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Chapter 4:Chapter 4:

The Mechanics of Financial The Mechanics of Financial AccountingAccounting

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Chapter 4: The Mechanics of Chapter 4: The Mechanics of Financial AccountingFinancial Accounting

The first step in the accounting process is transaction analysis.

This process examines relevant, objectively measurable economic events through their effect on the accounting equation:

Assets = Liabilities + Equity

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Now look at E4-2 SpreadsheetNow look at E4-2 Spreadsheet

Using a spreadsheet approach, analyze the transactions. (Spreadsheet on next slide.)

Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions.

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Exercise 4-2 SpreadsheetExercise 4-2 Spreadsheet

Cash + A/R + Land = N/P + CC + RE

1. =

2. =

3. =

4. =

5. =

6. _____ _____ _____= _____ _____ _____

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Exercise 4-2 Financial StatementsExercise 4-2 Financial Statements

Income Statement

Revenues ______

Expenses ______

Net Income ______

Statement of Retained Earnings

RE (beginning) ______

Add: Net Income _______

Less: Dividends _______

RE (ending) ______

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Exercise 4-2 Financial StatementsExercise 4-2 Financial Statements Balance SheetAssets Cash ______

A/R ______Land ______

Total ______

Liabilities and S.E.N/P ______CS ______RE (ending) ______Total ______

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Now look at E4-2 SpreadsheetNow look at E4-2 Spreadsheet

Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.

Therefore accountants use a “double entry” system based on debits and credits.

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Double Entry AccountingDouble Entry Accounting

Debit (dr) - means an entry to the left hand side of an account.

Credit (cr) - means an entry to the right hand side of an account.

Note that a debit or credit, per se, does not indicate increase or decrease.

To decide the effect of a debit or credit, the type of account must be considered.

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Effect of Debits and CreditsEffect of Debits and CreditsBased on the accounting equation, we

can increase or decrease various accounts depending on their classification:

Assets = Liabilities + Equity

Increase DR = CR CR

Decrease CR = DR DR

Note that we use debits and credits instead of plusses and minuses.

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The following rules can be derived from The following rules can be derived from the basic formula:the basic formula:Assets have normal debit balances and are

increased with a debit.Liabilities and equities have normal credit

balances and are increased with a credit.Revenues (a part of equity) have normal credit

balances and are increased with a credit.Expenses (which decrease equity) have normal

debit balances and are increased with a debit. Dividends (which decrease equity) have a

normal debit balance and are increased with a debit.

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The Format of a Journal EntryThe Format of a Journal Entry To initially record transactions, we use a journal

entry to represent the debits and credits. For example, in E4-2, Item 1:

Debit CreditCash 30,000

Common Stock 30,000

Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry on top), then the amount.

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Now back to E4-2, and prepare the Now back to E4-2, and prepare the other journal entries:other journal entries:

2: Purchased land for $20,000 cash.

3: Borrowed $9,000 cash from bank.

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Now back to E4-2, and prepare the Now back to E4-2, and prepare the other journal entries:other journal entries:

4: Provided services (on account) $8,000.

5: Paid $5,500 cash for expenses.

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Now back to E4-2, and prepare the Now back to E4-2, and prepare the other journal entries:other journal entries:

6: Paid $500 cash dividend to owners.

Note that dividends is a contra equity and reduces retained earnings.

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The Accounting CycleThe Accounting Cycle(more detail in Appendix 4A)(more detail in Appendix 4A)

Components of the accounting cycle include:A. Preparation of Daily Journal Entries -Post to the General Ledger -Unadjusted Trial BalanceB. Preparation of Adjusting Journal Entries -Post to the General Ledger

-Adjusted Trial BalanceC. Financial Statements D. Closing Journal Entries -Final Trial Balance

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A. Daily Journal Entries (DJEs)A. Daily Journal Entries (DJEs) The first step in the accounting process. Prepared for daily activity. Usually journalized in special journals for

efficiency, but we will record in “General Journal” format.

Identified through a document flow:– cash receipt, record a cash sale– charge receipt, record a credit sale– bank note, record a notes payable– employee time card, record wages

E 4-2 transactions are DJEs.

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Another Example of DJEAnother Example of DJE Often, investments and noncurrent assets are

sold for more or less than the amounts at which they are carried on the balance sheet. In such cases a gain (if a credit) or loss (if a debit) must be recognized.

Ex: Land that cost $10,000 is sold for $11,000 cash. Prepare the GJE:

Cash 11,000Land 10,000Gain on Sale of Land 1,000

Note: gains are a form of revenues and losses are a form of expenses on the income statement.

