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  • Chapter 4: The Mechanics of Financial Accounting
  • 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
  • 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.
    View slide
  • Exercise 4-2 Spreadsheet
    • Cash + A/R + Land = N/P + CC + RE
    • 1. =
    • 2. =
    • 3. =
    • 4. =
    • 5. =
    • 6. _____ _____ _____= _____ _____ _____
    View slide
  • Exercise 4-2 Financial Statements
    • Income Statement
    • Revenues ______
    • Expenses ______
    • Net Income ______
    • Statement of Retained Earnings
    • RE (beginning) ______
    • Add: Net Income _______
    • Less: Dividends _______
    • RE (ending) ______
  • Exercise 4-2 Financial Statements
    • Balance Sheet
    • Assets
    • Cash ______
    • A/R ______
    • Land ______
    • Total ______
    • Liabilities and S.E.
    • N/P ______
    • CS ______
    • RE (ending) ______
    • Total ______
  • 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 not sufficient.
    • Therefore accountants use a “double entry” system based on debits and credits.
  • 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.
  • Effect of Debits and Credits
    • Based on the accounting equation, we can increase or decrease various accounts depending on their classification:
    • Assets = Liabilities + Equity
    • Increase DR = CR CR
    • Decrease CR = DR DR
    • Note that we use debits and credits instead of plusses and minuses.
  • 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 .
  • 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.
  • Now back to E4-2, and prepare the other journal entries:
    • 2: Purchased land for $20,000 cash.
    • 3: Borrowed $9,000 cash from bank.
  • Now back to E4-2, and prepare the other journal entries:
    • 4: Provided services (on account) $8,000.
    • 5: Paid $5,500 cash for expenses.
  • Now back to E4-2, and prepare the other journal entries:
    • 6: Paid $500 cash dividend to owners.
    • Note that dividends is a contra equity and reduces retained earnings.
  • 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
  • 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.
  • 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.
  • 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.
  • Back to E4-2: Posting to G/L Now post transactions (for cash) to “T” account: Cash
  • 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).
  • 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
  • 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).
  • Types of AJEs
    • 1. Accrual of expenses
    • 2. Accrual of revenues
    • 3. Deferrals of expenses
    • 4. Deferrals of revenues
    • 5. Revaluation adjustments
  • 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.
  • 1. 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.
  • 2. Accrual of Revenues
    • For revenues that have not yet been recorded at the end of the period.
    • Ex: accrue interest revenue:
    • Interest Receivable xx
    • Interest Revenue xx
    • Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received.
  • 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).
  • 3.Deferral of Expenses
    • Example: Purchase 1 year insurance policy.
    • Daily JE at time of purchase:
    • Prepaid Insurance xx
    • Cash xx
    • AJE at end of the period (for the portion that has been used):
    • Insurance Expense xx
    • Prepaid Insurance xx
  • 3.Deferral of Expenses
    • Example: purchase of inventory.
    • Daily JE at time of purchase:
    • Merchandise Inventory xx
    • Cash 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.
  • 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).
  • 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 xx
    • AJE at end of the period (for portion):
    • Unearned Revenues xx
    • Subscription Revenues xx
  • 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.
  • P4-8
    • a. AJE at 12/31 for supplies used:
    • b. AJE at 12/31 for rent owed:
  • P4-8
    • c. AJE at 12/31 for services performed:
    • d. AJE at 12/31 for depreciation:
  • 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):
  • P4-8
    • f. AJE at 12/31 for amount owed for advertising:
    • g. AJE at 12/31 for insurance used from 7/1 to 12/31:
  • 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.
  • 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.
  • 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.
  • 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.
  • 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.
  • 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
  • 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
  • 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
  • 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
  • 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.