Basic Mechanics of Preparing a Balance Sheet

Basic Mechanics of Preparing a Balance Sheet

This video covers the fundamental mechanics involved in preparing a balance sheet …

Basic Mechanics of Preparing a Balance Sheet:Using the Basic Accounting Equation

… using the basic accounting equation.

Basic Mechanics of Preparing a Balance Sheet:Using the Basic Accounting Equation

Gone Fishin’

We illustrate the process by recording each of the transactions involved in setting up the business entered into by Gone Fishin’.

Basic Accounting EquationAssets = Liabilities + Shareholders’ Equity

Current Non-current Current Non-current Contributed RetainedAssets Assets Liabilities Liabilities Capital Earnings

Cash LT Invest Accts Pay LT Notes Pay Common stock RevenueST Invest Property Accrued Pay Bonds Pay less: ExpenseAccts Rec Plant Unearn Rev less: DividendsInventory Equipmt ST Notes PayPrep. Exp Intangibles

From the previous video (Video 9) recall the basic accounting equation …. broken down into ...




… account classifications and ....




… the accounts themselves.




Four Steps for Recording Transactions!

Four steps are involved in the recording process.





When we observe an exchange between two companies … for example ….





… we should always remember that in every exchange (or transaction) something is received and something is given up.

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Four Steps for Recording Transactions!1. Identify which 2 or more accounts are affected by the exchange.

In that exchange we must first identify which 2 (or more) of the accounts are effected.

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?





For example, did one company give up cash to receive equipment from the other company?





Or did one company provide a service to the other for a cash payment?





This system of recording is called double entry because at least two accounts are always involved.

Double entry




Four Steps for Recording Transactions!1. Identify which 2 or more accounts are affected by the exchange.2. Identify the dollar amount ($) of the exchange.

In step 2 we must identify the dollar amount of the exchange.

$

$





Was the equipment purchased for $100 …

$100

$100





… or $5,000?

$5,000

$5,000




Four Steps for Recording Transactions!1. Identify which 2 or more accounts are affected by the exchange.2. Identify the dollar amount ($) of the exchange.3. Identify whether the accounts are increased or decreased.

Step 3 involves determining whether the affected accounts are increased or decreased.




Four Steps for Recording Transactions!1. Identify which 2 or more accounts are affected by the exchange.2. Identify the dollar amount ($) of the exchange.3. Identify whether the accounts are increased or decreased.

Purchasing equipment with cash, for example, increases the equipment account and decreases the cash account.

Equipment Cash




Four Steps for Recording Transactions!1. Identify which 2 or more accounts are affected by the exchange.2. Identify the dollar amount ($) of the exchange.3. Identify whether the accounts are increased or decreased.4. Record the transaction so that the accounting equation is always maintained;

that is, assets ALWAYS equals liabilities plus shareholders’ equity.

And finally, in Step 4, given that you know the effected accounts, the dollar amount involved and whether the accounts are increasedor decreased, the exchange must be recorded so that ...





that is, assets ALWAYS equals liabilities plus shareholders’ equity.

… the equality of the accounting equation is ALWAYS maintained.





that is …

… Again, assets must ALWAYS equal liabilities plus shareholders’ equity.

“Assets ALWAYS equals liabilities plus shareholders’ equity”

Four steps to record the transactionsentered into by Gone Fishin’

Let’s now use these four steps to record each of the transactions (or exchanges) entered into by Gone Fishin’ prior to the dateit actually opened for business. We will call these set up transactions and lead to …

Four steps to record the transactionsentered into by Gone Fishin’

Beginning Balance Sheet

… Gone Fishins’ beginning balance sheet.

Gone Fishin’ Set Up Transactions

We begin with a worksheet on which to record the transactions involved in setting up the business. It contains …

Worksheet

Transactions


… one column on the left listing the transactions …

Transactions Sht-term Accts Merch Prop, plant Accts Unearn Accrued Lg-term Contrib Retained earningsCash investm rec Invent & equip payable revenue payables liab capital Revenue - expense - dividends


… and successive columns, from left to right, each devoted to a particular balance sheet account.



In this example the asset accounts include cash, short-term investments, accounts receivable, merchandise inventory, and property, plant & equipment.



The liability accounts include accounts payable, unearned revenue, accrued payables, and long-term liabilities.



The two shareholder equity accounts are contributed capital and retained earnings.



And recall that the balance sheet retained earnings account is comprised of past revenues less past expenses less past dividends.

Transactions Sht-term Accts Merch Prop, plant Accts Unearn Accrued Lg-term Contrib Retained earningsCash investm rec Invent & equip = payable revenue payables liab capital Revenue - expense - dividends


Note the equal sign, which denotes the fact that the assets equal the liabilities plus shareholders‘ equity; thus, the top row in the worksheet represents …

Equal (=) Sign



… the basic accounting equation. Let’s get started.

Assets = Liabilities + Owner’s Equity


Issue stockfor cash 200 = 200


Gone Fishin’ began by issuing common stock for cash in the amount of $200,000. This transaction increased the cash account and increasedcontributed capital, part of shareholders’ equity. Note that $200,000 has been recorded on both the left and the right side of the equation.

Issue stock for $200

Contributed capital

● Oversight rights● Profit rights$200,000

Recall how we depicted the issuance of equity shares for cash in the Gone Fishin’ story. Equity entails the right to overseemanagement’s business decisions and the right to profits … and these rights are always in proportion to the percent of the ownership.



Borrow$300 300 = 300


Gone Fishin’ then borrowed $300,000 from a bank, entering into a debt contract. The cash account was again increased and this time the long-term liability account is increased. Again, the equality of the accounting equation is maintained.

Borrow $300



Borrow$300 300 = 300


Note also that both the issuance of stock in the first transaction and the borrowing in this transaction are in red. In this exercise we will use thecolor red to indicate transactions classified as financing activities.

Financing Activities

Contributed Capital


Long-term Liabilities

● Contract with lender Terms:

… Collateral… Interest rate (8%)

$300,000

Again recall how we depicted the borrowing in the Gone Fishin’ story.

Contributed Capital





$300,000

These two financing transactions established the company’s capital structure – the sources of the company’s assets .

CapitalStructure

Contributed Capital





$300,000

… in this case, 40% equity and 60% debt.

Debt (60%)

Equity (40%)

CapitalStructure



Borrow$300 300 = 300

PurchasePP&E (400) 400


In the next transaction Gone Fishin’ began to build its asset structure by purchasing property, plant and equipment for $400K – The land, docks,buildings, structures and rental equipment necessary to operate the business. Cash decreased by $400k; the PP&E account increased by $400K.

Purchase property, plant & equipment

for $400

Contributed Capital





$300,000

Invest in

Property, plant & equipment● For use or rental; not for sale● Property, equipment, fixtures,

dock, parking lot, walkways, someboats, some fishing tackle

$400,000

In the Gone Fishin’ story we called these assets “producing assets.” They are expected to help generate revenues for the businessover a number of years in the future. They are not for sale, but will be used to support the operations.



Borrow$300 300 = 300


Purchasesh-tm inv (25) 25PurchaseInventory (70) 70

Total 5 25 70 400 = 300 200


Gone Fishin’ concluded that it had more cash than it needed to run the operations, so it invested $25,000 in securities issued by othercompanies. For example, Gone Fishin’s may have purchased common stocks or bonds issued by companies like Apple or Facebook.

Purchase short-term investmentsfor $25



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


This purchase reduced Gone Fishins’ cash account and increased the short-term investment account by $25K. Again, this transaction is recordedin a way that maintains the equality of the accounting equation.




Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


Note too that the last two transactions are in blue, both investing activities.

Investing transactions



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


Before Gone Fishin’ opens up for business, it stocked up on inventory items … all for sale to customers – boats, fishing equipment, food, drinks, etc. It purchased these items for $70K, decreasing cash and increasing inventory.

Purchase inventory for $70



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


We use green to signify operating transactions.

Operating transaction

Contributed Capital





$300,000

Invest in



$400,000

Operating assets● For sale; not for use● Some fishing tackle, some

boats, bait, food, drinks

$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

At this point Gone Fishin’ has completed its set up phase and is ready to open its doors for business.

Contributed Capital





$300,000

Invest in



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

It raised $200K in equity capital and $300K in debt capital …

Contributed Capital





$300,000

Invest in



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… both financing transactions.

Financingtransactions

Contributed Capital





$300,000

Invest in



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

It invested $400,000 in property, plant and equipment and $25,000 in short-term investments …


Contributed Capital





$300,000

Invest in



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… investing transactions …


Investingtransactions

Contributed Capital





$300,000

Invest in

Property, plant & equipment

$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… and used all but $5K of the remaining money to purchase inventory …



Contributed Capital





$300,000

Invest in


$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… operating transactions.



Operatingtransactions



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


If we total the asset, liability and shareholders’ equity account columns, we see …

Assets Liabilities Shareholders’ equity_______________________ ___________________ ________________________



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


… a beginning balance sheet with total assets of $500K balanced by total liabilities and shareholders’ equity of $500K.

Total Liabilities + Total Assets $500 = Shareholders’ equity $500


Contributed Capital





$300,000



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… and this beginning balance sheet would look something like the statement on the right … using the same color code as before.


Cash $ 5,000Short-term invest. 25,000Inventory 70,000

Prop, plant & equip. 400,000

Total assets $ 500,000

Long-term liabilities $ 300,000

Contributed capital 200,000

Total liab. & sh. equity $ 500,000

Contributed Capital





$300,000

Invest in



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… $5K in cash and $70K in inventory in green because these are operating assets.








Contributed Capital





$300,000


● For use or rental; not for sale● Property, equipment, fixtures,


$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… $25K in short-term investments and $400K in property, plant & equipment inblue because these arose from investing transactions …








Contributed Capital





$300,000



$400,000



$100,000Cash = $ 5,000STI = $25,000Inv = $70,000

… with a capital structure of $300K in debt and $200K in equity, both in redbecause they arose from financing transactions. This balance sheet is a moredetailed version of …









Cash $ 5,000Other operating assets 95,000Producing assets 400,000Total Assets $ 500,000

Debt 300,000Equity 200,000Total debt & equity $ 500,000

Statement of Cash Flows

Net cash from operating activities $ 58,000Net cash paid for investing activities (30,000)Net cash paid for financing activities (25,000) Change in cash balance 3,000Beginning cash balance 5,000Ending cash balance $ 8,000

Income Statement

Revenues $ 150,000Expenses (130,000)Net income $ 20,000

Statement of Shareholders’ Equity

Contributed RetainedCapital Earnings Total

Beg. balance $200,000 $0 $200,000+ Net income 20,000 20,000- Dividends ________ (2,000) (2,000)End. balance $200,000 $18,000 $218,000

Ending Balance Sheet

Cash $ 8,000Other operating assets 105,000Producing assets 410,000Total Assets $523,000

Debt 305,000Equity 218,000Total debt & equity $523,000

Gone Fishin’First year of operations

… the beginning balance sheet we showed you earlier in the Gone Fishin’ story. In the next video (Video 11) we show you how toprepare Gone Fishins’...






Income Statement









… financial statements for its first year of operations -






Income Statement









… the statement of cash flows …






Income Statement









… the income statement ...






Income Statement









… the statement of shareholders’ equity …






Income Statement









… and the ending balance sheet. To do so we will again record the transactions on the basic accounting equation worksheet, and foreach of the balance sheet accounts …



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


The ending balances of the worksheet we just completed will become …

Ending Balances


Beginning

Balances 5 25 70 400 = 300 200Sell Inv for (30) = (30)Cash & AR 70 30 = 100Buy Inv for

Cash &AP (2) 10 = 8Receive cashin advance

for services 60 = 60Perform

Services (50) 50Purchase

Land (30) 30Pay cash

for expenses (46) = (46)Pay cash

for interest (24) = (24)Pay down

LT liability (25) = (25)Declare

dividend 2 (2)AdjustmentsDepreciate

PP&E (20) = (20)Accrue

Income tax 10 (10)EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)

Gone Fishin’ Open for Business

… the beginning balances for the first year of operations.

Beginning Balances

Basic Mechanics of Preparing Financial Statements

In this video we cover the basic mechanics involved in creating a complete set of financial statements by preparing …


Gone Fishins’ First-year Financial Statements

… the financial statements for Gone Fishins’ first year of operations.


Gone Fishins’ First-year Financial Statements

Basic Accounting Equation

Of course, we will again rely on the basic accounting equation.



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


Recall in the last video that we recorded each of Gone Fishins’ set up transactions on this worksheet in a manner that maintained theequality of the basic accounting equation; and the final balances in each account comprised Gone Fishins’ beginning balance sheet.






Gone Fishin’Beginning Balance Sheet

In this video we take the balances in this balance sheet, and adjust them for the transactions occurring during …




Gone Fishin’Beginning Balance Sheet

… Gone Fishins’ first year of business; and again, using the basic accounting equation, for that first year we prepare …

First Year of Business







… the statement of cash flows …





Net cash from operating activities $ 58,000Net cash paid for investing activities (30,000)Net cash paid for financing activities (25,000)Change in cash balance 3,000Beginning cash balance 5,000Ending cash balance $ 8,000

Income Statement



… the income statement …






Income Statement






… statement of shareholders’ equity …






Income Statement









… and the ending balance sheet.


Beginning













On this worksheet the balances of the accounts from the balance sheet are listed above as beginning balances, and we will build upon them.The business is now ready to go. Let’s get started recording the transactions from the first year.


Beginning













During the first year of operations Gone Fishin’ sold inventory with a cost of $30K for a sales price of $100K - $70K was collected in cash andas of the end of the year $30K is still owed to Gone Fishin’ by its customers.

Sold inventory (cost = $30) for $100.Received $70 cash from customers.


Beginning

Balances 5 25 70 400 = 300 200Sell Inv for (30)Cash & AR












These transactions are recorded by first reducing the inventory account by $30K, the cost of the sold inventory.



