Financial accounting in an economic context 8e chapter 04

Preparation of Daily Journal Entries -Post to the General Ledger -Unadjusted Trial Balance B.. Preparation of Adjusting Journal Entries -Post to the General Ledger -Adjusted Trial Ba

Chapter 4:

The Mechanics of Financial

Accounting

Chapter 4: The Mechanics of

Financial Accounting

 The first step in the accounting process is

transaction analysis

 This process examines relevant, objectively

measurable economic events through their

effect on the accounting equation:

Assets = Liabilities + Equity

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.

Exercise 4-2 Financial Statements

Exercise 4-2 Financial Statements

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.

Double Entry Accounting

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

 Credit (cr) - means an entry to the right

hand side of an account.

 Note that a debit or credit, per se, does not

indicate increase or decrease.

 To decide the effect of a debit or credit,

the type of account must be considered.

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.

The following rules can be derived from the basic formula:

 Assets have normal debit balances and are

increased with a debit.

 Liabilities and equities have normal credit

balances and are increased with a credit.

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

 Expenses (which decrease equity) have normal debit balances and are increased with a debit

 Dividends (which decrease equity) have a

The Format of a Journal Entry

To initially record transactions, we use a

journal entry to represent the debits and

credits.

For example, in E4-2, Item 1:

Debit Credit Cash 30,000

Common Stock 30,000

Note that the debit is to the left and the credit

is to the right First we list the account (left hand entry on top), then the amount.

Now back to E4-2, and prepare the

other journal entries:

2: Purchased land for $20,000 cash.

Now back to E4-2, and prepare the

other journal entries:

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

Now back to E4-2, and prepare the

other journal entries:

6: Paid $500 cash dividend to owners.

Dividends 500

Note that dividends is a contra equity

account and ultimately reduces retained

earnings.

The Accounting Cycle

(more detail in Appendix 4A)

Components of the accounting cycle include:

A Preparation of Daily Journal Entries

-Post to the General Ledger

-Unadjusted Trial Balance

B Preparation of Adjusting Journal Entries

-Post to the General Ledger

-Adjusted Trial Balance

C Financial Statements

D Closing Journal Entries

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

Another Example of DJE

 Often, investments and noncurrent assets are

sold for more or less than the amounts at which they are carried on the balance sheet In such

cases a gain (if a credit) or loss (if a debit) must

be recognized.

 Ex: Land that cost $10,000 is sold for $11,000

cash Prepare the GJE:

Cash 11,000

Land 10,000

Gain on Sale of Land 1,000

Note: gains are a form of revenues and losses

are a form of expenses on the income statement The sale of inventory is recorded in a different

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.

Back to E4-2: Posting to G/L

Now post transactions (for cash) to “T” account:

Cash

30,000 20,000 9,000

5,500 500 Bal 13,000

Unadjusted Trial Balance

accounting cycle

totals (by account) at a particular point in

time

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).

total, and is a starting point for the Adjusting

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

B Adjusting Journal Entries (AJEs)

 Prepared at the end of the accounting

period to align revenues and expenses

Accrual System vs Accrual AJEs

“accrual of revenues and expenses” are

both discussed in this chapter

expenses” is a subset of the AJEs

discussed in this chapter.

accounting” refers to the entire process of revenue and expense recognition, and

1 Accrual of Expenses

 Probably the most common type of AJE.

Ex: accrue wages at the end of the period:

2 Accrual of Revenues

 For revenues that have not yet been

recorded at the end of the period.

 Ex: accrue interest revenue:

Interest Receivable xx

Interest Revenue xx

 Another example of receivable/revenue

accruals relates to rent revenue, where the

rental payment has not yet been received

3.Deferral of Expenses

of asset capitalization and the matching

principle.

(with future economic benefit) is incurred

An asset is recognized at that time.

of revenue, the related cost is recognized as

an expense (matching).

period of time (Supplies Expense), and

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

3.Deferral of Expenses

Equipment xx

Cash xx

AJE at end of the period (for the portion

that has been used):

Accumulated Depreciation xx

 Note: Accumulated Depreciation is a contra

asset account, and is presented as an

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:

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

Unearned Revenues xx

Subscription Revenues xx

P4-8

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 T

10,000 x .12 per year x 6/12 of a year

Interest Expense 600

Interest Payable 600

Adjusted Trial Balance

 The Adjusted Trial Balance reflects totals after the AJEs are posted to the general ledger

 The balance sheet accounts reflect the year balances, and the income statement

end-of-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.

C Preparation of Financial Statements

from 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.

Contributed Capital and

Retained Earnings

 The contributed capital in the adjusted trial

balance is an ending balance; the ledger

account must be examined to see if any

activity (like issue of additional stock)

occurred

 The retained earnings on the adjusted trial

balance is a beginning balance; while the

revenues, expenses and dividends are

displayed in the trial balance, they have not yet been included in (closed to) retained earnings.

Financial Statements

 The financial statements for Kelly Supply (next

4 slides), and other examples in text, can be

used as guidelines to prepare financial

statements.

 The financials should be prepared in the

following order:

– income statement (I/S)

– statement of stockholders’ equity (SSE)

– balance sheet (B/S)

 Note that the statement of cash flow (SCF) is not prepared from the adjusted trial balance,

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

Financial Statement Examples - Kelly Supply

Appendix 4-A

 Two methods are used to present the statement

of cash flows—the direct method and the far more common indirect method.

Appendix 4-A

 The statement of cash flows can be prepared

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.

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