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  1. 1. Chapter 4: The Mechanics of Financial Accounting
  2. 2. Chapter 4: The Mechanics of Financial Accounting <ul><li>The first step in the accounting process is transaction analysis. </li></ul><ul><li>This process examines relevant, objectively measurable economic events through their effect on the accounting equation: </li></ul><ul><li>Assets = Liabilities + Equity </li></ul>
  3. 3. Now look at E4-2 Spreadsheet <ul><li>Using a spreadsheet approach, analyze the transactions. (Spreadsheet on next slide.) </li></ul><ul><li>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. </li></ul>
  4. 4. Exercise 4-2 Spreadsheet <ul><li>Cash + A/R + Land = N/P + CC + RE </li></ul><ul><li>1. = </li></ul><ul><li>2. = </li></ul><ul><li>3. = </li></ul><ul><li>4. = </li></ul><ul><li>5. = </li></ul><ul><li>6. _____ _____ _____= _____ _____ _____ </li></ul>
  5. 5. Exercise 4-2 Financial Statements <ul><li>Income Statement </li></ul><ul><li>Revenues ______ </li></ul><ul><li>Expenses ______ </li></ul><ul><li>Net Income ______ </li></ul><ul><li>Statement of Retained Earnings </li></ul><ul><li>RE (beginning) ______ </li></ul><ul><li>Add: Net Income _______ </li></ul><ul><li>Less: Dividends _______ </li></ul><ul><li>RE (ending) ______ </li></ul>
  6. 6. Exercise 4-2 Financial Statements <ul><li>Balance Sheet </li></ul><ul><li>Assets </li></ul><ul><li>Cash ______ </li></ul><ul><li>A/R ______ </li></ul><ul><li>Land ______ </li></ul><ul><li>Total ______ </li></ul><ul><li>Liabilities and S.E. </li></ul><ul><li>N/P ______ </li></ul><ul><li>CS ______ </li></ul><ul><li>RE (ending) ______ </li></ul><ul><li>Total ______ </li></ul>
  7. 7. Now look at E4-2 Spreadsheet <ul><li>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 not sufficient. </li></ul><ul><li>Therefore accountants use a “double entry” system based on debits and credits. </li></ul>
  8. 8. Double Entry Accounting <ul><li>Debit (dr) - means an entry to the left hand side of an account. </li></ul><ul><li>Credit (cr) - means an entry to the right hand side of an account. </li></ul><ul><li>Note that a debit or credit, per se, does not indicate increase or decrease. </li></ul><ul><li>To decide the effect of a debit or credit, the type of account must be considered. </li></ul>
  9. 9. Effect of Debits and Credits <ul><li>Based on the accounting equation, we can increase or decrease various accounts depending on their classification: </li></ul><ul><li>Assets = Liabilities + Equity </li></ul><ul><li>Increase DR = CR CR </li></ul><ul><li>Decrease CR = DR DR </li></ul><ul><li>Note that we use debits and credits instead of plusses and minuses. </li></ul>
  10. 10. The following rules can be derived from the basic formula: <ul><li>Assets have normal debit balances and are increased with a debit . </li></ul><ul><li>Liabilities and equities have normal credit balances and are increased with a credit . </li></ul><ul><li>Revenues (a part of equity) have normal credit balances and are increased with a credit . </li></ul><ul><li>Expenses (which decrease equity) have normal debit balances and are increased with a debit . </li></ul><ul><li>Dividends (which decrease equity) have a normal debit balance and are increased with a debit . </li></ul>
  11. 11. The Format of a Journal Entry <ul><li>To initially record transactions, we use a journal entry to represent the debits and credits. </li></ul><ul><li>For example, in E4-2, Item 1: </li></ul><ul><li> Debit Credit </li></ul><ul><li>Cash 30,000 </li></ul><ul><li>Common Stock 30,000 </li></ul><ul><li>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. </li></ul>
  12. 12. Now back to E4-2, and prepare the other journal entries: <ul><li>2: Purchased land for $20,000 cash. </li></ul><ul><li>3: Borrowed $9,000 cash from bank. </li></ul>
  13. 13. Now back to E4-2, and prepare the other journal entries: <ul><li>4: Provided services (on account) $8,000. </li></ul><ul><li>5: Paid $5,500 cash for expenses. </li></ul>