Beginning

Balances 5 25 70 400 = 300 200Sell Inv for (30) = (30)Cash & AR












Simultaneously, retained earnings is reduced by recognizing a $30K expense. On the income statement this expense is called …



Beginning

Balances 5 25 70 400 = 300 200Sell Inv for (30) = (30)Cash & AR












… cost of goods sold because it represents the cost … of the goods … that were sold. Note that the balance in the accounting equationis maintained … $30K on the left of the equal sign and $30K on the right.

Sold inventory (cost = $30) for $100.Received $70 cash from customers. Cost of goods sold


Beginning













At the same time Gone Fishin’ can recognize the $100K sales price in revenue because the inventory has been delivered. This increasesretained earnings.



Beginning













However, only $70K in cash was received, increasing the cash account, and $30K still remains unpaid, which increases the accounts receivableaccount. Again, note that the equality in the accounting equation is maintained … $100 on the left of the equal sign and $100 on the right.



Beginning













We have recorded these entries in green to signify that they are operating transactions.



Beginning


Cash &AP 10 Receive cashin advance











During the year Gone Fishin’ also purchased additional inventory in the amount of $10K, increasing the inventory account.

Purchased inventory for $10


Beginning













However, only $2K was paid to Gone Fishins’ suppliers. This means that $8K was still owed to its suppliers, increasing accounts payable, andcash was reduced by $2K.

Purchased inventory for $10but only paid $2. Still owe $8.


Beginning













Note that a net of $8K was added to the left side of the accounting equation, matching the $8K added to the right side.



Beginning













Again, we use green to signify that these transactions are operating activities.



Beginning













Gone Fishin’ also provides services for its customers (boat rentals and guide services) and in these cases it asked for payment in advance, duringthe year receiving a total of $60K.

Received $60 for servicesyet to be performed


Beginning













These operating transactions (in green) increased cash and also increased a liability, called unearned revenue, which represents an obligation to perform the services that Gone Fishin’ has already been paid for.



Beginning













During the year … Gone Fishin’ performed most of these services, earning $50K of the $60K liability. Because the services were completed, GoneFishin’ was allowed to recognize (or record) the revenue, which increased retained earnings, and reduced the unearned revenue obligation.



Beginning













Again, this is an operating activity, and note that the equality of the accounting equation was maintained because $50K was both added to andsubtracted from the right side.



Beginning













Gone Fishin’ also purchased the lot next door during the year, paying $30K in cash.

Purchased land for $30 cash.


Beginning













This investing transaction (in blue) increased the property, plant & equipment account, and decreased the cash account – representingan exchange of one asset for another.

Purchased land for $30 cash.


Beginning













During the year Gone Fishin’ also paid $46K in cash to cover operating expenses like wages, utilities, insurance, repairs, and advertising.

Paid $46 to cover operating expenses.


Beginning













These operating transactions reduced cash and reduced retained earnings through the expense account.



Beginning













Expenses represent costs, normally repetitive, that help to generate revenue in the current period. The benefit from the expense is consideredused up in that period and, therefore …



Beginning













… expenses are subtracted from revenues in the calculation of net income for the period .



Beginning













Gone Fishin’ paid $24K to the bank for interest on the outstanding $300K loan, a long-term liability, taken out at the beginning of the year. Recall that the interest rate was 8%, which when multiplied by $300K equals $24K.

Paid $24 for interest onbank loan


Beginning













Interest is considered the operating cost associated with the outstanding loan, so paying interest is considered an operating activity andan expense that reduces retained earnings.



Beginning













Note that this payment did not reduce the $300K principle amount owed on the loan.


Outstanding loan


Beginning













However, Gone Fishin’ did decide to pay off some of the principle on the loan, and made a separate $25K payment to the bank. Because this is apayment of principal (not interest), it is considered a financing transaction (in red) that reduces both cash and the long-term liability balance.

Paid $25 cash to reduceloan principal


Beginning













Near the end of the year the shareholders of Gone Fishin’ declared a dividend of $2K to be paid to themselves. As of year end the payment hadnot yet been made, so a liability of $2K (to be paid) is recognized as accrued payables, and the declared dividend reduces retained earnings by $2K.

Declared dividend of $2 to bepaid later


Beginning













Dividends are financing activities, and recall that retained earnings represent past profits retained in the business and NOT paid to theshareholders in the form of dividends.



Beginning













Note too that dividends are NOT an expense. While they do reduce retained earnings, they do NOT reduce net income.



Beginning









dividend 2 (2)

Depreciate




This completes the transactions entered into by Gone Fishin’ during its first year of operations.


Beginning









dividend 2 (2)

Depreciate




At this point, immediately before the financial statements are prepared, a series of adjusting entries must be recorded so that the financialstatements reflect events that changed the dollar values of the accounts but did not result from exchange transactions. For example,

Adjusting Entries


Beginning









dividend 2 (2)

Depreciate




Gone Fishin’ must record depreciation on the property, plant & equipment. This represents an expense that reflects the fact that each year someportion of these assets are used up in the operations. In this case we estimate that 5% of the cost of the property, plant & equipment …

Adjusting entries

Record depreciation of $20.


Beginning









dividend 2 (2)

Depreciate




… was used up in Gone Fishins’ first year. The $20K depreciation entry (5% x $400K) creates both an expense, which reduces net incomeand retained earnings, and a reduction in the PP&E account, bringing its dollar value on the balance sheet down by $20K.

Adjusting entries



Beginning









dividend 2 (2)

Depreciate




We record this entry in green because it represents the amount of the property, plant and equipment used up in operations during thefirst year.

Adjusting entries



Beginning









dividend 2 (2)

Depreciate




Gone Fishin’ also has to pay income taxes for its first year of operations because it booked a positive profit. Revenues exceeded expenses. As itturns out, the $10K tax obligation does not have to be paid until next month, but it is owed at year end.

Adjusting entries

Income tax of $10 is owed at year end


Beginning









dividend 2 (2)

Depreciate




This means that Gone Fishin’ must ACCRUE an expense and an obligation of $10K.

Adjusting entries



Beginning









dividend 2 (2)

Depreciate




This operating cost (in green) increases the accrued payables liability account and recognizes an expense that reduces net income andretained earnings.

Adjusting entries



Beginning









dividend 2 (2)

Depreciate




The process of recording the transactions and adjustments is now complete, and we can total the balances in all the asset, liability andshareholders’ equity accounts. From the information on this worksheet we can now prepare all four of the financial statements.

Adjusting entries

Prepare Gone Fishins’ Financial Statements

Balance Sheet

The balance sheet …


Balance Sheet

Income Statement



Balance Sheet

Income Statement


… the statement of shareholders’ equity …


Balance Sheet

Income Statement



… and the statement of cash flows.


Balance Sheet

Income Statement



Let’s begin with the balance sheet – the statement of the basic accounting equation.


Beginning









dividend 2 (2)

Depreciate




Note first that already we have prepared a beginning balance sheet from the beginning balances above.

Adjusting entries


Cash $ 5,000Sht-term invest. 25,000Inventory 70,000Prop, plant & equip 400,000Total assets $ 500,000

Long-term liabilities 300,000Contributed capital 200,000Total Liabilities &share equity $ 500,000

It would be formatted as illustrated here.

Beginning During Ending




Current assets include cash, short-term investments, and inventories …





… non-current assets include property, plant & equipment. The $500K asset total is balanced by …





… $300K in long-term liabilities and $200K in shareholders’ equity.



Beginning









dividend 2 (2)

Depreciate




Similar to the beginning balance sheet, the balance sheet as of the end of the year can be prepared from the ending balances in the asset,liability and shareholders equity accounts.

Adjusting entries


Note that the asset total is now $523K …

Adjusting entries


Beginning









dividend 2 (2)

Shareholders’ equity = $218K

Assets = $523K Liabilities = $305K CC = $200K Retained Earnings = $18K

EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)


… liabilities now total $305K …

Adjusting entries


Beginning









dividend 2 (2)



EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)


… and shareholders equity now totals $218K …

Adjusting entries


Beginning









dividend 2 (2)



EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)


… made up of $200K in contributed capital …

Adjusting entries


Beginning









dividend 2 (2)



EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)


… and $18K in retained earnings.

Adjusting entries


Beginning









dividend 2 (2)



EndingBalances 8 25 30 50 410 = 8 10 12 275 200 150 (130) (2)





Cash $ 8,000Sht-term invest. 25,000Accts receivable 30,000Inventory 50,000Prop, plant & equip 410,000Total assets $ 523,000

Accts payable 8,000Unearned revenue 10,000Accrued payables 12,000 Long-term liabilities 275,000Contributed capital 200,000Retained earnings 18,000Total Liabilities &share equity $ 523,000

The ending balance sheet would appear as illustrated here. It looks very similar to the beginning balance sheet except that it now contains newdollar values, and a few new accounts created during the year …








… accounts receivable …








… accounts payable ...








… unearned revenue …








… and accrued payables.



Balance Sheet

Income Statement



We now go to the income statement.


Beginning









dividend 2 (2)

Depreciate




It is simply the recorded activity in the revenue and expense accounts …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… $150K in total revenue …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… less total expenses of $130K.

Adjusting entries







Income Statement

Service revenue $ 50,000Sales revenue 100,000Cost of goods sold (30,000)Operating expenses (46,000)Depreciation expense (20,000)Interest expense (24,000)Net income before tax 30,000Income tax expense (10,000)Net income $ 20,000

It would be illustrated as above, and note that …








Income Statement


… $20,000 of net income was earned by Gone Fishin’.








Income Statement


As indicated in prior videos, net income represents a measure of how well Gone Fishins’ operations (in green) performed duringthe year.


“Measure of operating performanceduring the year”


Balance Sheet

Income Statement



The statement of shareholders’ equity can be created from …


Beginning









dividend 2 (2)

Depreciate




… the activities in the shareholders’ equity accounts ...

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… contributed capital …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… and retained earnings, which is made up of …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… revenues ….

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… less expenses …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… less dividends.

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




Note that the $200K beginning balance in contributed capital was unchanged during the year …

Adjusting entries


Beginning

Balances 5 25 70 400 = 300 200 0 0 0Sell Inv for (30) = (30)Cash & AR 70 30 = 100Buy Inv for








dividend 2 (2)

Depreciate




… while the retained earnings account grew from zero …

Adjusting entries


Beginning

Balances 5 25 70 400 = 300 200 0 0 0Sell Inv for (30) = (30)Cash & AR 70 30 = 100Buy Inv for








dividend 2 (2)

Depreciate




… to $18K ($150k - $130k - $2k).

Adjusting entries







Income Statement


Here’s what the statement of shareholders’ equity would look like.




Beg. Balance $200,000 $ 0 $ 200,000+ Net income - 20,000 20,000- Dividends _______ (2,000) (2,000)End. Balance $200,000 $18,000 $ 218,000







Income Statement


It connects the shareholders’ equity sections of the two balance sheets …



Contributed Retained Capital Earnings Total








Income Statement


Note too that the $20,000 of net income from the income statement is added to retained earnings …











Income Statement


… which is reduced by the $2,000 dividend.






Balance Sheet

Income Statement



… and finally, the statement of cash flows.


Beginning









dividend 2 (2)

Depreciate




This statement simply explains what happened in the cash account during the year.

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




The cash balance increased from $5K to $8K. Explaining this change is …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… (1) cash inflows and outflows from operating activities (in green) … purchasing inventories, selling inventories, providing services, and payingexpenses …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… (2) a $30K cash outflow from an investing activity (in blue) … Land was purchased …

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




… and (3) a $25K cash outflow from a financing activity (in red) … to pay off part of the loan.

Adjusting entries

Beginning Balance SheetCash $ 5,000Sht-term invest. 25,000Inventory 70,000Prop, plant & equip 400,000Total assets $ 500,000


Ending Balance SheetCash $ 8,000Sht-term invest. 25,000Accts receivable 30,000Inventory 50,000Prop, plant & equip 410,000Total assets $ 523,000


Income StatementService revenue $ 50,000Sales revenue 100,000Cost of goods sold (30,000)Operating expenses (46,000)Depreciation expense (20,000)Interest expense (24,000)Net income before tax 30,000Income tax expense (10,000)Net income $ 20,000

Statement of Shareholders’ EquityContributed Retained

Capital Earnings TotalBeg. Balance $200,000 $ 0 $ 200,000+ Net income - 20,000 20,000- Dividends _______ (2,000) (2,000)End. Balance $200,000 $18,000 $ 218,000

Statement of Cash flowsCash from customers $130,000Cash paid for operations (72,000) Net cash from operations 58,000Cash paid for investment (30,000)Net cash used for investments (30,000)Cash paid on LT liabilities (25,000)Net cash used for financing (25,000)Increase in cash 3,000Beginning cash 5,000Ending cash 8,000

As the statement of cash flows above illustrates …









… net cash from operations increased the cash account by $58K …









… $30K in cash was used for investments (recall that land was purchased) …









… and $25K was used in a financing transaction to pay off part of the long-term liability.









These cash flows increased the overall cash balance …









… by $3,000, which when added to the …

*









… beginning cash balance of $5,000 …

**









… leads to the ending overall cash balance on the ending balance sheet of $8,000.

* *









All of this activity leads to the ending balance sheet, and we have a complete set of financial statements.









And finally, the ending balance sheet becomes the beginning balance sheet for the next year and the process continues.

Beginning

Preparing Financial Statements Using Journal Entries & Ledger

Gone Fishin’

In this video and the next two (Videos 13 & 14) we again prepare a complete set of financial statements for Gone Fishin’, but this time we doso by recording journal entries in a file called a journal, and maintaining account balances in T-accounts located in a separate file, called aledger.

Preparing Financial Statements Using Journal Entries & Ledgers

Gone Fishin’

Introduction to Journals and Ledgers

In this first video we introduce and illustrate how journals and ledgers work.

Assets = Liabilities + Shareholders’ Equity

Basic Accounting Equation, T-Accounts,& Journal Entries

We begin again with the basic accounting equation: assets equals liabilities plus shareholders’ equity.