The sale of inventory is recorded in a different manner – discussed in Chapters 4 and 7.

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The General Ledger (G/L)The General Ledger (G/L)The G/L serves as a place to “total”

amounts by account titles.After DJEs and AJEs are recorded, they

are posted (by account) to the G/L.We will use “T” accounts to represent G/L

accounts where needed.Appendix 4A discusses T accounts in

more detail.

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

Cash

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Unadjusted Trial BalanceUnadjusted Trial BalanceTrial balances are prepared throughout the

accounting cycle. The Unadjusted Trial Balance represents G/L

totals (by account) at a particular point in time. For E4-2, the Unadjusted Trial Balance would

consist of a list of all of the ending debit or credit balances taken from the various “T” account totals (illustrated on the next slide).

The Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter).

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

Debit CreditCash 13,000Accounts Receivable 8,000

Land 20,000 Notes Payable 9,000

Contributed Capital 30,000 Retained Earnings 2,000

Totals 41,000 41,000

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B. Adjusting Journal Entries (AJEs)B. Adjusting Journal Entries (AJEs)Prepared at the end of the accounting

period to align revenues and expenses (matching).

Usually NO document flow to trigger recording.

Based on the accrual system of accounting which records revenues as earned and expenses as incurred (rather than based on cash flows).

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Types of AJEsTypes of AJEs

1. Accrual of expenses

2. Accrual of revenues

3. Deferrals of expenses

4. Deferrals of revenues

5. Revaluation adjustments

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Accrual System vs. Accrual AJEsAccrual System vs. Accrual AJEsThe “accrual system of accounting” and

“accrual of revenues and expenses” are both discussed in this chapter.

Note that the “accrual of revenues and expenses” is a subset of the AJEs discussed in this chapter.

In comparison, the “accrual system of accounting” refers to the entire process of revenue and expense recognition, and relates to the definitions of matching and revenue recognition discussed in Chapter 3.

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1. Accrual of Expenses1. Accrual of Expenses Probably the most common type of AJE.

Ex: accrue wages at the end of the period:

Wages Expense xx

Wages Payable xx Note: this is a “skeletal” journal entry, where the

“xx” simply indicate values to be calculated later. The focus is on the account and direction.

Other examples of expense/payable include interest, rent, taxes.

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2. Accrual of Revenues2. Accrual of Revenues

For revenues that have not yet been recorded at the end of the period.

Ex: accrue interest revenue:

Interest Receivable xx

Interest Revenue xxAnother example of receivable/revenue

accruals relates to rent revenue, where the rental payment has not yet been received.

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3.Deferral of Expenses 3.Deferral of Expenses This category of AJE relates to the concept of

asset capitalization and the matching principle.

Asset capitalization occurs when a cost (with future economic benefit) is incurred. An asset is recognized at that time.

As the asset is “used up” in the generation of revenue, the related cost is recognized as an expense (matching).

Some expenses are deferred for a short period of time (Supplies Expense), and some expenses are deferred for many years (Depreciation Expense).

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3.Deferral of Expenses 3.Deferral of Expenses Example: Purchase 1 year insurance policy.

Daily JE at time of purchase:

Prepaid Insurance xx

Cash xx

AJE at end of the period (for the portion that has been used):

Insurance Expense xx

Prepaid Insurance xx

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3.Deferral of Expenses 3.Deferral of Expenses Example: purchase of inventory.

Daily JE at time of purchase:

Merchandise Inventory xx

Cash xx

AJE at end of the period (for the portion that has been sold):

Cost of Goods Sold xx

Merchandise Inventory xx Note: the treatment of merchandise inventory

is expanded significantly in Chapter 7.

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3.Deferral of Expenses 3.Deferral of Expenses Example: purchase of equipment.

Daily JE at time of purchase:Equipment xx

Cash xx AJE at end of the period (for the portion that

has been used):Depreciation Expense xx

Accumulated Depreciation xx Note: Accumulated Depreciation is a contra

asset account, and is presented as an offset to Equipment on the balance sheet (more in Chapter 9).

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4.Deferral of Revenues 4.Deferral of Revenues Cash is received from customer before

goods/services are delivered (before revenue can be recognized).

Ex: Received subscription in advance. Daily JE at time cash received:

Cash xxUnearned Revenues xx

AJE at end of the period (for portion):Unearned Revenues xx

Subscription Revenues xx

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5. Revaluation Adjustments5. Revaluation AdjustmentsThese are adjustments that do not fall into

the categories of accruals or deferrals.They serve to restate certain accounts to

keep their reported values in line with existing facts.