  14. 14. Now back to E4-2, and prepare the other journal entries: <ul><li>6: Paid $500 cash dividend to owners. </li></ul><ul><li>Note that dividends is a contra equity and reduces retained earnings. </li></ul>
  15. 15. The Accounting Cycle (more detail in Appendix 4A) <ul><li>Components of the accounting cycle include: </li></ul><ul><ul><li>A. Preparation of Daily Journal Entries </li></ul></ul><ul><ul><li>-Post to the General Ledger </li></ul></ul><ul><ul><li> -Unadjusted Trial Balance </li></ul></ul><ul><ul><li>B. Preparation of Adjusting Journal Entries </li></ul></ul><ul><ul><li>-Post to the General Ledger </li></ul></ul><ul><ul><li> -Adjusted Trial Balance </li></ul></ul><ul><ul><li>C. Financial Statements </li></ul></ul><ul><ul><li>D. Closing Journal Entries </li></ul></ul><ul><ul><li>-Final Trial Balance </li></ul></ul>
  16. 16. A. Daily Journal Entries (DJEs) <ul><li>The first step in the accounting process. </li></ul><ul><li>Prepared for daily activity. </li></ul><ul><li>Usually journalized in special journals for efficiency, but we will record in “General Journal” format. </li></ul><ul><li>Identified through a document flow: </li></ul><ul><ul><li>cash receipt, record a cash sale </li></ul></ul><ul><ul><li>charge receipt, record a credit sale </li></ul></ul><ul><ul><li>bank note, record a notes payable </li></ul></ul><ul><ul><li>employee time card, record wages </li></ul></ul><ul><li>E 4-2 transactions are DJEs. </li></ul>
  17. 17. Another Example of DJE <ul><li>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. </li></ul><ul><li>Ex: Land that cost $10,000 is sold for $11,000 cash. Prepare the GJE: </li></ul><ul><li>Cash 11,000 </li></ul><ul><li>Land 10,000 </li></ul><ul><li>Gain on Sale of Land 1,000 </li></ul><ul><li>Note: gains are a form of revenues and losses are a form of expenses on the income statement. </li></ul><ul><li>The sale of inventory is recorded in a different manner – discussed in Chapters 4 and 7. </li></ul>
  18. 18. The General Ledger (G/L) <ul><li>The G/L serves as a place to “total” amounts by account titles. </li></ul><ul><li>After DJEs and AJEs are recorded, they are posted (by account) to the G/L. </li></ul><ul><li>We will use “T” accounts to represent G/L accounts where needed. </li></ul><ul><li>Appendix 4A discusses T accounts in more detail. </li></ul>
  19. 19. Back to E4-2: Posting to G/L Now post transactions (for cash) to “T” account: Cash
  20. 20. Unadjusted Trial Balance <ul><li>Trial balances are prepared throughout the accounting cycle. </li></ul><ul><li>The Unadjusted Trial Balance represents G/L totals (by account) at a particular point in time. </li></ul><ul><li>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). </li></ul><ul><li>The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter). </li></ul>
  21. 21. Unadjusted Trial Balance - Exercise 4-2 (after posting and totaling G/L accounts) <ul><li> Debit Credit </li></ul><ul><li>Cash 13,000 </li></ul><ul><li>Accounts Receivable 8,000 </li></ul><ul><li>Land 20,000 </li></ul><ul><li>Notes Payable 9,000 </li></ul><ul><li>Contributed Capital 30,000 </li></ul><ul><li>Retained Earnings 2,000 </li></ul><ul><li>Totals 41,000 41,000 </li></ul>
  22. 22. B. Adjusting Journal Entries (AJEs) <ul><li>Prepared at the end of the accounting period to align revenues and expenses (matching). </li></ul><ul><li>Usually NO document flow to trigger recording. </li></ul><ul><li>Based on the accrual system of accounting which records revenues as earned and expenses as incurred (rather than based on cash flows). </li></ul>
  23. 23. Types of AJEs <ul><li>1. Accrual of expenses </li></ul><ul><li>2. Accrual of revenues </li></ul><ul><li>3. Deferrals of expenses </li></ul><ul><li>4. Deferrals of revenues </li></ul><ul><li>5. Revaluation adjustments </li></ul>
  24. 24. Accrual System vs. Accrual AJEs <ul><li>The “accrual system of accounting” and “accrual of revenues and expenses” are both discussed in this chapter. </li></ul><ul><li>Note that the “accrual of revenues and expenses” is a subset of the AJEs discussed in this chapter. </li></ul><ul><li>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. </li></ul>