Contributed RetainedCapital Earnings

We build upon the equation by noting that shareholders’ equity is comprised of contributed capital and retained earnings ...




Revenues – Expenses - Dividends

… and retained earnings is comprised of past revenues minus past expenses minus past dividends.





The basic accounting equation can now be expressed in the following way …

Assets = Liabilities + Contributed capital + Revenues – Expenses - Dividends





… assets …






… equals …






… liabilities …






… plus contributed capital ...






… plus revenues …






… minus expenses …






… minus dividends.






This expression highlights the fact that there are only … I repeat only … 6 kinds of accounts …


1 2 3 4 5 6

6 Kinds of Accounts





… assets like cash, receivables, inventory, property, plant and equipment …


1 2 3 4 5 6

CashReceivablesInventoryPP&E





… liabilities like accounts payable, accrued payables, unearned revenues, and notes payable …


1 2 3 4 5 6


Accounts payableAccrued payablesUnearned revenuesNotes payable





… contributed capital, which represents direct contributions from the owners usually recorded as common stock.


1 2 3 4 5 6



Common stock





… revenues from providing services to clients or selling goods to customers …


1 2 3 4 5 6



Common stock ServicesSales





… expenses like the cost of the goods sold, wages paid to employees, utilities, depreciation of producing assets, and interest …


1 2 3 4 5 6




COGSWagesUtilitiesDepreciationInterest





… and finally dividends, the distribution of profits to the owners.


1 2 3 4 5 6




COGSWagesUtilitiesDepreciationInterest





Only 6 kinds of accounts. You will see that it is helpful to keep in mind that virtually all accounts fit into one of these six account groups.


1 2 3 4 5 6

6 Kinds of Accounts





Retained earnings is comprised of three of these 6 groups - revenues, expenses, and dividends ...


1 2 3 4 5 6





… and shareholders’ equity is comprised of 4 of these groups - contributed capital, revenues, expenses, and dividends ...






… which leaves assets and liabilities to round out the 6 account groupings.






Given this 6-account expression, we can then …






… re-arrange the equation by adding expenses and dividends to both sides …


+ Expenses + Expenses + Dividends+ Dividends





… which effectively eliminates expenses and dividends from the right side and adds them to the left side of the equal sign …


+ Expenses + Expenses + Dividends+ Dividends





… leading to a re-arranged accounting equation that looks like this where we only have plus signs on both sides of the equation …


Rearranged equation,

Assets + Expenses + Dividends = Liabilities + Contributed capital + Revenues





… assets plus expenses plus dividends ....








… equals liabilities plus contributed capital plus revenues.








Rearranging the equation in this way is useful because it highlights the fact that …








… assets, expenses and dividends, all added together, equal …








… liabilities, contributed capital, and revenues … all added together.








This is helpful because it shows that when exchange transactions are recorded …








… assets, expenses and dividends, which are all on the left side of the equal sign, are treated in a way opposite from …








… liabilities, contributed capital and revenues, which are all located on the right side of the equal sign.








The relationships between these two groups of accounts, as illustrated by this form of the basic accounting equation, is centralto how journal entries are recorded and posted into the ledger in the double entry system of accounting.








To further illustrate their importance, let’s now return to an earlier version of the basic accounting equation, keeping in mind that ...





… the asset, expense and dividend accounts are treated opposite from ...





… the liability, contributed capital and revenue accounts.





In the double entry system of accounting to keep track of the balances in each of these six groups of accounts …





Assets Liabilities Contr. Cap. Revenue Expenses Dividends

… we create a T-account for each individual account, so named because it is in the form of a “T.”






Note that each T-account has a ….






… left side ….

L L L L L L






… and a right side.

L R L R L R L R L R L R






The double entry system keeps track of increases and decreases in these account groupings by whether the transaction dollar amounts are recorded on the left or right side of the T-account..

L R L R L R L R L R L R





+ - + - + -- + - + - +


For the asset, expense and dividend accounts, increases are recorded on the left side of the “T” and decreases are recorded on the right side.





+ - + - + -- + - + - +


For the liability, contributed capital and revenue accounts, which are treated in an opposite way, their increases are recorded on theright side of the “T” and their decreases are recorded on the left.





+ - + - + -- + - + - +


All this takes place in the company’s ledger, a file where there is a T-account for each account and, accordingly, each account balance is maintained.

LEDGER





+ - + - + -- + - + - +

Journal


However, the original entries to record the exchange transactions are located in another separate file, called the journal.





+ - + - + -- + - + - +

Journal


In this file an entry for each individual transaction is recorded. It is called a journal entry and it provides information about threecharacteristics of the transaction:

Account $Account $





+ - + - + -- + - + - +

Journal


Account $Account $

… (1) the type of account effected - whether it be …





+ - + - + -- + - + - +

Journal


Account $Account $

… asset …





+ - + - + -- + - + - +

Journal


Account $Account $

… liability …





+ - + - + -- + - + - +

Journal


Account $Account $

… contributed capital …





+ - + - + -- + - + - +

Journal


Account $Account $

… revenue …





+ - + - + -- + - + - +

Journal


Account $Account $

… expense …





+ - + - + -- + - + - +

Journal


Account $Account $

… or dividend.





+ - + - + -- + - + - +

Journal


… (2) The dollar value of the transaction (the value exchanged) …

Account $Account $





+ - + - + -- + - + - +

Journal


… and (3) whether the account is increased or decreased by that amount of money, which is indicated by whether the account is placed …

Account $Account $





+ - + - + -- + - + - +

Journal


… on the left side …

Account $Account $

Left side





+ - + - + -- + - + - +

Journal


… or the right side of the entry.

Account $Account $

Left side

Right side





+ - + - + -- + - + - +

Journal


In accounting jargon, debit simply means left side ...

Account $Account $

Left side

Right side

Debit





+ - + - + -- + - + - +

Journal


… and credit simply means right side.

Account $Account $

Left side

Right side

Debit

Credit





+ - + - + -- + - + - +

Journal


Recall from our earlier discussion about the ledger …

Account $Account $

Left side

Right side





+ - + - + -- + - + - +

Journal


… that asset, expense, and dividend accounts are all increased on the left (or debit) side, and decreased on the right (or credit) side …

Account $Account $

Left side

Right side

(+)

(-)





+ - + - + -- + - + - +

Journal


… while liability, contributed capital and revenue accounts are all increased on the right (or credit) side and decreased on the left (or debit) side.

Account $Account $

Left side

Right side

(-)

(+)





+ - + - + -- + - + - +

Examples:


Let’s try a few examples to illustrate how the double entry system works, using journals and ledgers.





+ - + - + -- + - + - +

Journal entry: Issue stock: Cash (+A) 200

Contr. Cap. (+CC) 200


If a company issues stock and receives $200 in the exchange, the journal entry would look like this.





+ - + - + -- + - + - +




The asset account, cash, would be increased on the left …





+ - + - + -- + - + - +




… and the contributed capital account would be increased on the right.





+ - + - + -- + - + - +




The entry would also be simultaneously reflected in the corresponding ledger (T) accounts – the asset increase on the left and the contributedcapital increase on the right.

200 200





+ - + - + -- + - + - +




In terms of the accounting equation, the increase to the asset account would balance the increase to the contributed capitalaccount ($200 on each side of the equal sign).

200 200





+ - + - + -- + - + - +




Also, note the parenthetical indicators in the journal entries and the related key. We will use this key to help you connect each journalentry to its effect on the accounting equation. In this case +A means increase in assets and +CC means increase in contributed capital.

200 200

Key:A = Assets L = LiabilityCC = Contributed CapitalRE = Retained Earnings

R = RevenueE = ExpenseD = Dividend

Shareholders’ Equity





+ - + - + -- + - + - +

Journal entries: Issue stock: Cash (+A) 200


Borrow: Cash (+A) 300Note payable (+L) 300


If a company borrows $300 issuing a note payable, the asset account, cash, would be increased on the left; the liability account, note payable,would be increased on the right; and again the equality of the accounting equation would be maintained.

300300





+ - + - + -- + - + - +




Buy asset: Equipment (+A) 400Cash (-A) 400


If a company buys equipment for $400, the asset account, equipment, would be increased on the left, and the asset account, cash, wouldbe decreased on the right. In this case the accounting equality is maintained by increasing and deceasing two different asset accounts.

400400





+ - + - + -- + - + - +






Sell service: Cash and/or AR (+A) 150Revenue (R, +RE) 150

If a company sells a service for $150, an asset account (cash and/or accounts receivable) would be increased on the left, depending onwhether the customer paid for the service, and a revenue account would be increased on the right.

150150





+ - + - + -- + - + - +







The accounting equality is achieved by increasing the assets and also shareholders’ equity via an increase to revenues and retained earnings.

150150





+ - + - + -- + - + - +







Accrue expense: Expense (E, -RE) 130Accrued payable (+L) 130

If a company incurs an expense for $130, but does not yet pay it, an expense account would be increased on the left and a liability account,accrued payable, would be increased on the right.

130130





+ - + - + -- + - + - +







Accrue expense: Expense (E, -RE) 130Accrued payable (+L) 130

Here, the equality is maintained by increasing a liability account on the right and decreasing shareholders’ equity via an increased expenseon the left, which reduces retained earnings.

130130





+ - + - + -- + - + - +







Accrue expense: Expense (E, -RE) 130Accrued liability (+L) 130

Declare dividend: Dividend (D, -RE) 20Dividend payable (+L) 20

If the board of directors declares - but does not yet pay - a dividend, the dividend account would be increased on the left and a liability account,dividend payable, would be increased on the right. Again, the equality is maintained by increasing a liability and decreasing retained earnings.

2020





+ - + - + -- + - + - +









Now that we have worked through a few examples, in the next video (Video 13) we return to the transactions entered into by Gone Fishin’during its first year of operations, and see how we can create a set of financial statements using ...





+ - + - + -- + - + - +









… journal entries located in the journal …





+ - + - + -- + - + - +









and T-accounts located in the ledger.

Ledger:


Gone Fishins’ Set Up Transactions

In this video we record the transactions Gone Fishin’ entered into prior to the start of its operations leading to its beginning balance sheetby recording journal entries and posting them into T-accounts located in the ledger.





+ - + - + -- + - + - +






Sell service: Cash and/or AR (+A) 150Revenue (+RE) 150

Accrue expense: Expense (-RE) 130Accrued liability (+L) 130

Declare dividend: Dividend (-RE) 20Dividend payable (+L) 20

As a review, recall the journal entries we illustrated in the last video (Video 12) …

Ledger:





+ - + - + -- + - + - +









… and how they are posted in the T-accounts in the ledger.

Ledger:





+ - + - + -- + - + - +









Note in particular how the account increases and decreases are indicated by the debit (left) and credit (right) structure of the journal entry …

Ledger:





+ - + - + -- + - + - +









… and how they are posted to the left and right sides of the T-accounts in the ledger.

200 200

Ledger:

We begin the process of recording Gone Fishins’ set up transactions with a journal … an original book of record … and this journal willinclude an entry to record each transaction entered into by Gone Fishin’.

Journal

General Ledger

Cash Sht-tm investments Accounts receivable Inventory Property, plant & equip

Accounts payable Unearned revenue Accrued payables Long-term liabilities

Contributed capital Retained earnings

Service revenue Sales revenue

Cost of goods sold Operating exp Depreciation exp Interest exp Income tax exp

Dividends

We will also maintain a ledger, which will include a T-account for each asset, liability, shareholders’ equity, revenue, expense, and dividendaccount. Remember that there are only six groups of accounts.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

Note that for each account we have included plus and minus signs indicating which side of the “T” indicates an increase or decrease.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

The asset accounts, which are increased on the left and decreased on the right, include cash, short-term investments, accounts receivable, inventory and property, plant & equipment.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

The liability accounts, which are increased on the right and decreased on the left, include accounts payable, unearned revenue, accrued payables, and long-term liabilities.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

The shareholders’ equity accounts, which are also increased on the right and decreased on the left, include contributed capital and retained earnings …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

… and retained earnings is made up of …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

… two different revenue accounts – service and sales revenue - both increased on the right …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

… 5 different expense accounts, all increased on the left …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

General Ledger






Dividends

… and a dividend account, which is also increased on the left.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


Take a moment now and recall the spreadsheet format we used earlier to prepare Gone Fishins’ beginning balance sheet.





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


The accounts, which we just reviewed, were all placed at the top of the columns: cash, short-term investments, accounts receivable,merchandise inventory, property, plant & equipment …





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


… accounts payable, unearned revenue, accrued payables, long-term liability, contributed capital, and retained earnings, which is comprised of revenues, expenses and dividends.





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


The transactions we are about to record were described in the first column, one transaction for each row.





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


… and the dollar values were recorded in each cell as positive or negative, depending on whether they increased or decreased the account. Also,recall that operating, investing, and financing transactions were indicated in green, blue, and red, respectively.





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


We will now repeat the process, but this time we will use journal entries and ledgers.





Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


We will keep referring back to this spreadsheet as we work through the journal entries … primarily to demonstrate that we are doing exactly thesame thing with the journal and ledger that we did with the spreadsheet. Two equivalent ways of producing financial statements.



In the first transaction, during Gone Fishins’ set-up phase, common stock was issued to 10 shareholders, each of whom contributed$20,000 in exchange for 5% of the ownership (or equity). Note that all journal entries will be recorded in thousands of dollars.

Journal(Set–up phase)

1. Cash (+A) 200Contributed capital (+SE) 200

The asset account, cash, is increased on the left, and contributed capital is increased on the right. The accounting equality ismaintained by increasing an asset account and increasing a shareholders’ equity account.

Journal(Set-up phase)


Ledger (set-up phase)






Dividends

This first transaction is posted in the ledger, increasing the asset T-account on the left, and increasing the contributed capital T-account on the right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200




This is how it was recorded on the spreadsheet – an increase in cash and an increase in contributed capital.

