Chapter 4: The Mechanics of Financial Accounting

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2 Chapter 4: The Mechanics of Financial Accounting 2

3 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, (20,000) 20,000 = 3. = 9, = 5. = 9,000 8,000 8,000 Rev. (5,500) (5,500) Exp. (500) (500) Div. 6. = Tot. 13, , ,000= 9, , ,000 5

6 Exercise 4-3 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 4-3 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 The journal entry is an efficient representation of economic events and how they affect the accounting equation. 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 and Figure 4-7 (previous slide): 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 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 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 T- Accounts Running tally of the affect of transactions on an account in the General Ledger. We call this process posting to the GL. The running tally makes it possible to complete trial balances and financial statements. 16

17 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 17

18 Recognizing Gains and Losses 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. 18

19 Periodic Adjustments 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). 19

20 Types of Periodic Adjustments 1. Accruals (expenses and revenues) 2. Deferrals (expenses and revenues) 3. Revaluation adjustments 20

21 Example - Accrual of Expenses Probably the most common type of AJE. Ex: accrue wages at the end of the period: Wages Expense xx Wages Payable xx 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. Other examples of expense/payable include interest, rent, taxes. 21

22 Example - 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. 22

23 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 contributes to the generation of revenue (revenue recognition), 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). 23

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25 Deferral of Expenses Example: Purchase 1 year insurance policy. Journal Entry at time of purchase: Prepaid Insurance xx Cash xx Adjustment at the end of the period (for the portion that has been used): Insurance Expense Prepaid Insurance xx xx 25

26 Deferral of Expenses (cont d) Example: purchase of equipment. Journal Entry at time of purchase: Equipment xx Cash Adjustment at end of the period (for the portion that has been used): Depreciation Expense xx Accumulated Depreciation xx xx 26

27 Deferral of Expenses (cont d) Intangible Assets are often capitalized as well and amortized over their useful life: Patent xx Cash xx Adjustment at end of the period (for the portion that has been used): Amortization Expense xx Accumulated Amortization xx 27

28 Deferral of Revenues Cash is received from customer before goods/services are delivered (before revenue can be recognized). Ex: Received cash for an airline ticket for a flight to take place at a future date. Journal Entry at time cash received: Cash xx Unearned Revenues xx Adjustment at end of the period (for portion completed): Unearned Revenues xx Ticket Revenues xx 28

29 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 Accounts receivable Inventories 29

30 Preparing Adjusting Journal Entries - 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 30

31 Preparing Adjusting Journal Entries - 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 31

32 Preparing Adjusting Journal Entries - P4-8 e. AJE at 12/31 for interest owed to the bank on the notes payable. Use Principal x Rate x Time 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 600 to 32

33 Preparing Adjusting Journal Entries - 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

34 Reporting Difficulties Faced by Multinational Companies Multinationals have a home in one country but operate, own subsidiaries, or raise capital in others. Financials must be consolidated data is in difference Languages Currencies Using difference accounting standards Conversion and consolidation Costly Time consuming 34

35 Adjusted Trial Balance The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger. The balance sheet accounts reflect the end-of-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. 35

36 Financial Statements The financial statements for Kelly Supply (upcoming 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 (see appendix). 36

37 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. 37

38 Financial Statement Examples - Kelly Supply 38

39 Figure

40 Figure

41 T- Account Analysis and the statement of Cash Flows *Appendix 4- A Two methods are used to present the statement of cash flows the direct method and the far more common indirect method. 41

42 *Appendix 4- A The statement of cash flows can be prepared from two balance sheets, an income statement, and some additional information. The approach involves T-account analysis. 42

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