  25. 25. 1. Accrual of Expenses <ul><li>Probably the most common type of AJE. </li></ul><ul><li>Ex: accrue wages at the end of the period: </li></ul><ul><li>Wages Expense xx </li></ul><ul><li>Wages Payable xx </li></ul><ul><li>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. </li></ul><ul><li>Other examples of expense/payable include interest, rent, taxes. </li></ul>
  26. 26. 2. Accrual of Revenues <ul><li>For revenues that have not yet been recorded at the end of the period. </li></ul><ul><li>Ex: accrue interest revenue: </li></ul><ul><li>Interest Receivable xx </li></ul><ul><li>Interest Revenue xx </li></ul><ul><li>Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received. </li></ul>
  27. 27. 3.Deferral of Expenses <ul><li>This category of AJE relates to the concept of asset capitalization and the matching principle. </li></ul><ul><li>Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset is recognized at that time. </li></ul><ul><li>As the asset is “used up” in the generation of revenue, the related cost is recognized as an expense (matching). </li></ul><ul><li>Some expenses are deferred for a short period of time (Supplies Expense), and some expenses are deferred for many years (Depreciation Expense). </li></ul>
  28. 28. 3.Deferral of Expenses <ul><li>Example: Purchase 1 year insurance policy. </li></ul><ul><li>Daily JE at time of purchase: </li></ul><ul><li>Prepaid Insurance xx </li></ul><ul><li>Cash xx </li></ul><ul><li>AJE at end of the period (for the portion that has been used): </li></ul><ul><li>Insurance Expense xx </li></ul><ul><li>Prepaid Insurance xx </li></ul>
  29. 29. 3.Deferral of Expenses <ul><li>Example: purchase of inventory. </li></ul><ul><li>Daily JE at time of purchase: </li></ul><ul><li>Merchandise Inventory xx </li></ul><ul><li>Cash xx </li></ul><ul><li>AJE at end of the period (for the portion that has been sold): </li></ul><ul><li>Cost of Goods Sold xx </li></ul><ul><li>Merchandise Inventory xx </li></ul><ul><li>Note: the treatment of merchandise inventory is expanded significantly in Chapter 7. </li></ul>
  30. 30. 3.Deferral of Expenses <ul><li>Example: purchase of equipment. </li></ul><ul><li>Daily JE at time of purchase: </li></ul><ul><li>Equipment xx </li></ul><ul><li>Cash xx </li></ul><ul><li>AJE at end of the period (for the portion that has been used): </li></ul><ul><li>Depreciation Expense xx </li></ul><ul><li>Accumulated Depreciation xx </li></ul><ul><li>Note: Accumulated Depreciation is a contra asset account, and is presented as an offset to Equipment on the balance sheet (more in Chapter 9). </li></ul>
  31. 31. 4.Deferral of Revenues <ul><li>Cash is received from customer before goods/services are delivered (before revenue can be recognized). </li></ul><ul><li>Ex: Received subscription in advance. </li></ul><ul><li>Daily JE at time cash received: </li></ul><ul><li>Cash xx </li></ul><ul><li>Unearned Revenues xx </li></ul><ul><li>AJE at end of the period (for portion): </li></ul><ul><li>Unearned Revenues xx </li></ul><ul><li>Subscription Revenues xx </li></ul>
  32. 32. 5. Revaluation Adjustments <ul><li>These are adjustments that do not fall into the categories of accruals or deferrals. </li></ul><ul><li>They serve to restate certain accounts to keep their reported values in line with existing facts. </li></ul><ul><li>Examples include the revaluation of: </li></ul><ul><ul><li>short-term investments </li></ul></ul><ul><ul><li>inventories </li></ul></ul><ul><li>More in later chapters. </li></ul>
  33. 33. P4-8 <ul><li>a. AJE at 12/31 for supplies used: </li></ul><ul><li>b. AJE at 12/31 for rent owed: </li></ul>
  34. 34. P4-8 <ul><li>c. AJE at 12/31 for services performed: </li></ul><ul><li>d. AJE at 12/31 for depreciation: </li></ul>
  35. 35. P4-8 <ul><li>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): </li></ul>