Issue stock for $200

In the second transaction Gone Fishin’ borrowed $300,000 from the bank, increasing the cash account on the left and increasingthe long-term liability account on the right. The accounting equality is maintained by increasing an asset and a liability.



2. Cash (+A) 300Long-term liability (+L) 300

Ledger (Set-up phase)






Dividends

Again, the journal entry is posted in the ledger, increasing the asset (cash) account balance on the left to $500K, and increasing the long-termliability account on the right by $300K.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300



Borrow$300 300 = 300


This is how it was recorded on the spreadsheet – an increase in cash and an increase in long-term liability.

Borrow $300

Transaction 3 involved purchasing equipment for $400,000 – increasing the property, plant & equipment account on the left, and decreasing the cash account on the right. Here, one asset is being exchanged for another asset, maintaining the accounting equality.




3. Property, plant & equipment (+A) 400Cash (-A) 400







Dividends

This transaction is posted in the ledger, decreasing cash on the right (credit) side and increasing property, plant & equipment on the left(debit) side.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400



Borrow$300 300 = 300



This is how it was recorded on the spreadsheet.

Purchase property, plant & equipment

for $400

Gone Fishin’ then purchased short-term investment securities for $25,000. This transaction increased the short-term investmentaccount and decreased the cash account. Again, the accounting equality is maintained by exchanging one asset for another.





4. Short-term investment (+A) 25Cash (-A) 25







Dividends

Posting this exchange in the ledger would look like this, increasing the short-term investment balance on the left and decreasing cash on theright.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


This is how it looked on the spreadsheet.


In the final transaction of the set-up phase Gone Fishin’ purchased inventory, paying $70K in cash. The inventory account is increasedon the debit side and the cash is decreased on the credit side.





4. Short-term investment (+A) 25Cash (-A) 25

5. Inventory (+A) 70Cash (-A) 70







Dividends

Like the other transactions, the inventory purchase would need to be posted in the proper T-accounts – increasing the inventory account anddecreasing the cash account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70



Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


This is how it was recorded on the spreadsheet.

Purchase inventory for $70







Dividends

We are now finished with the set-up phase and Gone Fishin’ is ready for business. Consequently, at this time we total the balances in the T-accounts, which will serve to represent the beginning balances in these accounts when Gone Fishin’ opens for business.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200




These ending balances constitute a beginning balance sheet for Gone Fishin’ – total assets of $500K, made up of cash, short-term investments,and property, plant & equipment … all financed with $300K in borrowings and $200K in equity contributions.




Borrow$300 300 = 300



Total 5 25 70 400 = 300 200


Recall the spreadsheet format ended with the same balances – total assets of $500K and total liabilities and shareholders’ equity of $500K.





In the next video (Video 14) we build from the ending balances in the ledger to create …









… a complete set of financial statements for Gone Fishins’ first year … this time using journal entries and a ledger.


Gone Fishins’ First Year

In this session we start with Gone Fishins’ beginning balance sheet and then record in the journal and ledger the transactions andadjusting entries for the first year, leading to a complete set of financial statements.

Ledger (Start-up phase)






Dividends

Recall from the last video that Gone Fishins’ beginning balance sheet is comprised of the ending balances in the following accounts:

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… cash $5,000 …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… short-term investments $25,000 …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… inventory $70,000 …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… property, plant & equipment $400, 000 …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… long-term liabilities $300,000 ...

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300







Dividends

… and contributed capital $200,000.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

(1) 200

(1) 200

(2) 300

(2) 300

(3) 400

(3) 400

(4) 25

(4) 25

(5) 70

(5) 70

5

25 70 400

200

300


Beginning









dividend 2 (2)

Depreciate




These account balances are also the same as the beginning balances we saw earlier during the worksheet exercise …

Adjusting entries




… and they constitute a beginning balance sheet for Gone Fishin’ – total assets of $500K, made up of cash, short-term investments, inventory and property, plant & equipment … all financed with $300K in borrowings and $200K in equity contributions.




Let’s now record in the journal and ledger the entries that reflect Gone Fishin’ doing business during its first year of operations.


Ledger (Operating phase)






Dividends

We start with a ledger that has these beginning balances. Note that most of the accounts have zero balances, except for those used duringthe set-up phase.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

During the first year Gone Fishin’ sold goods (boats, fishing equipment, etc.) for $100K. The company received $70K in cash and as of the end of the year customers still owed $30K. Gone Fishin’ purchased these goods previously for $30K. Each of these sales required 2 entries.

Journal(Operating phase)

5. Cash (+A) 70 Accounts receivable (+A) 30

Sales revenue (R, +RE) 100

5. Cost of goods sold (E, -RE) 30Inventory (-A) 30

… one to record the sale and recognize the revenue ...





… and a second to record the outflow of the inventory and recognize an expense. Regarding the sale …





… the sales revenue account would be increased on the right by $100K …





… and two asset accounts – cash and accounts receivable – would be increased on the left … cash for $70K and accounts receivablefor $30K. Regarding the outflow of inventory …





.. the expense – cost of goods sold – would be increased on the left …





… and inventory would be decreased on the right – each for $30K.











Dividends

Both entries are posted in the ledger, increasing cash, accounts receivable and cost of goods sold on the left …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 (5) 30 30 (5)

100 (5)

(5) 30







Dividends

… while increasing sales revenue on the right, and decreasing inventory on the right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 (5) 30 30 (5)

100 (5)

(5) 30







Dividends

Note that $130K is recorded on both the left ....

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 (5) 30 30 (5)

100 (5)

(5) 30

$130







Dividends

… and the right, which maintains the accounting equality.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 (5) 30 30 (5)

100 (5)

(5) 30

$130$130

During the year Gone Fishin’ also purchased additional inventory in the amount of $10K, paying $2K in cash to its suppliers and as of yearend Gone Fishin’ still owed $8K.





6. Inventory (+A) 10Accounts payable (+L) 8Cash (-A) 2

This entry increases inventory on the left ...






… and on the right decreases cash, and increases accounts payable.












Dividends

In the ledger the cash account is reduced by $2K on the right …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

8 (6)

100 (5)

(5) 30







Dividends

… inventory is increased by $10K on the left ...

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

8 (6)

100 (5)

(5) 30







Dividends

… and accounts payable, a liability account, is increased on the right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

8 (6)

100 (5)

(5) 30







Dividends

Again, the entries on the left side, totaling $10K, equal the entries on the right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

8 (6)

100 (5)

(5) 30

$10 $10

Gone Fishin’ also collected $60K during the year in advance for services like guiding and rentals.






7. Cash (+A) 60Unearned revenue (+L) 60

This increased the asset account – cash …







… and the liability account – unearned revenue, which represents an obligation to perform the services.













Dividends

This activity increased the cash T-account on the left (debit) side, and increased the unearned revenue T-account on the right (credit) side –both by $60K .

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

(7) 60

8 (6) 60 (7)

100 (5)

(5) 30

During the year Gone Fishin’ performed most of the services for which it had been paid in advance – totaling $50K – which allowedthe company to recognize service revenue for $50K and reduce the unearned revenue liability by that same amount.







8. Unearned revenue (-L) 50Service revenue (R, +RE) 50







Dividends

Posting these activities in the ledger reduces the unearned revenue liability by $50K, down to a balance of $10K, and increases servicerevenue by $50K. Again, the entries on the left and right sides are equal.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5)

(7) 60

8 (6) (8) 50 60 (7)

50 (8) 100 (5)

(5) 30

During the year Gone Fishin’ also purchased the lot (real estate) next door to its location and paid $30K for the land, increasing theproperty, plant & equipment account on the left and reducing the cash account on the right – exchanging one asset for another.















Dividends

In the ledger, the asset account – cash - is decreased on the right and the asset account - property, plant & equipment - is increased on the left.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7)

50 (8) 100 (5)

(5) 30

Operating expenses like wages, utilities, advertising, property taxes, repairs and maintenance were paid during the year in the amount of$46K. Consequently, an expense account – called operating expenses – was increased on the left and cash was reduced on the right.









10. Operating expenses (E, -RE) 46Cash (-A) 46







Dividends

This entry was posted as an increase to the operating expense T-account and a decrease to the cash account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7)

46 (10)

50 (8) 100 (5)

(5) 30 (10) 46

Recall that the bank charged an 8% interest rate on the $300K loan, which led to an interest charge of $24K for the year. When GoneFishin’ paid the interest, it recorded this journal entry – increasing the interest expense account and decreasing the asset account, cash.










11. Interest expense (E, -RE) 24Cash (-A) 24







Dividends

This journal entry led to the following posting in the ledger – an increase to the left side of the interest expense T-account and a decrease tothe right side of the cash T-account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7)

46 (10)

24 (11)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

Near the end of the year Gone Fishin’ paid off part of the principle of the bank loan, paying $25K to the bank. This transactionreduced cash on the right and reduced the long-term liability account on the left.











12. Long-term liability (-L) 25 Cash (-A) 25







Dividends

Again, this transaction was posted to the ledger – reducing cash and reducing the outstanding long-term obligation.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

Near the end of the year Gone Fishins’ board of directors declared a $2K dividend to be paid early the following year to the shareholders.This action created a $2K liability – accrued payables – recorded on the right and also increased the dividend account on the left.












13. Dividend (D, -RE) 2Accrued payables (+L) 2







Dividends

In the ledger the dividend account, which will ultimately reduces retained earnings, is increased on the left and the liability is increased onthe right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2







Dividends

Commonly, several different liabilities are included in accounts like accrued payables. This economizes the number of accounts appearing on thefinancial statements. In this example the dividend liability could have been correctly posted instead into a separate …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2







Dividends

… dividend payable (liability) account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2

Dividend payable

2 (13)







Dividends

A company’s internal records normally maintain separate accounts for separate kinds of assets, liabilities, revenues and expenses, but including all those separate accounts on the financial statements would make them more detailed than necessary.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2







Dividends

To make the financial statements less detailed but still useful, groups of accounts are often combined into a single account for purposes ofpreparing the financial statements.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2







Dividends

Common examples include accounts receivable, which contains accounts from many different customers … property, plant & equipment,accounts payable, which includes accounts from many different vendors, accrued payables and many others.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (11) 24

(13) 2

At the end of the year before the financial statements are prepared Gone Fishin’ recorded two adjusting journal entries, designed toreflect changes in the accounts that were not represented by exchange transactions that occurred during the year.












13. Dividend (-RE) 2Accrued payables (+L) 2

Adjusting Entries:

The first is an entry to record the depreciation during the year associated with the company’s property, plant and equipment. Thisgroup of assets, which supports the revenue generation process, is gradually used up and ultimately will need to be replaced.













Adjusting Entries:

14. Depreciation expense (E, -RE) 20Property, plant & equipment (-A) 20

Depreciation is an expense that reflects the portion of the cost of these assets used up during the year. The dollar amount is determined by estimating both a useful life for the assets and a rate of usage each year. Gone Fishin’ estimated an amount of $20K …













Adjusting Entries:


… and recorded this entry – creating both a $20K expense …













Adjusting Entries:


… and a $20K reduction in the property, plant & equipment account. We discuss later that another account …













Adjusting Entries:


… called accumulated depreciation, is normally used to reduce property, plant & equipment, but reducing the PP&E account directlyresults in essentially the same financial statements.













Adjusting Entries:

14. Depreciation expense (E, -RE) 20Accumulated depreciation (-A) 20







Dividends

Similar to the other transactions, the adjusting entries are posted to the ledger – in this case increasing the depreciation expense account onthe left and decreasing the property, plant & equipment account on the right.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24

(13) 2

The second adjusting entry reflects the fact that as of the end of the year Gone Fishin’ owed the U.S. Federal government $10K, a taxamount assessed on profits earned by Gone Fishin’ during the year. This liability grew (or accrued) gradually during the year as Gone Fishin’earned its profits.













Adjusting Entries:


15. Income tax expense (E, -RE) 10Accrued payables (+L) 10

As a result, at year end Gone Fishin’ recorded an accrued liability on the right …













Adjusting Entries:



… and an income tax expense on the left.













Adjusting Entries:









Dividends

In the ledger, income tax expense is increased on the debit side and the accrued payable obligation is increased on the credit side.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)







Dividends

We have recorded all the transactions and adjustments, and can now proceed with the preparation of the financial statements.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)







Dividends

The first step is to simply total the balances in each account as has been done here.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

Note that the asset, expense and dividend accounts have left-side (debit) balances …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… while the liability, contributed capital and revenue accounts have right-side (credit) balances.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

Step 2 involves identifying the income statement accounts, which consists of the …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… revenues …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… and the expenses. You can now compute net income (revenues minus expenses) and prepare an income statement, which looks like …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2




Income Statement


this – a statement of Gone Fishins’ operating performance for its first year.





Income Statement


Revenues …


Revenues




Income Statement


…less expenses …


Revenues

Expenses




Income Statement


…leads to net income.


Revenues

Expenses

Net income







Dividends

Step 3 involves realizing that the revenue, expense and dividend accounts are actually what makes up retained earnings. This means that atyear end the retained earnings balance is equal to its beginning balance, which in this case is zero …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… plus net income of $20K …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

20 (NI)







Dividends

… less dividends of $2K …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)







Dividends

… leading to an ending balance of $18K …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… which is simply the beginning balance (zero) …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… plus $20K (revenues minus expenses) …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… less $2K, the dividends.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

The actual mechanical process of transferring the balances of the revenue, expense, and dividend accounts into the retained earningsaccount is called closing, and if you wish to see how it works, we cover it in the next video (Video 15).

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

Now that we have completed the income statement, in the shaded area above, which contains the balance sheet accounts, we have theinformation we need to complete the remaining financial statements.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

The ending balance sheet can be prepared by simply organizing the final balances in the asset, liability and shareholder equity accounts,which now includes a balance in retained earnings, into a balance sheet format, which would look like …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Income Statement


… this - a statement of the financial condition of Gone Fishin’ as of the end of the year.








