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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.

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Chapter 4: The Mechanics of Financial Accounting

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  1. Chapter 4:The Mechanics of Financial Accounting

  2. 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 Chapter 4: The Mechanics of Financial Accounting

  3. 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. Now look at E4-2 Spreadsheet

  4. Cash + A/R + Land = N/P + CC + RE 1. = 2. = 3. = 4. = 5. = 6. _____ _____ _____= _____ _____ _____ Exercise 4-2 Spreadsheet

  5. Income Statement Revenues ______ Expenses ______ Net Income ______ Statement of Retained Earnings RE (beginning) ______ Add: Net Income _______ Less: Dividends _______ RE (ending) ______ Exercise 4-2 Financial Statements

  6. Balance Sheet Assets Cash ______ A/R ______ Land ______ Total ______ Liabilities and S.E. N/P ______ CS ______ RE (ending)______ Total ______ Exercise 4-2 Financial Statements

  7. 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. Now look at E4-2 Spreadsheet

  8. 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. Double Entry Accounting

  9. 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. Effect of Debits and Credits

  10. Assets have normal debitbalances and are increased with a debit. Liabilities and equitieshave normal creditbalances 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 debitbalances and are increased with a debit. Dividends (which decrease equity) have a normal debit balance and are increased with a debit. The following rules can be derived from the basic formula:

  11. 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. The Format of a Journal Entry

  12. 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:

  13. 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:

  14. 6: Paid $500 cash dividend to owners. Note that dividends is a contra equity and reduces retained earnings. Now back to E4-2, and prepare the other journal entries:

  15. 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 The Accounting Cycle(more detail in Appendix 4A)

  16. 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. A. Daily Journal Entries (DJEs)

  17. 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. Another Example of DJE

  18. 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. The General Ledger (G/L)

  19. Back to E4-2: Posting to G/LNow post transactions (for cash) to “T” account: Cash

  20. 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

  21. 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 Unadjusted Trial Balance - Exercise 4-2(after posting and totaling G/L accounts)

  22. 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). B. Adjusting Journal Entries (AJEs)

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

  24. 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. Accrual System vs. Accrual AJEs

  25. 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. 1. Accrual of Expenses

  26. 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. 2. Accrual of Revenues

  27. 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

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

  29. Example: purchase of inventory. Daily JEat time of purchase: Merchandise Inventory xx Cash xx AJEat 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

  30. Example: purchase of equipment. Daily JEat time of purchase: Equipment xx Cash xx AJEat 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). 3.Deferral of Expenses

  31. 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 AJEat end of the period (for portion): Unearned Revenues xx Subscription Revenues xx 4.Deferral of Revenues

  32. 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. 5. Revaluation Adjustments

  33. a. AJE at 12/31 for supplies used: b. AJE at 12/31 for rent owed: P4-8

  34. c. AJE at 12/31 for services performed: d. AJE at 12/31 for depreciation: P4-8

  35. 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

  36. f. AJE at 12/31 for amount owed for advertising: g. AJE at 12/31 for insurance used from 7/1 to 12/31: P4-8

  37. 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. Adjusted Trial Balance

  38. 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. C. Preparation of Financial Statementsfrom the Adjusted Trial Balance

  39. 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 beginningbalance; while the revenues, expenses and dividends are displayed in the trial balance, they have not yet been included in (closed to) retained earnings. Contributed Capital and Retained Earnings

  40. 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

  41. 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 Statements

  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. 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) 40,000 $6,550 $6,550

  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. 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. 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. D. Closing Journal Entries (CJEs)

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