Examples include the revaluation of:– short-term investments– inventories

More in later chapters.

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P4-8P4-8a. AJE at 12/31 for supplies used:

b. AJE at 12/31 for rent owed:

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

d. AJE at 12/31 for depreciation:

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P4-8P4-8e. AJE at 12/31 for interest owed to the bank

on the notes payable. Use Principal x Rate x Time to calculate the interest owed from July 1 to Dec. 31 (6 months):

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P4-8P4-8f. AJE at 12/31 for amount owed for

advertising:

g. AJE at 12/31 for insurance used from 7/1 to 12/31:

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Adjusted Trial BalanceAdjusted Trial BalanceThe Adjusted Trial Balance reflects totals

after the AJEs are posted to the general ledger.

The balance sheet accounts reflect the end-of-year balances, and the income statement accounts reflect the proper revenues and expense to be recognized for the year.

This list of accounts and amounts is used to prepare the balance sheet and income statement.

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C. Preparation of Financial StatementsC. Preparation of Financial Statementsfrom the Adjusted Trial Balancefrom the Adjusted Trial Balance

The amounts in the Adjusted Trial Balance are used to prepare the balance sheet and the income statement.

The statement of stockholders’ equity (SSE) requires some additional investigation.

Remember from Chapter 3 that the SSE shows all activity during the period for contributed capital and retained earnings.

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Contributed Capital and Contributed Capital and Retained EarningsRetained Earnings

The contributed capital in the adjusted trial balance is an ending balance; the ledger account must be examined to see if any activity (like issue of additional stock) occurred.

The retained earnings on the adjusted trial balance is a beginning balance; while the revenues, expenses and dividends are displayed in the trial balance, they have not yet been included in (closed to) retained earnings.

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Financial StatementsFinancial Statements The financial statements for Kelly Supply (next 4

slides), and other examples in text, can be used as guidelines to prepare financial statements.

The financials should be prepared in the following order:– income statement (I/S)– statement of stockholders’ equity (SSE)– balance sheet (B/S)

Note that the statement of cash flow (SCF) is not prepared from the adjusted trial balance, but from a detailed analysis of the cash flow activities of the company.

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Financial StatementsFinancial Statements Comments on the preparation of financial

statements from adjusted trial balance (ATB):– revenue and expense balances from the ATB

are carried to the income statement.– net income is carried to the retained earnings

column in the SSE.– other activity, like dividends and issue of stock,

are reflected in the SSE.– ending balances in the SSE are carried to the

stockholders’ equity section of the balance sheet.

– asset and liability balances from the ATB are carried to the balance sheet.

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Financial Statement Examples - Kelly SupplyKelly SupplyIncome StatementFor the Year Ended December 31, 2006

Revenues:Sales $27,000Interest revenue 50

Total revenues $27,050Expenses:

Cost of goods sold $ 9,000Wages expense 8,000Rent expense 1,000Interest expense 3,000Depreciation expense 3,000Amortization expense 500 Total expenses . 24,500

Net income $ 2,550

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2,550

(1,000)$6,550

10,0002,550

(1,000)

$6,55040,000

Kelly SupplyStatement of Stockholders’ EquityFor the Year Ended December 31, 2006

Common Retained Total Stock EarningsBeginning balance $30,000 $5,000 $35,000Common stock issuances 10,000 Net income DividendsEnding balance

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Kelly SupplyBalance SheetDecember 31, 2006

Assets:Cash $ 9,500 Accounts receivable 22,000 Interest receivable 50 Merchandise inventory 13,000 Prepaid rent 2,000 Machinery $26,000 Less: Accumulated depreciation 8,000 18,000 Patent 4,500 Total assets $69,050

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Kelly SupplyBalance SheetDecember 31, 2006

Liabilities and stockholders’ equity:Accounts payable $ 5,000Wages payable 1,000Interest payable 2,000Dividends payable 1,000Unearned revenue 1,000Short-term notes payable 2,500Long-term notes payable 10,000Common stock 40,000Retained earnings 6,550Total liabilities and stockholders’ equity $69,050

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D. Closing Journal Entries (CJEs)D. Closing Journal Entries (CJEs)Prepared after the financial statements

have been completed.Close temporary accounts to retained

earnings, so that the balances in those accounts at the start of the next accounting period will be zero.

Temporary accounts include revenues, expenses and dividends.

The final trial balance after closing will display only permanent, balance sheet accounts.