Dividends

The statement of shareholders’ equity simply describes the activity in the shareholders’ equity accounts – contributed capital andretained earnings, and would look like …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Income Statement


… this – a statement of the changes in the shareholders’ investment during the year … And finally …











Dividends

… the statement of cash flows can be prepared by categorizing the cash inflows and outflows during the year into 3 groups …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… cash flows from operating activities (green) …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… cash flows from investing activities (blue) …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18







Dividends

… and cash flows from financing activities (red) … leading to …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(Div) 2 20 (NI)18









… this – a statement that explains the change in Gone Fishins’ cash balance from the beginning to the end of the year.







Capital Earnings TotalBeg. Balance $200,000 $ 0 $ 200,000+ Net income - 20,000 20,000- Dividends _______ (2,000) (2,000)End. Balance $ 200,000 $18,000 $ 218,000


We have now prepared a complete set of financial statements for Gone Fishin’ using journal entries and T-accounts in a ledger. Noteimportantly that these same exact statements were prepared in an earlier video (Video 11) directly from …


Beginning









dividend 2 (2)

Depreciate




… this worksheet.

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




The beginning and ending balances in the balance sheet accounts – assets, liabilities, and shareholders’ equity – represent the beginning andending balance sheets.

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




The activity in the revenue and expense accounts comprised the income statement.

Adjusting entries


Beginning









dividend 2 (2)

Depreciate




The activity in the contributed capital and retained earnings accounts provided the information for the statement of shareholders’equity.

Adjusting entries


Beginning





Land (30)Pay cash




dividend 2 (2)

Depreciate




… and the activity in the cash account provided the information for the statement of cash flows.

Adjusting entries


The Closing Process

In this video we explain and illustrate the closing process, a sequence of journal entries recorded at year end immediately priorto preparing the financial statements. These entries transfer the balances in the revenue, expense and dividend accounts intothe retained earnings account. It is where we get the expression to “close the books.”







Dividends

Here is Gone Fishins’ ledger immediately after all transactions and adjusting entries have been posted at the end of its first year.Note that the ending balances in each account (in purple) have been computed.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

Note also that there is a zero balance in the retained earnings account. An important step in preparing the financial statements, therefore, isto create a balance in that account. In addition, we also need to adjust the balances …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… in the revenue,

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… expense …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… and dividend accounts …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… to zero because they need to start anew – with a zero balance – at the beginning of each year – in this case next year or … year 2 for Gone Fishin’.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Adjust to

zero







Dividends

Recall that the revenue, expense and dividend accounts are designed to keep track of activity that occurs during the year, while the …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Periodof

time







Dividends

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

… retained earnings account reflects the accumulation of that activity up to a specific point in time. These differences highlight …

Pointin

time







Dividends

… an important distinction among the accounts. That is ...

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… the revenue …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… expense …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… … and dividend accounts are called …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… temporary accounts because they are closed out at the end of every period, beginning the next period with zero balances.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Temporary Accounts







Dividends

On the other hand, the balance sheet accounts …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… assets …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… liabilities …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… and shareholders’ equity …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2







Dividends

… are called permanent accounts because their balances accumulate from one period to the next.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Permanent Accounts







Dividends

At this point, therefore, in order to prepare the financial statements, we must close the temporary accounts – revenues, expenses, and dividends …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Temporary Accounts- closed at year end …







Dividends

… into the permanent account – retained earnings. Recall that retained earnings is the permanent account that houses all past revenuesminus past expenses minus past dividends. The closing process requires …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Temporary Accounts… into Retained earnings

… a set of closing journal entries, recorded in the journal …

Journal

Closing entries:

Ledger Cash Sht-tm investments Accounts receivable Inventory Property, plant & equip





Dividends

… and posted to the ledger.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

It involves 4 steps …

Closing Process

4 Steps

… (1) create a temporary account called income summary …

Closing Process

1. Create a temporary account called income summary.

… (2) close the revenue and expense accounts into the income summary account …

Closing Process


2. Close the revenue and expense accounts into the income summaryaccount.

… (3) close the income summary account into the retained earnings account …

Closing Process



3. Close the income summary into the retained earnings account.

… and (4) close the dividend account directly into the retained earnings account. Unlike revenues and expenses, dividends arenot closed to retained earnings through the income summary because they are not part of the net income calculation. Let’sget started.

Closing Process



3. Close the income summary into the retained earnings account.

4. Close the dividend account into the retained earnings account.




Contributed capital Retained earnings Income Summary



Dividends

Step 1 – Create a new TEMPORARY account called income summary.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

Step 2 – Close the revenue and expense accounts into the income summary account. We begin first with service revenue by recordingthis closing journal entry – a left-side debit to service revenues and a right-side credit to income summary for $50K.

Journal

Closing entries:

16. Service revenue (-R) 50Income summary 50







Dividends

When this entry is posted in the ledger, it zeroes out the service revenue account and places a $50K credit in the income summary account.The service revenue account is now closed. It has a zero balance.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

50 (16)

(16) 50

)

We then record a similar entry for the sales revenue account – a debit to sales revenue and a credit to income summary for theamount of sales revenue recognized during the year, $100K.

Journal

Closing entries:


17. Sales revenue (-R) 100Income summary 100







Dividends

… and again in the ledger the revenue account is closed to zero and the right side of the entry is placed in the income summary account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

50 (16)

100 (17)

(16) 50 (17) 100

We focus now on closing the expense accounts, starting with cost of goods sold with this closing entry. This entry records a left-sidedebit to income summary and a right-side credit to cost of good sold for the dollar amount booked during the year, $30K.

Journal

Closing entries:



18. Income summary 30Cost of goods sold (-E) 30







Dividends

In the ledger the cost of goods sold account is now zero and the cost of goods sold dollar amount is now on the left side of income summary.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

100 (17)

(16) 50 (17) 100

30 (18)

We make a similar entry for the remaining expense accounts – operating expenses, depreciation expense, interest expense, andincome tax expense. In all cases, income summary is recorded on the left and the expense account is recorded on the right.

Journal

Closing entries:




19. Income summary 46Operating expenses (-E) 46

20. Income summary 20Depreciation expense (-E) 20

21. Income summary 24Interest expense (-E) 24

22. Income summary 10Income tax expense (-E) 10







Dividends

In each case the expense account is closed to zero and the dollar amount is moved to the left side of the income summary account. At thispoint all the revenue and expense accounts have a zero balance and have been closed to the income summary.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)







Dividends

We can now compute an ending balance in the income summary account and we find that it equals $20K and is located on the right side.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

20

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)







Dividends

This number happens to be net income …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)







Dividends

… revenues on the right of the income summary account …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

Rev







Dividends

… less expenses on the left.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

Rev

Exp







Dividends

Thus, the name of the account – income summary. We can now move to Step 3 in the closing process, which is to close the incomesummary account to the retained earnings account … and this is done …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10

20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

… with this closing journal entry, which records $20K on the left side of income summary and $20K on the right side of retained earnings.

Journal

Closing entries:








23. Income summary 20Retained earnings (+RE) 20







Dividends

When posted in the ledger, this entry closes (or zeroes out) the temporary account, income summary …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

2 (25)

20 (23)







Dividends

… and transfers the net income amount to the right side of the retained earnings account. Net income for the year has now beenformally placed in the retained earnings account.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

The fourth and final step in the closing process closes the dividend account to zero with this entry – a debit to retained earnings anda credit to the dividend account. Note again that dividends are closed directly to retained earnings, not through the income summary.

Journal

Closing entries:








23. Income summary 20Retained earnings (+RE) 20

24. Retained earnings (-RE) 2Dividends (-D) 2







Dividends

When this entry is posted to the ledger, it simultaneously closes the dividend account to zero, and reduces retained earnings by $2K, the dollar amount of the dividend.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2







Dividends

The final balance in the retained earnings account is now an $18K right-side credit, calculated in the following way.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

The beginning balance of zero …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

… and plus net income of $20K …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

… and minus dividends of $2K.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

We now have everything in place to prepare the financial statements.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

The end-of-year balance sheet can be prepared from the final balances in the permanent …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

… asset …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

… liability …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

… and shareholders’ equity accounts …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

The income statement for the year can be prepared from the revenues and expenses listed on the income summary account ...

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18

Rev

Exp







Dividends

The statement of shareholders’ equity can be prepared from the activity in the components of shareholders’ equity – the contributedcapital and retained earnings accounts …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18

NIDiv







Dividends

And the statement of cash flows can be prepared from the activity in the cash account, organized into operating (in green), investing (in blue)and financing (in red) cash flows. And finally the closing process has the accounts ready for the next year.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

5 25 0 70 400

200 0

0 0 0 300

0 0

0 0 0 0 0

0

(5) 70 2 (6) (5) 30 (6) 10 30 (5) (9) 30 20 (14)

(7) 60 30 (9)

8 (6) (8) 50 60 (7) 2 (13) (12) 25

46 (10)

24 (11)

25 (12)

50 (8) 100 (5)

(5) 30 (10) 46 (14) 20 (11) 24 (15) 10

(13) 2

10 (15)8

25 30 50 410

8 1012

275

200

50 100

30 46 20 24 10

2

(18) 30 50 (16)

(19) 46 100 (17)

(20) 20(21) 24(22) 10(23) 20 20 Net income

(16) 50 (17) 100

30 (18) 46 (19) 20 (20) 24 (21) 10 (22)

20 (23)

2 (24)

(24) 2

18







Dividends

That is, the permanent (balance sheet) asset, liability and shareholders’ equity accounts have their accumulated beginning balances …

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

8 25 30 50 410

200 18 0

8 10 12 275

0 0

0 0 0 0 0

0







Dividends

… and the temporary accounts all have zero balances, ready to accumulate the revenue, expense and dividend activity during year 2.

+ - + - + - + - + -

- + - + - + - +

- + - +

- + - +

+ - + - + - + - + -

+ -

8 25 30 50 410

200 18 0

8 10 12 275

0 0

0 0 0 0 0

0

Contra Accounts

In this video we describe contra accounts … accounts disclosed on the financial statements with negative balances, often subtracted fromthe balances of other related accounts, leading to a “net” dollar value.

THE HOME DEPOT, INC.FINANCIAL STATEMENTS

Year ended January 29, 2017(dollar amounts in millions)

Before we get started, let’s take a quick look at Home Depot’s financial statements for fiscal year 2016, which ended on January 29,2017.

BALANCE SHEETJanuary 31, 2016

ASSETSCash $ 2,216Accounts receivable 1,890Inventory 11,809Other current assets 569Total current assets 16,484Property & equipment 39,266Less: accum. depreciation (17,075)Net property & equipment 22,191Other assets 3,298Total assets $ 41,973

LIABILITIES & SHARE EQUITYAccounts payable $ 6,565Other current liabilities 5,959Total current liabilities 12,524Long-term liabilities 23,133Total liabilities 35,657Shareholders’ equity 6,316Total liabilities &

shareholders’ equity $ 41,973



Here’s the beginning balance sheet (dated January 31, 2016) …











and the ending balance sheet (dated January 29, 2017).









STATEMENT OF CASH FLOWSYear ended January 29, 2017

Cash flows from operating activities $ 9,783Cash flows from investing activities (1,583)Cash flows from financing activities (7,878)Change in cash balance 322Beginning cash balance 2,216Ending cash balance $ 2,538



Here’s the statement of cash flows …













… which explains the change in the cash balance from the beginning to the end of the year …









INCOME STATEMENTYear ended January 29, 2017

Sales $ 94,595Cost of goods sold (62,282)Gross profit 32,313Selling, general & adm expenses (17,132)Depreciation & amortization (1,754)Net operating income 13,427 Other income (loss) 36Interest expense (972)Net income before taxes 12,491Income tax expense (4,534)Net income $ 7,957





… Home Depot’s income statement …













STATEMENT OF SHAREHOLDERS’ EQUITYYear ended January 29, 2017

Beginning balance $ 6,316Plus: net income 7,957Less: dividends (3,404)Less: stock repurchases (7,000)Plus: other 464Ending balance $ 4,333



… and the statement of shareholders’ equity …

















… which includes the net income number from the income statement …

















… and explains the change in the shareholders’ equity balance from the beginning to the end of the year. As we go through thediscussion of contra accounts, we will periodically refer to these statements.

Contra Accounts on theBalance Sheet

Recall how we accounted for the purchase of property, plant and equipment and its depreciation at the end of the period.

Purchase property, plant & equipment:

Depreciation of property, plant & equipment:


When property, plant & equipment is purchased with cash, for example, the journal entry looks like this, assumingthat $100 is paid for the asset.


Property, plant & equipment (+A) 100Cash (-A) 100


This investing transaction both increases and decreases assets, exchanging one asset for another – thereby affecting …



Investingactivity

















… the balance sheet (Home Depot’s cash and property & equipment accounts) as well as ...

















… the investing section of Home Depot’s statement of cash flows, which includes the cash outflows associated with investing in producingassets such as property and equipment.

















Note in the box in the upper, right-hand corner, which details Home Depot’s investing cash flows …

Capital expenditures $ (1,621)Proceeds from property and investment sales 38Total $ (1,583)

















… that over $1.6 billion was invested by Home Depot during the year in capital expenditures, which are primarily property and equipment.



At the end of each reporting period, as part of the adjustments to the financial statements, recall that a journal entry is recordedto reflect the fact that a portion of the property, plant & equipment was used up (or depreciated) in the operations of the business during the period that just ended.





That entry looks like this, assuming that 1/10th of the investment in property, plant & equipment was used up (or depreciated)during the year. This entry created …




Depreciation expense (E, -RE) 10Property, plant & equipment (-A) 10


… a $10 expense, called depreciation expense, that reduced net income on the income statement …





















… as shown here on Home Depot’s income statement. At the same time the entry ...


… reduces the balance sheet value of property, plant & equipment by $10. However, in practice this entry is recorded a little differentlythan indicated here. Rather than directly reducing the property, plant & equipment account as shown here, a separate account isused and credited on the right side of the entry.






