Chapter 4: The Mechanics of Financial Accounting

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2 Chapter 4: The Mechanics of Financial Accounting 2

3 Chapter 4: The Mechanics of Financial Accounting The first step in the accounting process is transaction analysis. This process examines relevant, objectively measurable economic events through their effect on the accounting equation: Assets = Liabilities + Equity 3

4 Now look at E4-2 Spreadsheet Using a spreadsheet approach, analyze the transactions. (Spreadsheet on next slide.) Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions. 4

5 Exercise 4-2 Spreadsheet Cash + A/R + Land = N/P + CC + RE 1. = 30,000 30,000 (20,000) 20, = 9,000 9,000 8,000 8,000 Rev. 3. = 4. = 5. (5,500) = 6. = (500) (5,500) Exp. (500) Div. Tot. 13, , ,000 = 9, , ,000 5

6 Exercise 4-2 Financial Statements Income Statement Revenues $8,000 Expenses 5,500 Net Income $2,500 Statement of Retained Earnings RE (beginning) $ 0 Add: Net Income 2,500 Less: Dividends (500) RE (ending) $2,000 6

7 Exercise 4-2 Financial Statements Balance Sheet Assets Cash $13,000 A/R 8,000 Land 20,000 Total $41,000 Liabilities and S.E. N/P $ 9,000 CS 30,000 RE (ending) 2,000 Total $41,000 7

8 Now look at E4-2 Spreadsheet Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is inefficient. Therefore accountants use a double entry system based on debits and credits. 8

9 Double Entry Accounting Debit (dr) - means an entry to the left hand side of an account. Credit (cr) - means an entry to the right hand side of an account. Note that a debit or credit, per se, does not indicate increase or decrease. To decide the effect of a debit or credit, the type of account must be considered. 9

10 Effect of Debits and Credits Based on the accounting equation, we can increase or decrease various accounts depending on their classification: Note that we use debits and credits instead of plusses and minuses. 10

11 The following rules can be derived from the basic formula: Assets have normal debit balances and are increased with a debit. Liabilities and equities have normal credit balances and are increased with a credit. Revenues (a part of equity) have normal credit balances and are increased with a credit. Expenses (which decrease equity) have normal debit balances and are increased with a debit. Dividends (which decrease equity) have a normal debit balance and are increased with a debit. 11

12 The Format of a Journal Entry To initially record transactions, we use a journal entry to represent the debits and credits. For example, in E4-2, Item 1: Debit Credit Cash 30,000 Common Stock 30,000 Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount. 12

13 Now back to E4-2, and prepare the other journal entries: 2: Purchased land for $20,000 cash. Land 20,000 Cash 20,000 3: Borrowed $9,000 cash from bank. Cash 9,000 Notes Payable 9,000 13

14 Now back to E4-2, and prepare the other journal entries: 4: Provided services (on account) $8,000. Accts. Receivable 8,000 Service Revenue 8,000 5: Paid $5,500 cash for expenses. Expenses 5,500 Cash 5,500 14

15 Now back to E4-2, and prepare the other journal entries: 6: Paid $500 cash dividend to owners. Dividends 500 Cash 500 Note that dividends is a contra equity account and ultimately reduces retained earnings. 15

16 The Accounting Cycle (more detail in Appendix 4A) Components of the accounting cycle include: A. Preparation of Daily Journal Entries -Post to the General Ledger -Unadjusted Trial Balance B. Preparation of Adjusting Journal Entries -Post to the General Ledger -Adjusted Trial Balance C. Financial Statements D. Closing Journal Entries -Final Trial Balance 16

17 A. Daily Journal Entries (DJEs) The first step in the accounting process. Prepared for daily activity. Usually journalized in special journals for efficiency, but we will record in General Journal format. Identified through a document flow: cash receipt, record a cash sale charge receipt, record a credit sale bank note, record a notes payable employee time card, record wages E 4-2 transactions are DJEs. 17