  36. 36. P4-8 <ul><li>f. AJE at 12/31 for amount owed for advertising: </li></ul><ul><li>g. AJE at 12/31 for insurance used from 7/1 to 12/31: </li></ul>
  37. 37. Adjusted Trial Balance <ul><li>The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger. </li></ul><ul><li>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. </li></ul><ul><li>This list of accounts and amounts is used to prepare the balance sheet and income statement. </li></ul>
  38. 38. C. Preparation of Financial Statements from the Adjusted Trial Balance <ul><li>The amounts in the Adjusted Trial Balance are used to prepare the balance sheet and the income statement. </li></ul><ul><li>The statement of stockholders’ equity (SSE) requires some additional investigation. </li></ul><ul><li>Remember from Chapter 3 that the SSE shows all activity during the period for contributed capital and retained earnings. </li></ul>
  39. 39. Contributed Capital and Retained Earnings <ul><li>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. </li></ul><ul><li>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. </li></ul>
  40. 40. Financial Statements <ul><li>The financial statements for Kelly Supply (next 4 slides), and other examples in text, can be used as guidelines to prepare financial statements. </li></ul><ul><li>The financials should be prepared in the following order: </li></ul><ul><ul><li>income statement (I/S) </li></ul></ul><ul><ul><li>statement of stockholders’ equity (SSE) </li></ul></ul><ul><ul><li>balance sheet (B/S) </li></ul></ul><ul><li>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. </li></ul>
  41. 41. Financial Statements <ul><li>Comments on the preparation of financial statements from adjusted trial balance (ATB): </li></ul><ul><ul><li>revenue and expense balances from the ATB are carried to the income statement. </li></ul></ul><ul><ul><li>net income is carried to the retained earnings column in the SSE. </li></ul></ul><ul><ul><li>other activity, like dividends and issue of stock, are reflected in the SSE. </li></ul></ul><ul><ul><li>ending balances in the SSE are carried to the stockholders’ equity section of the balance sheet. </li></ul></ul><ul><ul><li>asset and liability balances from the ATB are carried to the balance sheet. </li></ul></ul>
  42. 42. Financial Statement Examples - Kelly Supply Kelly Supply Income Statement For the Year Ended December 31, 2006 Revenues: Sales $27,000 Interest revenue 50 Total revenues $27,050 Expenses: Cost of goods sold $ 9,000 Wages expense 8,000 Rent expense 1,000 Interest expense 3,000 Depreciation expense 3,000 Amortization expense 500 Total expenses . 24,500 Net income $ 2,550
  43. 43. 2,550 (1,000) $6,550 10,000 2,550 (1,000) $6,550 40,000 Kelly Supply Statement of Stockholders’ Equity For the Year Ended December 31, 2006 Common Retained Total Stock Earnings Beginning balance $30,000 $5,000 $35,000 Common stock issuances 10,000 Net income Dividends Ending balance
  44. 44. Kelly Supply Balance Sheet December 31, 2006 Assets: Cash $ 9,500 Accounts receivable 22,000 Interest receivable 50 Merchandise inventory 13,000 Prepaid rent 2,000 Machinery $26,000 Less: Accumulated depreciation 8,000 18,000 Patent 4,500 Total assets $69,050
  45. 45. Kelly Supply Balance Sheet December 31, 2006 Liabilities and stockholders’ equity: Accounts payable $ 5,000 Wages payable 1,000 Interest payable 2,000 Dividends payable 1,000 Unearned revenue 1,000 Short-term notes payable 2,500 Long-term notes payable 10,000 Common stock 40,000 Retained earnings 6,550 Total liabilities and stockholders’ equity $69,050
  46. 46. D. Closing Journal Entries (CJEs) <ul><li>Prepared after the financial statements have been completed. </li></ul><ul><li>Close temporary accounts to retained earnings, so that the balances in those accounts at the start of the next accounting period will be zero. </li></ul><ul><li>Temporary accounts include revenues, expenses and dividends. </li></ul><ul><li>The final trial balance after closing will display only permanent, balance sheet accounts. </li></ul>