are affected and how the accounts are affected without having to worry about debits or credits. The second step is to have students prepare journal entries for the transactions they recorded in the first step. This step allows students to focus exclusively on the debits and credits. 3. Students need help in understanding what each account represents and measures to be able to analyze economic events and prepare the appropriate journal entry. A written assignment or inclass presentation that requires them to explain what a particular account balance represents is recommended. 4. Many introductory students have difficulty differentiating between cash collections and revenue, and between cash disbursements and expenses. It is critical that these differentiations are made when discussing revenues and expenses so that students will be able to correctly analyze economic events and prepare journal entries. 5. Extra effort is often needed to help students understand adjusting entries. The key to this is the students understanding of the relationship of specific income statement accounts to specific balance sheet accounts. A suggested method for helping students understand how specific accounts on these two statements fit together is to have students create T-accounts for balance sheet and income statement accounts. They should then indicate what the beginning and ending

5 balances in each account represent, what economic events cause various accounts to increase or decrease, and which economic events affect more than one account. It is this last step that should help students better understand the relationships between income statement and balance sheet accounts. This exercise is also very useful in helping students understand which accounts have permanent balances and which ones have temporary balances; why some accounts have permanent balances; and what each account balance represents. Other potential ways to help students understand the relationships between specific income statement and balance sheet accounts are listed below: a. Presenting several examples of each type of adjustment. b. Discussing the effects on the financial statements of not making a required adjusting journal entry. c. Converting from accrual accounting amounts to cash accounting amounts or vice versa. It is also important for students to understand why adjusting entries are necessary. This understanding comes when students truly comprehend the difference between accrual accounting and cash-basis accounting. Spending time illustrating the differences using examples relevant to the students is strongly recommended. 6. Students need help in grasping the rationale for closing entries. Time should be spent discussing why temporary accounts are used rather than recording events affecting revenues, expenses, and dividends directly in the retained earnings account. A particularly useful approach is to have students record economic events on the accounting equation (similar to Figure 4 2) expanded to include revenue, expense, and dividend accounts. After recording the events, point out that assets do not equal the sum of liabilities and shareholders' equity unless the balances in the temporary accounts are considered. ANSWERS TO IN-TEXT DISCUSSIONS QUESTIONS Page No Yes, the pharmaceuticals and the software companies become more valuable when critical events occur such as those described. Nonetheless, those events are not recorded in the financial statements, because they have not yet reached the point where their impact on the financial statements can be objectively measured The purchase of inventory by a retailer from a supplier ordinarily results in an increase in the current asset, inventory, and a corresponding increase in the current liability, accounts payable The basic accounting equation applied to the balance sheet of Zimmer Holdings is: Assets = Liabilities + Contributed Capital + Retained Earnings $7,239 = $1,585 + $1,268 + $4, Coca Cola s purchase of $2 billion of property, plant, and equipment would both increase and decrease assets by the same amount, because property, plant, and equipment would increase and cash would decrease. The borrowing of $4.3 billion would increase an asset, cash, and increase a liability, notes payable.

6 121. Target s balance sheet, with total assets of $44,106 (million) and total liabilities and shareholders equity of $$44,106 (million) epitomizes the accounting equation (Assets = Liabilities + Shareholders Equity) The statement of cash flows summarizes the increases and decreases in cash for a period of time but has little direct relationship to the accounting equation. The accounting equation, however, is used extensively in the analysis necessary to prepare the statement of cash flows. The income statement summarizes the effects of transactions for a period of time on the retained earnings as reflected in the equity section of the balance sheet. The statement of shareholders equity summarizes the increases and decreases in the equity accounts for a period of time. It is useful to understand that the balance sheet which reflects the accounting equation as of a specific point in time, is linked to other balance sheets (as of other specific points in time i.e. the beginning and end of an accounting period), by the income statement, the statement of cash flows and the statement of shareholders equity. The four statements together provide a pretty complete picture of all the economic activity of the entity for a period of time Revenue of $36.1 (billion) at Cisco would increase assets, specifically accounts receivable, and correspondingly increase shareholders equity, specifically retained earnings. The journal entry (in billions) would be: DR CR Accounts receivable (+A) 36.1 Revenue (R, +SE) The loss arises because the (adjusted) cost of the asset sold was greater than the amount realized from the sale The transaction could be summarized (dollars in millions) as follows: DR CR Cash (+A) 53.3 Investment in subsidiary 27.6 Gain on sale of subsidiary (R, +SE) Accrued liabilities of $6 billion at Honeywell represent expenses incurred, but not yet paid by year-end Typical examples include wages and interest Capitalization of routine maintenance expenses violates the matching principle because this type of expense should be matched against the current revenues of the period and should reduce net income. Capitalization of costs suggests they will benefit future periods and should be matched against future revenues. By capitalizing such expenses management seriously (and fraudulently) overstated net income. Routine maintenance expenses are always expensed (under GAAP) in the period in which they are incurred The use of different accounting principles, US GAAP as opposed to IFRS, means that in order to compare apples to apples, an analyst would need to convert one set of financial statements into the accounting method used by the other Journal entries would be as follows (billions):

7 DR CR Accounts receivable (+A) 9.4 Sales (R, +SE) 9.4 To record revenues Interest expense (E, SE).108 Cash(-A).108 Interest costs on debt (current period expense) Inventory (+A) 7.3 Accounts payable (+L) 7.3 Inventory purchases on account Property, plant, and equipment (+A).254 Cash (-A).254 Purchase PPE (future period asset) Depreciation and amortization (E, SE).5 Accumulated depreciation and amortization ( A).5 Adjust for useful life expired

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