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Chapter 4:
The Mechanics of Financial Accounting
The Mechanics of Financial Accounting• The first step in the accounting process is transaction analysis.
• This process examines relevant, objectively measurable economic events through their effect on the accounting equation:
Assets = Liabilities + Equity
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Now look at E4-‐2 Spreadsheet� Using a spreadsheet approach, analyze the transactions. (Spreadsheet on next slide).
� Note that effects may be on both sides of the equation, in the same direction, or effects may be on one side of the equation with offsetting directions.
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Exercise 4-‐2 SpreadsheetCash + A/R + Land = N/P + CC + RE
1. =2. =3. =4. =5. =6. _____ _____ _____ = _____ _____ _____
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30,000 30,000
(20,000) 20,000
9,000 9,0008,000 8,000 Rev.
(5,500) (5,500) Exp.(500) (500) Div.
Tot. 13,000 + 8,000 + 20,000= 9,000 + 30,000 + 2,000
Exercise 4-‐3 Financial StatementsIncome StatementRevenues $8,000Expenses 5,500Net Income $2,500
Statement of Retained EarningsRE (beginning) $ 0Add: Net Income 2,500Less: Dividends (500)RE (ending) $2,000
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Exercise 4-‐3 Financial StatementsBalance Sheet
AssetsCash $13,000A/R 8,000Land 20,000Total $41,000
Liabilities and S.E.N/P $ 9,000CS 30,000RE (ending) 2,000Total $41,000
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Now look at E4-‐2 Spreadsheet� Note that the transaction analysis was relatively simple with a few transactions and a few accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is inefficient.
� Therefore accountants use a “double entry” system based on debits and credits.
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Double Entry Accounting� The journal entry is an efficient representation of economic events and how they affect the accounting equation.
� Debit (dr) - means an entry to the left hand side of an account.
� Credit (cr) - means an entry to the right hand side of an account.
� Note that a debit or credit, per se, does not indicate increase or decrease.
� To decide the effect of a debit or credit, the type of account must be considered.
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Effect of Debits and Credits� Based on the accounting equation, we can increase or decrease various accounts depending on their classification:
� Note that we use debits and credits instead of plusses and minuses.
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The following rules can be derived from the basic formula and Figure 4-‐7 (previous slide):
• 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 debitbalances and are increased with a debit.
• Dividends (which decrease equity) have a normal debitbalance and are increased with a debit.
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The Format of a Journal Entry� To initially record transactions, we use a journal entry to represent the debits and credits.For example, in E4-2, Item 1:
Debit 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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Back to E4-‐2, and prepare the other journal entries:
2: Purchased land for $20,000 cash.Land 20,000
Cash 20,000
3: Borrowed $9,000 cash from bank.Cash 9,000
Notes Payable 9,000
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Back to E4-‐2, and prepare the other journal entries:
4: Provided services (on account) $8,000.Accts. Receivable 8,000
Service Revenue 8,000
5: Paid $5,500 cash for expenses.Expenses 5,500
Cash 5,500
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Now back to E4-‐2, and prepare the other journal entries:
6: Paid $500 cash dividend to owners.Dividends 500
Cash 500
� Note that dividends is a contra equity account and ultimately reduces retained earnings.
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T-‐Accounts�Running tally of the affect of transactions on an account in the General Ledger.
�We call this process ‘posting’ to the GL.
�The running tally makes it possible to complete trial balances and financial statements.
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Back to E4-‐2: Posting to G/LNow post transactions (for cash) to “T” account:
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Cash
30,000 20,0009,000 5,500
500
Bal. 13,000
Recognizing Gains and Losses� 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.
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Periodic Adjustments� 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 Periodic Adjustments1. Accruals (expenses and revenues)
2. Deferrals (expenses and revenues)
3. Revaluation adjustments
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Example -‐ Accrual of Expenses� Probably the most common type of AJE.Ex: accrue wages at the end of the period:
Wages Expense xxWages 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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Example -‐ Accrual of Revenues� For revenues that have not yet been recorded at the end of the period.
� Ex: accrue interest revenue:Interest Receivable xx
Interest Revenue xx
� Another example of receivable/revenue accruals relates to rent revenue, where the rental payment has not yet been received.