This account is called accumulated depreciation. Accumulated depreciation is a permanent, balance sheet account, and its purpose is tokeep an accumulated record of the amount of depreciation recorded on the asset being depreciated over its useful life. It carries aright-side, credit balance …




Depreciation expense (E, -RE) 10Accumulated depreciation (-A) 10

















… and on the balance sheet, as shown here, its balance is subtracted from the cost of the property & equipment account, leading to anumber called NET property & equipment, which reflects the reduced balance sheet value of the asset.

















The accumulated depreciation account is called a CONTRA account because it is subtracted from the account to which it relates; in this caseproperty & equipment. This disclosure highlights both …

Contra account

















… the original cost of the asset …

















… and the accumulation of its depreciation over time, reflected in a contra account ...

















… leading to a net number for the asset group.


Similar to property, plant & equipment, companies often purchase - or invest in the development of - intangible assets, such as patents, copyrights, and trademarks , that are used up over their useful lives. These assets are accounted for in the same manner as property, plant & equipment …

Purchase intangible asset (e.g., patent, copyright, trademark):


… that is, when they are purchased, a long-term asset is exchanged for cash …


Intangible asset (+A) 100Cash (-A) 100


… in an investing transaction, which is reflected on the balance sheet and the investing section of the statement of cash flows …



Investingactivity

















… as shown here on Home Depot’s balance sheet and statement of cash flows. For Home Depot … intangible assets are included ina larger category of assets on the balance sheet called “other assets.”


When intangible assets are “depreciated,” the asset is gradually converted into an expense, which again reduces net income on theincome statement. The only difference is that the depreciation of an intangible asset is called …



Depreciation of intangible asset:

Depreciation expense (E, -RE) 10Accumulated depreciation (-A) 10


… amortization, so there is an ....



Amortization of intangible asset:

Amortization expense (E, -RE) 10Accumulated amortization (-A) 10


… amortization expense and …






… an accumulated amortization contra asset account.





Contra Asset Account

















You can see here on Home Depot’s income statement that depreciation and amortization expense are added together because theyare so similar … depreciation for property, plant and equipment … amortization for intangibles. Also …


ASSETSCash $ 2,216Accounts receivable 1,890Inventory 11,809Other current assets 569Total current assets 16,484Property & equipment 39,266Less: accum. depreciation (17,075)Net property & equipment 22,191Other assets (NET) 3,298Total assets $ 41,973















… if you would look back into Home Depot’s footnotes to the financial statements, you would find that the “other asset” category includesHome Depot’s intangible assets at their NET amount; that is, their original cost less accumulated amortization.

















Accumulated depreciation and accumulated amortization are two examples of contra accounts, and both happen to be contra ASSETaccounts. There are other contra accounts – some for assets, some for liabilities, and some for equities … but all serve the same purpose …

















… to keep track of the original book value of the account and the amount of the reduction in book value, leading to a NET book valuedollar amount.

Home DepotAsset Section of the Balance Sheet

Let’s close by taking a quick look at the actual asset section of Home Depots’ January 2017 balance sheet.


Note that accumulated depreciation is disclosed on the balance sheet …

*


… but accumulated amortization is not. Companies vary with regard to how they handle the disclosure of contra accounts.


Some companies simply place the “net” number on the balance sheet and provide the detail, including the contra account, in the footnotes …

Detail in footnotes


… others provide the detail on the financial statement itself.

Detail provided here


Either treatment is acceptable as long as the company is disclosing somewhere – either on the statements or in the footnotes – the information users need to reasonably assess the financial condition and performance of the company.

Introduction toTreasury Stock

In this video we provide a brief introduction to treasury stock … previously issued stock (normally common stock) that is repurchasedby the issuing company and held for possible re-issuance at a later date. In Video 43 of this series, entitled “Shareholders’ Equity,” weprovide a much deeper description of treasury stock and related issues.





















… the ending balance sheet (dated January 29, 2017) …




























































































… and explains the change in the shareholders’ equity balance from the beginning to the end of the year. As we go through thediscussion of treasury stock, we will periodically refer to these statements.

Treasury Stock

Companies issue stock to raise equity capital. Recall that the owner or shareholder, who buys the stock, receives the rights ofownership; that is, control over management and a right to future net income.

Issue common stock:

Treasury Stock

When the stock is issued, this journal entry is recorded assuming that $100 in equity capital is raised.

Issue common stock:

Cash (+A) 100Common stock (+CC) 100

Treasury Stock

This financing transaction increases the company’s assets and contributed capital, which is reflected …

Issue common stock:


Financing activity

















… on the balance sheet in the cash and shareholders’ equity accounts ...

















… and on statement of cash flows in the financing section.

















Note in the box in the upper right-hand corner, which includes the actual breakdown of Home Depot’s financing cash flows, $218 million wascollected from stock issuances during the year – not a large amount given the dollar values of some of the other financing cash flows.

Net proceeds from borrowings $ 2,274Repurchases of common stock (7,000)Proceeds from sales of common stock 218Cash dividends (3,404)Other 34Total $ (7,878)

















Stock issuances are also disclosed on the statement of shareholders’ equity as an increase in contributed capital. In Home Depot’s casethe stock issuances, which were relatively small, were included and netted against a variety of accounts in the “other” category.

Treasury Stock

Often, and for a variety of reasons, companies buy outstanding stock back from their shareholders. When this occurs …

Issue common stock:


Buy it back:

Treasury Stock

… this entry is recorded assuming that $50 was paid by the company to buy back some of the outstanding stock.

Issue common stock:


Buy it back:

Treasury stock (-CC) 50Cash (-A) 50

Treasury Stock

This is also a financing activity and it reduces contributed capital and cash, which again is reflected …

Issue common stock:


Buy it back:


Financing activity

















… on the balance sheet in the cash and shareholders’ equity accounts, on the statement of cash flows in the financing section, and on thestatement of shareholders’ equity as a reduction in shareholders’ equity.

















Note again in the top right-hand corner, which describes Home Depots’ financing cash flows, that Home Depot repurchased $7 billionof its own stock during the year – a very large amount, reflected on both the statements of cash flows and shareholders’ equity.

Net proceeds from borrowings $ 2,274Repurchases of common stock (7,000)Proceeds from sales of common stock 218Cash dividends (3,404)Other 34Total $ (7,878)

Treasury Stock

When a treasury stock purchase is recorded, instead of reducing the common stock account, which was established when the stockwas originally issued, the entry increases a contra EQUITY account, called treasury stock, which appears as a negative number in theshareholders’ equity section of the balance sheet.

Issue common stock:


Buy it back:


Contra equityaccount







LIABILITIES & SHARE EQUITYAccounts payable $ 7,000Other current liabilities 7,133Total current liabilities 14,133Long-term liabilities 24,500Total liabilities 38,633Shareholders’ equity 4,333*Total liabilities &










Here is a breakdown of the components of the shareholders’ equity section of Home Depot’s January 29, 2017 balance sheet. You can seethat the $4.333 billion dollar shareholders’ equity balance is comprised of contributed capital plus retained earnings, less treasury stock …

* Contributed capital $ 9,875Retained earnings 34,652Less: Treasury stock (40,194)Total shareholders’ equity $ 4,333







LIABILITIES & SHARE EQUITYAccounts payable $ 7,000Other current liabilities 7,133Total current liabilities 14,133Long-term liabilities 24,500Total liabilities 38,633Shareholders’ equity 4,333*Total liabilities &










… which is extremely large; in this case over $40 billion. Large treasury stock accounts are not unusual for successful companies thathave been in business for a long time. Treasury stock purchases are indeed very common.

* Contributed capital $ 9,875Retained earnings 34,652Less: Treasury stock (40,194)Total shareholders’ equity $ 4,333

Home DepotStatement of Shareholders’ Equity Section of the Balance Sheet

2017 2016

Let’s conclude by taking a quick look at the shareholders’ equity section of Home Depot’s actual balance sheet.


2017 2016

Note that treasury stock, a negative number in the shareholders’ equity section, began the year with a balance of over $33 billion,which grew by $7 billion, the dollar amount of the treasury shares purchased during the year, to over $40 billion.

*


2017 2016

The disclosure also shows that 53 million shares were purchased during the year by Home Depot …

53 million (573m – 520m) shares purchased


2017 2016

… which means that one can compute the average price of the shares purchased … $7 billion divided by 53 million shares = $132 per share.

$7 billion / 53 million shares =$132 million per share


2017 2016

During the period of time treasury stock is held by the company, it retains no rights of ownership; that is, it has no voting rights and no rightsto future profits. It can be re-issued at a later date, and at that point would become outstanding common stock with full ownership rights.

No rights of ownership

Sales of Non-inventory Assets

In this video we discuss sales of non-inventory assets, such as investments, accounts receivable, property, plant & equipment andintangible assets.





















… and the ending balance sheet (dated January 29, 2017) …









































… Home Depot’s income statement …



















































… and explains the change in the shareholders’ equity balance from the beginning to the end of the year. As we go through thediscussion of the sale of non-inventory assets, we will periodically refer to these statements.


When we refer to non-inventory assets we include …


… investments in stocks and bonds and real estate that are purchased and sold by many companies …

● Investments


… accounts receivable from customers that are sometimes sold to financial institutions to accelerate the collection of cash …

● Investments

● Accounts receivable


… as well as property, plant & equipment and intangible assets that are often sold after they have been used in running the business.

● Investments

● Accounts receivable

● Property, plant & equipment

● Intangible assets


When investments, property and equipment and intangibles are purchased, for $100 cash in this example, the relevant asset account isincreased and cash is reduced.

Purchase of non-inventory asset:

Asset (+A) 100Cash (-A) 100


This investing transaction is reflected on ...


Asset (+A) 100Cash (-A) 100

Investing activity

















… the balance sheet in the cash account and an in any number of other non-inventory asset accounts, which for Home Depot wouldinclude “other current assets,” “property and equipment,” and “other assets.”

















The cash payment made to purchase these assets would also be reflected as a cash outflow in the investing section of thestatement of cash flows.

















Note in the box in the upper, right-hand corner, which details Home Depot’s investing cash flows, that over $1.6 billion was investedin capital expenditures, mostly property and equipment, during fiscal 2017.



When the asset - accounts receivable - is recognized … revenue is earned because the company has performed a serviceor delivered a good prior to being paid by the customer.

Recognition of accounts receivable:

Accounts receivable (+A) 100Sales (R, +RE) 100

















For Home Depot this transaction leads to an accounts receivable balance on the balance sheet and the recognized revenueappears on the company’s income statement as sales.


How do we account for transactions where these non-inventory balance sheet assets are sold?


When a portion (say half) of the asset’s $100 book value is sold for (say) $60; $60 cash is collected, half the book value of the asset ($50)is removed from the balance sheet, and a realized gain on the sale is recognized. This gain increases net income on the income statement.


Asset (+A) 100Cash or revenue (-A or R, +RE) 100

Sale of half the non-inventory asset for $60:

Cash (+A) 60Asset (-A) 50Realized gain on sale (R, +RE) 10


If half of the $100 book value was sold for $40; only $40 would be collected, again half of the book value of the asset ($50) would beremoved from the balance sheet, and this time a realized loss on the sale would be recognized, which would reduce net income on theincome statement.





Sale of half the non-inventory asset for $40.

Cash (+A) 40Realized loss on sale (Lo, -RE) 10

Asset (-A) 50


In both the realized gain and the realized loss cases, the cash proceeds are reflected in the investing section of the statementof cash flows.







Asset (-A) 50

Investing section ofthe statement of cash flows

















… as is shown here for Home Depot, which collected $38 million during fiscal 2017 from these kinds of asset sales.



The realized gains and losses resulting from these asset sales are normally disclosed …







Asset (-A) 50

















… in a special section of the income statement, separate from the revenues and expenses associated with the normal operations of thebusiness. Home Depot included these gains and losses – totaling $36 million - in the “other income (loss)” account on its income statement.


One final note regarding the sale of depreciable or amortizable assets like property, plant and equipment or intangible assets. In thesecases it is important to remember that the accumulated depreciation or accumulated amortization associated with the sold asset shouldbe removed from the balance sheet along with the cost of the asset. For example …

Sale of assets subject to depreciation or amortization


Let’s say that a company purchased a piece of equipment for $100, used it for 8 years, recognizing $10 of depreciation each year,and after 8 years had accumulated depreciation of …


Equipment $ 100


…$80 … and by the end of the 8th year …


Equipment $ 100Less: accumulated depreciation (80)


… the net balance sheet value was $20 and it appeared on the company’s balance sheet like this. Assume further that at the endof the 8th year the company sells this equipment for $30, $10 above its $20 balance sheet (or book) value.


Equipment $ 100Less: accumulated depreciation (80)Net balance sheet value $ 20


$30 of cash would be collected on the sale …



Cash (+A) 30


… the $80 of accumulated depreciation and the $100 cost of the equipment would be removed from the balance sheet sincethe asset is no longer possessed by the company …



Cash (+A) 30Accumulated depreciation (+A) 80

Equipment (-A) 100


and a realized gain on the sale, which would increase net income on the income statement, would be recognized in the amount of thedifference between the $30 proceeds and the $20 balance sheet (or book) value of the equipment. If the equipment would have beensold for less than the net balance sheet value (say for $15 instead of $30) …



Cash (+A) 30Accumulated depreciation (+A) 80

Equipment (-A) 100Realized gain on sale (R, +RE) 10


… a realized loss of $5 would have been recognized, and this loss would have reduced net income on the income statement.



Cash (+A) 15Accumulated depreciation (+A) 80Realized loss on sale (Lo, -RE) 5

Equipment (-A) 100


In summary, when non-inventory assets are sold …


… realized gains or losses, which increase or decrease net income, are recognized in the amount of the difference between …

Sale of asset for a gain:

Cash (+A) 60Asset (-A) 50 Realized gain on sale (R, +RE) 10

Sale of asset for a loss:

Cash (+A) 40 Realized loss on sale (Lo, -RE) 10

Asset (-A) 50


… the proceeds collected and the …





Asset (-A) 50


… net balance sheet (or book) value of the asset.