18 Another Example of DJE Often, investments and noncurrent assets are sold for more or less than the amounts at which they are carried on the balance sheet. In such cases a gain (if a credit) or loss (if a debit) must be recognized. Ex: Land that cost $10,000 is sold for $11,000 cash. Prepare the GJE: Cash 11,000 Land 10,000 Gain on Sale of Land 1,000 Note: gains are a form of revenues and losses are a form of expenses on the income statement. The sale of inventory is recorded in a different manner discussed in Chapters 4 and 7. 18

19 The General Ledger (G/L) The G/L serves as a place to total amounts by account titles. After DJEs and AJEs are recorded, they are posted (by account) to the G/L. We will use T accounts to represent G/L accounts where needed. Appendix 4A discusses T accounts in more detail. 19

20 Back to E4-2: Posting to G/L Now post transactions (for cash) to T account: Cash 30,000 9,000 20,000 5, Bal. 13,000 20

21 Unadjusted Trial Balance Trial balances are prepared throughout the accounting cycle. The Unadjusted Trial Balance represents G/L totals (by account) at a particular point in time. For E4-2, the Unadjusted Trial Balance would consist of a list of all of the ending debit or credit balances taken from the various T account totals (illustrated on the next slide). The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter). 21

22 Unadjusted Trial Balance - Exercise 4-2 (after posting and totaling G/L accounts) Debit Credit Cash 13,000 Accounts Receivable 8,000 Land 20,000 Notes Payable 9,000 Contributed Capital 30,000 Retained Earnings 2,000 Totals 41,000 41,000 22

23 B. Adjusting Journal Entries (AJEs) Prepared at the end of the accounting period to align revenues and expenses (matching). Usually NO document flow to trigger recording. Based on the accrual system of accounting which records revenues as earned and expenses as incurred (rather than based on cash flows). 23

24 Types of AJEs 1. Accrual of expenses 2. Accrual of revenues 3. Deferrals of expenses 4. Deferrals of revenues 5. Revaluation adjustments 24

25 Accrual System vs. Accrual AJEs The accrual system of accounting and accrual of revenues and expenses are both discussed in this chapter. Note that the accrual of revenues and expenses is a subset of the AJEs discussed in this chapter. In comparison, the accrual system of accounting refers to the entire process of revenue and expense recognition, and relates to the definitions of matching and revenue recognition discussed in Chapter 3. 25

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27 1. Accrual of Expenses Probably the most common type of AJE. Ex: accrue wages at the end of the period: Wages Expense Wages Payable Note: this is a skeletal journal entry, where the xx simply indicate values to be calculated later. The focus is on the account and direction. xx xx Other examples of expense/payable include interest, rent, taxes. 27

28 2. Accrual of Revenues For revenues that have not yet been recorded at the end of the period. Ex: accrue interest revenue: Interest Receivable Interest Revenue xx xx Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received. 28

29 3.Deferral of Expenses This category of AJE relates to the concept of asset capitalization and the matching principle. Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset is recognized at that time. As the asset is used up in the generation of revenue, the related cost is recognized as an expense (matching). Some expenses are deferred for a short period of time (Supplies Expense), and some expenses are deferred for many years (Depreciation Expense). 29

30 3.Deferral of Expenses Example: Purchase 1 year insurance policy. Daily JE at time of purchase: Prepaid Insurance Cash xx xx AJE at end of the period (for the portion that has been used): Insurance Expense Prepaid Insurance xx xx 30

31 3.Deferral of Expenses Example: purchase of inventory. Daily JE at time of purchase: Merchandise Inventory Cash xx xx AJE at end of the period (for the portion that has been sold): Cost of Goods Sold xx Merchandise Inventory xx Note: the treatment of merchandise inventory is expanded significantly in Chapter 7. 31

32 3.Deferral of Expenses Example: purchase of equipment. Daily JE at time of purchase: Equipment xx Cash xx AJE at end of the period (for the portion that has been used): Depreciation Expense xx Accumulated Depreciation xx Note: Accumulated Depreciation is a contra asset account, and is presented as an offset to Equipment on the balance sheet (more in Chapter 9). 32