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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 contributes to the generation of revenue (revenue recognition), 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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Deferral of Expenses �Example: Purchase 1 year insurance policy.Journal Entry at time of purchase:
Prepaid Insurance xxCash xx
Adjustment at the end of the period (for the portion that has been used):
Insurance Expense xxPrepaid Insurance xx
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Deferral of Expenses (cont’d)� Example: purchase of equipment.
Journal Entry at time of purchase:Equipment xx
Cash xx
Adjustment at end of the period (for the portion that has been used):Depreciation Expense xx
Accumulated Depreciation xx
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Deferral of Expenses (cont’d) � Intangible Assets are often capitalized as
well and amortized over their useful life:Patent xx
Cash xx
Adjustment at end of the period (for the portion that has been used):Amortization Expense xx
Accumulated Amortization xx
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Deferral of Revenues� Cash is received from customer before goods/services are delivered (before revenue can be recognized).Ex: Received cash for an airline ticket for a flight to take place at a future date.Journal Entry at time cash received:
Cash xxUnearned Revenues xx
Adjustment at end of the period (for portion completed):
Unearned Revenues xxTicket Revenues xx
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Revaluation Adjustments� These are adjustments that do not fall into the categories of accruals or deferrals.
� They serve to restate certain accounts to keep their reported values in line with existing facts.
�Examples include the revaluation of:�Short-term investments�Accounts receivable� Inventories
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Preparing Adjusting Journal Entries -‐ P4-‐8a. AJE at 12/31 for supplies used:(85,000 - 30,000 unused = $55,000 used)Supplies Expense 55,000
Supplies 55,000
b. AJE at 12/31 for rent owed:Rent Expense 2,400Rent Payable 2,400
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Preparing Adjusting Journal Entries -‐ P4-‐8c. AJE at 12/31 for services performed:(18,000 x 2/3 = 12,000 earned by 12/31)Unearned Revenue 12,000
Service Revenue 12,000
d. AJE at 12/31 for depreciation:(500,000/10 = 50,000 per year)Depreciation Expense 50,000
Accumulated Depr. 50,000
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Preparing Adjusting Journal Entries -‐ P4-‐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):
P x R x T10,000 x .12 per year x 6/12 of a year
Interest Expense 600Interest Payable 600
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Preparing Adjusting Journal Entries -‐ P4-‐8f. AJE at 12/31 for amount owed for advertising:Advertising Expense 28,000Advertising Payable 28,000
g. AJE at 12/31 for insurance used from 7/1 to 12/31:($350 x 1/2 year)Insurance Expense 175Prepaid Insurance 175
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Reporting Difficulties Faced by Multinational Companies
� Multinationals have a home in one country but operate, own subsidiaries, or raise capital in others.
� Financials must be consolidated – data is in difference� Languages� Currencies� Using difference accounting standards
� Conversion and consolidation � Costly� Time consuming
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Adjusted Trial Balance� The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger.
� The balance sheet accounts reflect the end-of-year balances, and the income statement accounts reflect the proper revenues and expense to be recognized for the year.
� This list of accounts and amounts is used to prepare the balance sheet and income statement.
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Financial Statements• The financial statements for Kelly Supply (upcoming 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 (see appendix).
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Financial Statements�Comments on the preparation of financial statements from adjusted trial balance (ATB):• Revenue and expense balances from the ATB are carried to the income statement.
• Net income is carried to the retained earnings column in the SSE.
• Other activity, like dividends and issue of stock, are reflected in the SSE.
• Ending balances in the SSE are carried to the stockholders’ equity section of the balance sheet.
• Asset and liability balances from the ATB are carried to the balance sheet.
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Financial Statement Examples -‐ Kelly Supply
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Figure 4-23
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Figure 4-23
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T-‐Account Analysis and the statement of Cash Flows *Appendix 4-‐A
� Two methods are used to present the statement of cash flows—the direct method and the far more common indirect method.
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*Appendix 4-‐A
� The statement of cash flows can be prepared from two balance sheets, an income statement, and some additional information. The approach involves T-account analysis.
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