Asset (-A) 50


If the asset is subject to depreciation or amortization like property, equipment or intangible assets …

Sale of asset for a gain: Sale of depreciable asset for a gain:

Cash (+A) 60 Cash (+A) 30 Asset (-A) 50 Accumulated depreciation (+A) 80Realized gain on sale (R, +RE) 10 Asset (-A) 100

Realized gain on sale (R, +RE) 10

Sale of asset for a loss: Sale of depreciable asset for a loss:

Cash (+A) 40 Cash (+A) 15Realized loss on sale (Lo, -RE) 10 Accumulated depreciation (+A) 80

Asset (-A) 50 Realized loss on sale (Lo, -RE) 5 Asset (-A) 100


… the accumulated depreciation or amortization is considered in determining the net balance value, and again …








… the realized gain or loss is equal to the difference between …








… the proceeds from the sale …








… and the balance sheet (or book) value of the asset.







Accrual and Cash Differences:An Introduction

In this first of two videos (Videos 19 & 20), which together address accrual and cash differences, we introduce the important distinctionbetween …


… revenues and expenses on the income statement, which lead to net income …

Income statement

Revenues =(Expenses) =Net income =


… and the cash inflows and outflows in the operating section of the statement of cash flows, which lead to net cash from operatingactivities.

Income statement Statement of cash flows

Revenues = Operating cash inflows

(Expenses) = (Operating cash outflows)

Net income = Net cash from operating activities


The measurement of revenues and expenses is based on what we call the accrual concept, while cash inflows and outflows simplyreflect the movement of cash.





Accrual concept Cash concept


Both measures … net income and net cash from operating activities … are important indicators of a company’s operating performance,but they tell us very different things. In the second video (Video 20) we work a mechanical example.





Accrual concept Cash concept

Balance Sheet(1/1/20XX)

Cash $ 100Accounts receivable 1,300Prepaid expenses 1,000Total Assets $ 2,400

Accrued payables 800Unearned revenues 900Contributed capital 500Retained earnings 200Total debt & equity $ 2,400

Simple Company(20XX)

Let’s begin with a simple balance sheet. The managers of Simple Company began the year with a balance sheet looking like this …





A cash balance in the amount of $100.





Accounts receivable of $1,300.





This account represents the value of goods and services that Simple Company has already provided to its customers and recordedas revenue. The company is still awaiting cash payment from the customers.

“Already booked as revenue but cash receipthas not been collected.”

Accounts receivable (+A) 1,300Revenue (R, +RE) 1,300





Prepaid expenses of $1,000.





This asset represents operating expenses (like insurance and rent) that Simple Company has paid for, but not yet used. They have paidfor these expenses in advance, and list the cost as an asset on the balance sheet.

“Expenses paid for in advance.”

Prepaid expense (+A) 1,000Cash (-A) 1,000





This leads to total assets of $2,400.





Accrued payables amount to $800.





This obligation represent expenses already recognized by Simple Company for which payment has not yet been made. Wages, interest,and taxes represent common examples.

“Expenses incurred but not yet paid for.”

Expense (E, -RE) 1,000Accrued payables (+L) 1,000





Accrued payables represent the opposite side of the transaction from accounts receivable. That is …

Opposite sides of transaction





… each time a company a company has completed a service and recognized a receivable and revenue …


Accounts receivable (+A) XXRevenue (R, +RE) XX





… the company on the other side of the transaction should be recognizing a payable and an expense.


Accounts receivable (+A) XXRevenue (R, +RE) XX

Expense (E, -RE) XXAccrued payable (+L) XX





Unearned revenues of $900.





This liability reflects the fact that Simple Company owes customers goods or services for which the customers have already paid.

“Cash has been received but service not yet performed.”

Cash (+A) 1,000Unearned revenue (+L) 1,000





Unearned revenues represent the opposite side of the transaction from prepaid expenses.






Again, each time a company pays cash in advance for an expense …


Prepaid expense (+A) XXCash (+A) XX





… the company on the other side of the transaction should be recognizing a cash receipt and a liability for the future obligation.


Prepaid expense (+A) XXCash (+A) XX

Cash (+A) XXUnearned revenue (+L) XX





To round out the balance sheet, Simple Company also has contributed capital of $500 … Direct contributions made to Simple Companyby the shareholders in exchange for ownership interests.





And, finally, retained earnings of $200, a measure of Simple Company’s past profits left in the company and not paid to the owners in theform of dividends. Overall … to start the year, the managers of Simple Company had at their disposal …





Assets of $2,400, financed by …





… liabilities of $1,700 …

1,700





… and owner (or shareholder) investments, through either direct contributions or re-invested profits, of $700.

700





Assume that Simple Company started the year with this balance sheet, and during the year entered into a series of transactions, leading to …




Statement of Cash Flows(year ended 12/31/20XX)

Cash from operating activities $ 2,550Cash paid for investing activities (0)Cash paid for financing activities (2,430) Change in cash balance 120Beginning cash balance 100Ending cash balance $ 220

Income Statement(year ended 12/31/20XX)


Statement of Shareholders’ Equity(year ended 12/31/20XX)


1/1/20XX balance $ 500 $ 200 $ 700Plus: Net income 3,000 3,000Less: Dividends ____ (2,430) (2,430)12/31/20XX balance $ 500 $ 770 $ 1,270





… a statement of cash flows, which explains the changes in the cash balance from the beginning to the end of the year …





Net cash from operating activities $ 2,550Net cash paid for investing activities (0)Net cash paid for financing activities (2,430) Change in cash balance 120Beginning cash balance 100Ending cash balance $ 220










… a statement of shareholders’ equity, which explains the changes during the year in the shareholders’ equity accounts ...















… an income statement, which matches the expenses against the revenues, highlighting net income ….















… and finally a balance sheet, which reflects the company’s financial condition at the end of the year.















Lets now focus on two very important indicators of the company’s performance during the year -















… net income …















… and net cash from operating activities … and now let’s explore ...















… why these two measures of operating performance have different values.

Why different?















As we get started, understand first that net income is the product of …















… an accrual system of accounting that recognizes revenue when it is earned, not necessarily when the cash is received,and recognizes expenses when they are incurred, not necessarily when the cash is paid.

Accrual accounting















Net cash from operating activities, on the other hand, reflects the actual cash inflows and outflows associated with the activities leading to therevenues and expenses that appear on the income statement.

= Operating cash inflows – operating cash outflows















With this in mind we now look at the balance sheet and focus on changes in certain balance sheet accounts from the beginning to the endof the year. These changes will help us to better understand why net income is a different number than net cash from operating activities.





Let’s go back to the original balance sheet, and take a close look at the four balance sheet accounts we reviewed earlier.





Accounts receivable …





… prepaid expenses …





… accrued payables …





… and unearned revenues. All four have one very important thing in common.





They all involve the recognition of a revenue or an expense at a time different from the receipt or payment of cash.

“Represent cases where revenue and expenserecognition differs from cash flows”





That is, revenues do not match cash inflows and expenses do not match cash outflows. For example, …

“Represent cases where revenue and expenserecognition differs from cash flows”

Revenue/expense = Cash flow





… accounts receivables arise when revenue from providing a service or delivering a good to a customer is recognized before …

Revenue recognized before cash received.

1. Accounts receivable (+A) XXRevenue (+R, +RE) XX





… cash is received from the customer.

Revenue recognized before cash received.

1. Accounts receivable (+A) XXRevenue (+R, +RE) XX

2. Cash (+A) XXAccounts receivable (-A) XX





Unearned revenues, on the other hand, involve cases where cash is received from customers before …

Cash received before service performed.

1. Cash (+A) XXUnearned revenue (+L) XX





… a good or service is delivered and the related revenue is recognized.

Cash received before service performed.

1. Cash (+A) XXUnearned revenue (+L) XX

2. Unearned revenue (-L) XXRevenue (R, +RE) XX





Similarly, prepaid expenses arise when cash is paid for services before …

Cash paid before service used.

1. Prepaid expense (+A) XXCash (-A) XX





… the services are used and the related expense is recorded …

Cash paid before service used.

1. Prepaid expense (+A) XXCash (-A) XX

2. Expense (-E, -RE) XXPrepaid expense (-A) XX





… and accrued payables are booked when expenses are recorded before ...

Expense recorded before cash paid.

1. Expense (E, -RE) XXAccrued payable (+L) XX





… cash payments for those expenses are made.

Expense recorded before cash paid.

1. Expense (E, -RE) XXAccrued payable (+L) XX

2. Accrued payable (-L) XXCash (-A) XX















All in all, these accounts ...















and how they change from the beginning to the end of the period, explain why differences exist between …















… net income, which is equal to revenues minus expenses on the income statement …















… and net cash from operating activities, which is equal to operating cash inflows minus operating cash outflows, and appears on the statement of cash flows. In the next video (Video 20) we record the entries leading to these differences and show mechanically how ….
















… changes in these four balance sheet accounts explain the difference between net income and net cash from operating activities.

The Difference between Net Incomeand Net Cash from Operating Activities:

In this … the second of two videos devoted to differences between net income and net cash from operating activities …

Mechanical Example

… we work through a mechanical example that explains these differences in terms of changes in related balance sheet accounts.


Mechanical Example

Indirect Form of Presentation

The final product is the indirect form of presentation which is used by most companies when preparing the operating section of thestatement of cash flows.
















Recall from the last video (Video 19) that we introduced the differences between net income on the income statement …















… which is based on the accrual concept (revenues minus expenses) …

Accrualconcept















… and net cash from operating activities ...















… which simply reflects operating cash inflows minus operating cash outflows.
















Recall as well that we noted that for Simple Company these differences can be explained by changes in four balance sheet accounts …
















… accounts receivable …
















… prepaid expenses ...
















… accrued payables …
















… and unearned revenues ...
















… all of which reflect cases where revenues or expenses are booked at a time different from the related operating cash inflow or outflow.
















Let’s now take a look at a series of transactions entered into by Simple Company during the year, paying special attention to …
















… the changes in these four balance sheet accounts ...
















… and how they relate to the differences between the revenues and expenses reported on the income statement …
















… and the cash inflows and outflows reported in the operating section of the statement of cash flows.


Cash Accounts receivable Prepaid expenses Accrued payables Unearned revenue Common stock

Retained earnings Revenues Expenses Dividends Income summary

100 1,300 1,000 800 900 500

200

We begin by looking at the general ledger of Simple Company that existed at the beginning of the year, noting the beginning balances in all the permanent, balance sheet, accounts. They are the same balances that appear ...















… on our balance sheet as of the beginning of the year.


Retained earnings Revenue Expenses Dividends Income summary

100 1,300 1,000 800 900 500

200

Entries during the year

We start our analysis of the events during the year by recording the company’s activity ...



100 1,300 1,000 800 900 500

200


… in the revenue account ... and the related balance sheet accounts …



100 1,300 1,000 800 900 500

200


… accounts receivable and unearned revenue ...



100 1,300 1,000 800 900 500

200


… as well as the related operating cash inflows reflected in the cash account.



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows:

Cash 9,700 Revenue 9,700

9,700

9,700

During the year Simple Company provided $9,700 in services for its customers for which it collected cash at the exact time when the service was completed. This entry would be recorded in the company’s books, increasing cash and recognizing revenue by the same amount, $9,700.



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows:Cash 9,700

Revenue 9,700

Cash 1,300Accounts receivable 1,300

9,700

9,700

1,3001,300

Simple Company also collected from its customers the $1,300 in cash, reflected in the accounts receivable balance on services completedin a prior period. Note that during the year so far Simple Company has received …



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows:Cash 9,700

Revenue 9,700


9,700

9,700

1,3001,300

… $11,000 ($9,700 + $1,300) from customers, but only booked $9,700 in revenue. The revenue associated with the accounts receivablebalance of $1,300 was booked in a prior period.

11,000



100 1,300 1,000 800 900 500

200





Accounts receivable 1,400 Revenue 1,400

9,700

9,700

1,300 1,300

1,400

1,400

During the year Simple Company also provided services to customers for which the customers have not yet paid, leading to this entry,which increases accounts receivable and recognizes revenue because the service has now been completed. No cash was collected here.



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

Let’s take a moment to examined what just happened.



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

During the year revenues were recognized faster than …



100 1,300 1,000 800 900 500

200






9,700

9,700

1,3001,300

1,400

1,400

… than cash was collected from customers …



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

… $11,100 of revenue was recognized …

$11,100



100 1,300 1,000 800 900 500

200






9,700

9,700

1,3001,300

1,400

1,400

… but only $11,000 in cash was collected.

$11,100

$11,000



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

This difference caused the accounts receivable balance to grow by $100. Thus, when accounts receivable grows, it is because morerevenue is being recognized than cash is being collected. When accounts receivable decreases, the opposite is true.

1,400

+100



100 1,300 1,000 800 900 500

200




Cash 1,300 Accounts receivable 1,300


9,700

9,700

1,300 1,300

1,400

1,400

900

900

220

Let’s now move to the relationship among unearned revenue ...



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

900

900

220

… revenues …



100 1,300 1,000 800 900 500

200






9,700

9,700

1,300 1,300

1,400

1,400

900

900

220

… and cash.



100 1,300 1,000 800 900 500

200






Unearned revenue 900 Revenue 900

9,700

9,700

1,300 1,300

1,400

1,400

900

900

220

During the year Simple Company completed the services for which they already had been paid in a prior period. This allowed the companyto remove the obligation, called unearned revenue, and recognize the revenue on those services. No cash is collected here because it wasalready received in a prior period.



100 1,300 1,000 800 900 500

200







Cash 700 Unearned revenue 700

9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

Simple Company also received $700 in cash in advance from customers for services to be performed at a later date. This increased thecompany’s cash balance and created an obligation (not a revenue), called unearned revenue, to perform the services in the future.