33 4.Deferral of Revenues Cash is received from customer before goods/services are delivered (before revenue can be recognized). Ex: Received subscription in advance. Daily JE at time cash received: Cash xx Unearned Revenues AJE at end of the period (for portion): Unearned Revenues xx Subscription Revenues xx xx 33

34 5. Revaluation Adjustments These are adjustments that do not fall into the categories of accruals or deferrals. They serve to restate certain accounts to keep their reported values in line with existing facts. Examples include the revaluation of: short-term investments inventories More in later chapters. 34

35 P4-8 a. AJE at 12/31 for supplies used: (85,000-30,000 unused = $55,000 used) Supplies Expense 55,000 Supplies 55,000 b. AJE at 12/31 for rent owed: Rent Expense 2,400 Rent Payable 2,400 35

36 P4-8 c. AJE at 12/31 for services performed: (18,000 x 2/3 = 12,000 earned by 12/31) Unearned Revenue 12,000 Service Revenue 12,000 d. AJE at 12/31 for depreciation: (500,000/10 = 50,000 per year) Depreciation Expense 50,000 Accumulated Depr. 50,000 36

37 P4-8 e. AJE at 12/31 for interest owed to the bank on the notes payable. Use Principal x Rate x Time to calculate the interest owed from July 1 to Dec. 31 (6 months): P x R x T 10,000 x.12 per year x 6/12 of a year Interest Expense 600 Interest Payable

38 P4-8 f. AJE at 12/31 for amount owed for advertising: Advertising Expense 28,000 Advertising Payable 28,000 g. AJE at 12/31 for insurance used from 7/1 to 12/31: ($350 x 1/2 year) Insurance Expense 175 Prepaid Insurance

39 Adjusted Trial Balance The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger. The balance sheet accounts reflect the endof-year balances, and the income statement accounts reflect the proper revenues and expense to be recognized for the year. This list of accounts and amounts is used to prepare the balance sheet and income statement. 39

40 C. Preparation of Financial Statements from the Adjusted Trial Balance The amounts in the Adjusted Trial Balance are used to prepare the balance sheet and the income statement. The statement of stockholders equity (SSE) requires some additional investigation. Remember from Chapter 3 that the SSE shows all activity during the period for contributed capital and retained earnings. 40

41 Contributed Capital and Retained Earnings The contributed capital in the adjusted trial balance is an ending balance; the ledger account must be examined to see if any activity (like issue of additional stock) occurred. The retained earnings on the adjusted trial balance is a beginning balance; while the revenues, expenses and dividends are displayed in the trial balance, they have not yet been included in (closed to) retained earnings. 41

42 Financial Statements The financial statements for Kelly Supply (next 4 slides), and other examples in text, can be used as guidelines to prepare financial statements. The financials should be prepared in the following order: income statement (I/S) statement of stockholders equity (SSE) balance sheet (B/S) Note that the statement of cash flow (SCF) is not prepared from the adjusted trial balance, but from a detailed analysis of the cash flow activities of the company. 42

43 Financial Statements Comments on the preparation of financial statements from adjusted trial balance (ATB): revenue and expense balances from the ATB are carried to the income statement. net income is carried to the retained earnings column in the SSE. other activity, like dividends and issue of stock, are reflected in the SSE. ending balances in the SSE are carried to the stockholders equity section of the balance sheet. asset and liability balances from the ATB are carried to the balance sheet. 43

44 Financial Statement Examples - Kelly Supply 44

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47 Appendix 4-A Two methods are used to present the statement of cash flows the direct method and the far more common indirect method. 47

48 Appendix 4-A The statement of cash flows can be prepared from two balance sheets and an income statement. The approach involves T-account analysis. 48

49 D. Closing Journal Entries (CJEs) Prepared after the financial statements have been completed. Close temporary accounts to retained earnings, so that the balances in those accounts at the start of the next accounting period will be zero. Temporary accounts include revenues, expenses and dividends. The final trial balance after closing will display only permanent, balance sheet accounts. 49

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