Chapter 4: The Mechanics of Financial Accounting

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Chapter 4The Mechanics of Financial
Accounting
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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

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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.

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Exercise 4-2 Spreadsheet

• Cash A/R Land N/P
  CC RE
• 1.
• 2.
• 3.
• 4.
• 5.
• 6. _____ _____ _____ _____
  _____ _____

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Exercise 4-2 Financial Statements

• Income Statement
• Revenues ______
• Expenses ______
• Net Income ______
• Statement of Retained Earnings
• RE (beginning) ______
• Add Net Income _______
• Less Dividends _______
• RE (ending) ______

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Exercise 4-2 Financial Statements

• Balance Sheet
• Assets
• Cash ______
• A/R ______
• Land ______
• Total ______
• Liabilities and S.E.
• N/P ______
• CS ______
• RE (ending) ______
• Total ______

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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.

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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.

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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.

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Back to E4-2 Posting to G/LNow post
transactions (for cash) to T account
Cash

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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).

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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

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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).

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Types of AJEs

• 1. Accrual of expenses
• 2. Accrual of revenues
• 3. Deferrals of expenses
• 4. Deferrals of revenues
• 5. Revaluation adjustments

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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.

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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.

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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.

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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).

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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

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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.

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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).

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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

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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.

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P4-8

• a. AJE at 12/31 for supplies used
• b. AJE at 12/31 for rent owed

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P4-8

• c. AJE at 12/31 for services performed
• d. AJE at 12/31 for depreciation

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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)

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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

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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.

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C. Preparation of Financial Statementsfrom 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.

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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.

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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.

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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.

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Financial Statement Examples - Kelly Supply
Kelly Supply Income Statement For the Year Ended
December 31, 2006 Revenues Sales 27,000 Inter
est 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 Amortiz
ation expense 500 Total expenses .
24,500 Net income 2,550
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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

10,000
2,550
2,550
(1,000)
(1,000)
6,550
6,550
40,000
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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
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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
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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.