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

Again, let’s take a moment to see what happened here.



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

Revenue was increased by more than cash was increased … by $200 …



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

… leading to a decrease in the unearned revenue account. In other words, when the unearned revenue account gets smaller, it must bebecause …

700

-200



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

… more revenue is being recognized ...

700

-200



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

… than cash is being collected. When unearned revenue grows, the opposite must be true - cash is being collected faster thanservices are being performed.

700

-200



100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400 700

When we analyze the activity in the cash, accounts receivable, unearned revenue and revenue accounts altogether, we can see that the totaloperating cash collected from these transactions equaled ....



100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400 700

… $11,700 ($9,700 + $1,300 + $700) …

11,700



100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400

12,000

700

… while the total revenue recognized equaled $12,000 ($9,700 + $1,400 + $900) …



100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400

12,000

700

… leading to a $300 difference ($12,000 - $11,700).

11,700

$300 ($11,700 - $12,000)



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

Revenue $ 12,000

Less: increase in accounts receivable (100)

Less: decrease in unearned revenue (200)

Cash inflows from operating activities $ 11,700

This $300 difference can be explained by the changes in the accounts receivable and unearned revenue accounts as described above.

12,000

11,700



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

The $100 increase in accounts receivable indicates …

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

… that more revenue was generated during the year on accounts receivable sales ($1,400) …

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400 700

… than cash was received from customers in the payment of receivables ($1,300), making revenues $100 larger than the related cash inflows.

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

Similarly, the $200 decrease in unearned revenue indicates that …

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

… more revenue was recognized on services performed ($900) …

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

… than cash was received in advance ($700), again meaning that revenues exceeded the related cash inflows … this time by $200.

Revenue $ 12,000






100 1,300 1,000 800 900 500

200








9,700

9,700

1,3001,300

1,400

1,400

900

900

700

700

1,400 700

As a result, revenue, which appears on the income statement, exceeded receipts of operating cash, which appears on the statement ofcash flows, by $300, and the difference is explained by …

Revenue $ 12,000




12,000

11,700



100 1,300 1,000 800 900 500

200








9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400 700

… the changes in the accounts receivable and unearned revenue accounts.

Revenue $ 12,000




12,000

+100 -200



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows: Expenses/operating cash outflows:






9,700

9,700

1,300 1,300

1,400

1,400

900

900

700

700

1,400

Let’s now take a look at the expenses during the year and the related balance sheet accounts (prepaid expenses and accrued payables)as well as the related operating cash outflows.



100 1,300 1,000 800 900 500

200



Cash 9,700 Expenses (rent & wages) 7,150 Revenue 9,700 Cash 7,150





9,700 7,150

9,700 7,150

1,300 1,300

1,400

1,400

900

900

700

700

1,400

Simple Company recognized expenses (rent and wages) during the year of $7,150 in transactions where it made the cash payment at the exactsame time the expenses were recognized, leading to a decrease in the cash balance and an increase in expenses by the same dollar amount.

700



100 1,300 1,000 800 900 500

200




Cash 1,300 Rent expense 1,000 Accounts receivable 1,300 Prepaid expense 1,000




9,700 7,150

9,700 7,150

1,300 1,300

1,400

1,400 1,000

900

900

700

700

1,000

1,400

In addition, the rental period expired for which the prepaid expenses on the balance sheet were paid, requiring the company to recognizerent expense and reduce the prepaid expense account by $1,000. Here, an expense is recognized but no cash is paid.

700



100 1,300 1,000 800 900 500

200





Accounts receivable 1,400 Prepaid expense 1,200Revenue 1,400 Cash 1,200



9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

Simple Company also made cash payments in advance during the year of $1,200 to cover future rentals. These payments created an asset, called prepaid expenses, because these pre-payments are expected to help generate future revenues. Here, there is a cash payment, but noexpense is recognized.

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

Let’s now review what happened here in the ...

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

… expense account, which appears on the income statement ...

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

… and the prepaid expense and cash accounts, both balance sheet accounts.

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400 1,000

900

900

700

700

1,000

1,200

1,400

A total expense of $8,150 was recognized …

700

8,150

1,400



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400 1,000

900

900

700

700

1,000

1,200

1,400

… while the cash payment was $8,350 … $200 higher.

700

8,150

8,350



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,200 1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

Note too that the prepaid expense account grew by $200. This growth occurred …

7001,200

+200



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,200 1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

… because the cash payments to create the prepaid expense asset (1,200) exceeded ....

7001,200

+200



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,200 1,400

1,400 1,000

900

900

700

700

1,000

1,200

1,400

… the expiration of the rental period ($1,000). In other words, the prepaid expense asset grew because cash was being paid faster thanthe asset was being used up. The prepaid expense asset goes down when cash payments are slower than the expiration of the rental periods.

7001,200

+200



100 1,300 1,000 800 900 500

200






Unearned revenue 900 Accrued payables 800Revenue 900 Cash 800


9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900

700 800

700

1,000 800

1,200

1,400

The company also paid off the $800 accrued payables obligation on the balance sheet with an $800 cash payment. This reduced both theobligation and operating cash flows, but recognized no additional expense because the related expense was recognized in a prior period.

700



100 1,300 1,000 800 900 500

200







Cash 700 Wage expense 850Unearned revenue 700 Accrued payables 850

9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

And, finally, at the end of the year, Simple Company owed its employees $850 for wages earned but not yet paid. This createdfor the company a requirement to record an accrual of wage expense and a related payable - an expense but no cash payment.

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Summarizing what just happened here in the accrued payables, expense, and cash accounts …

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… an expense of $850 was recognized, but only $800 in cash was paid.

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

This $50 difference corresponds to the $50 growth in the accrued payables account. In other words, growth in the accrued payablesliability occurs when …

700850

+50



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… expense recognition is faster than …

700850

+50



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… cash is being paid for those expenses. The accrued payables account goes down when cash payments exceed the recognition ofthe expense.

700850

+50



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Let’s now compare the total expenses recognized during the year to the related operating cash outflows.

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

We see that expenses totaled $9,000 ($7,150 + $1,000 + $850), while …

9,000

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… while operating cash outflows totaled $9,150 ($7,150 + $1,200 + $800) …

9,000

9,150

700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… leading to a difference of $150.

9,000

9,150

700

$150 ($9,150 - $9,000)



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Similar to the revenue/operating cash inflow illustration earlier, this $150 difference can be explained by the changes in the relatedbalance sheet accounts – this time – prepaid expenses and accrued payables.

700

9,000

9,150



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,200 1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Prepaid expenses increased by $200, which means that …

8501,200

Expenses $ 9,000

Plus: increase in prepaid expense 200

Less: increase in accrued payables (50)

Operating cash outflows $ 9,150

700

9,000

9,150+200



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… more cash was paid to establish a prepaid expense ($1,200) …

8501,200

Expenses $ 9,000




700



100 1,300 1,000 800 900 500

200




Cash 1,300 Rent expense 1,000Accounts receivable 1,300 Prepaid expense 1,000




9,700 7,150

9,700 7,150 2,430

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… than expense was recognized on the expiration of the prepaid expense ($1,000), making the cash outflow larger than the recognized expenseby $200.

8501,200

Expenses $ 9,000




700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Accrued payables increased by $50 (from $800 to $850), which means that …

8501,200

Expenses $ 9,000




700

+50



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… less cash was paid to reduce the accrued payable obligation ($800) ...

8501,200

Expenses $ 9,000




700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… than the amount of expenses accrued during the year ($850), making the operating cash outflow less than the recognized expense by $50.

8501,200

Expenses $ 9,000




700



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

In total, therefore, operating cash outflows on the statement of cash flows of $9,150 exceeded expenses on the incomestatement of $9,000 by $150.

8501,200

Expenses $ 9,000




700











Balance Sheet

(12/31/20XX)Cash $ 220Accounts receivable 1,400Prepaid expenses 1,200Total Assets $ 2,820



Returning to Simple Company’s financial statements, we can now explain the difference between ....











Balance Sheet




… net cash from operating activities on the statement of cash flows ...











Balance Sheet




… and net income on Simple Company’s income statement … in terms of changes in the related balance sheet accounts.



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150 2,430

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

The explanation appears in red in the box on the right.

8501,200

9,00012,000

700

* Revenues $ 12,000Less: Expenses (9,000)Net income $ 3,000

** Operating cash inflows $11,700Less: Operating cash outflows (9,150)Net cash from operating activities $ 2,550

Net income $ 3,000 *Less: increase in accounts receivable (100)Less: decrease in unearned revenues (200)Less: increase in prepaid expenses (200)Plus: increase in accrued payables 50Net cash from operating activities $ 2,550 **



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

Starting with net income of $3,000, which is equal to …

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… revenues of $12,000 …

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… less expenses of $9,000. We adjust that dollar amount by …

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… the changes in the four balance sheet accounts …

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700

9,700 7,150

1,300 1,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… the $100 increase in accounts receivable, which indicates less cash inflow thanrevenue … thus, it is subtracted from net income to get to net cash from operating activities.

8501,200

9,00012,000

700




+100



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… the $200 decrease in unearned revenues, which also indicates less cash inflowthan revenue ... Again, it is subtracted from net income.

8501,200

9,00012,000

700




-200



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,200 1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… the $200 decrease in prepaid expenses, which indicates more cash outflow thanexpenses … again, it is also subtracted from net income.

8501,200

9,00012,000

700




+200



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… and finally the $50 increase in accrued payables, which indicates less cash outflowthan expenses … this time … it is added to net income to get to net cash from operating activities.

8501,200

9,00012,000

700




+50



100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… which leads to net cash from operating activities ($2,550), which in turn is equal to …

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… operating cash inflows of $11,700 ...

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200








9,700 7,150

9,700 7,150

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

1,400

… less operating cash outflows of $9,150.

8501,200

9,00012,000

700






100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows: Expenses/operating cash outflows: Dividend:

Cash 9,700 Expenses (rent & wages) 7,150 Dividend 2,430Revenue 9,700 Cash 7,150 Cash 2,430





9,700 7,150

9,700 7,150 2,430

1,300 1,2001,300

1,400

1,400 1,000

900

900 850

700 800

700

1,000 800

1,200 850

2,430

2,430

1,400 1,200 850 700

Let’s now complete the recording of the transactions during the year by noting that Simple Company paid a dividend at the end of the yearof $2,430, which would increase the dividend account and decrease FINANCING (not operating,) cash flows …

12,000 9,000



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows: Expenses/operating cash outflows: Dividend and closing:

Cash 9,700 Expenses (rent & wages) 7,150 D ividend 2,430Revenue 9,700 Cash 7,150 Cash 2,430

Cash 1,300 Rent expense 1,000 Revenue 12,000Accounts receivable 1,300 Prepaid expense 1,000 Expenses 9,000

Income summary 3,000Accounts receivable 1,400 Prepaid expense 1,200

Revenue 1,400 Cash 1,200 Income summary 3,000Retained earnings 3,000

Unearned revenue 900 Accrued payables 800Revenue 900 Cash 800 Retained earnings 2,430

Dividends 2,430Cash 700 Wage expense 850

Unearned revenue 700 Accrued payables 850

9,700 7,150

9,700 7,150 2,430

1,300 1,2001,300

1,400

1,400 1,000

900

900 850 9,000

700 800

700

1,000 800

1,200 850

2,430

12,000

3,000

3,0003,0002,430 2,430

1,400 1,200 850 700

… and the books were closed by recording and posting the following closing entries. The closing process is covered in Video 15.



100 1,300 1,000 800 900 500

200


Revenue/operating cash inflows: Expenses/operating cash outflows: Dividend and closing:

Cash 9,700 Expenses (rent & wages) 7,150 D ividend 2,430Revenue 9,700 Cash 7,150 Cash 2,430

Cash 1,300 Rent expense 1,000 Revenue 12,000Accounts receivable 1,300 Prepaid expense 1,000 Expenses 9,000

Income summary 3,000Accounts receivable 1,400 Prepaid expense 1,200

Revenue 1,400 Cash 1,200 Income summary 3,000Retained earnings 3,000

Unearned revenue 900 Accrued payables 800Revenue 900 Cash 800 Retained earnings 2,430

Dividends 2,430Cash 700 Wage expense 850

Unearned revenue 700 Accrued payables 850

9,700 7,150

9,700 7,150 2,430

1,300 1,2001,300

1,400

1,400 1,000

900

900 850 9,000

700 800

700

1,000 800

1,200 850

2,430

12,000

3,000

3,0003,0002,430 2,430220

1,400 1,200 850 700 500

770 0 0 0 0

After closing we are now able to total the final account balances, leading to …















… the resulting financial statements.















Focusing specifically on the operating section of the statement of cash flows, we now can compute net cash from operating activities ineither of two ways.















The direct method, which subtracts the actual operating cash outflows from the actual operating cash inflows ...

Direct Method

Operating cash inflows $11,700Less: operating cash outflows (9,150)Net cash from operating activities $2,550















… or the indirect method which begins with the net income number and then adjusts it for the differences between the timing of therevenues and expenses … and receipt and payment of operating cash … by looking at the changes in the related balance sheet accounts.

Indirect MethodNet income $ 3,000Less: increase in accounts receivable (100)Less: decrease in unearned revenues (200)Less: increase in prepaid expenses (200)Plus: increase in accrued payables 50Net cash from operating activities $ 2,550















The indirect method is used by almost all major companies, so it is important to understand this disclosure. In this video we have coveredonly the basics of the indirect method. As you are exposed to more transactions in the future you will see other adjustments to net incomein addition to the four we have described here. Keep in mind that they all result from the fact that the timing of revenue and expenserecognition does not necessarily coincide with the timing of operating cash inflows and outflows.

Indirect MethodNet income $ 3,000Less: increase in accounts receivable (100)Less: decrease in unearned revenues (200)Less: increase in prepaid expenses (200)Plus: increase in accrued payables 50Net cash from operating activities $ 2,550

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Basic Mechanics of Preparing a Balance Sheet

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