Financial accounting 9th jamie pratt chapter 04

• 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.. • D

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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

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 4-3 Financial Statements

Income Statement Revenues $8,000

Exercise 4-3 Financial Statements

Balance Sheet Assets

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

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 debit balances and are increased with a debit

• Dividends (which decrease equity) have a normal debit balance and are increased with a debit

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.

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

2: Purchased land for $20,000 cash

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

 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/L

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

Cash

30,000

20,000 9,000

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

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)

Types of Periodic Adjustments

1 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:

Example - Accrual of Revenues

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

 Ex: accrue interest revenue:

Deferral of Expenses

matching principle.

An asset is recognized at that time.

related cost is recognized as an expense (matching).

some expenses are deferred for many years (Depreciation Expense).

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Deferral of Expenses

Journal Entry at time of purchase:

Deferral of Expenses (cont’d)

Journal Entry at time of purchase:

Deferral of Expenses (cont’d)

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:

Preparing Adjusting Journal Entries - P4-8

a AJE at 12/31 for supplies used:

Preparing Adjusting Journal Entries - P4-8

c AJE at 12/31 for services performed:

Preparing Adjusting Journal Entries - P4-8

e AJE at 12/31 for interest owed to the bank on the notes payable Use Principal x Rate x Time to calculate the interest owed from July 1 to Dec 31 (6 months):

Preparing Adjusting Journal Entries - P4-8

f AJE at 12/31 for amount owed for advertising:

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

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

Figure 4-23

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Figure 4-23

T-Account Analysis and the statement of Cash Flows *Appendix 4-A

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 account analysis

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