2

Chapter 4:

The Mechanics of Financial

Accounting

3

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

4

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 Spreadsheet

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

1. =

2. =

3. =

4. =

5. =

6. _____ _____ _____= _____ _____ _____

30,000 30,000

(20,000) 20,000

9,000 9,000

8,000 8,000 Rev.

(5,500) (5,500) Exp.

(500) (500) Div.

Tot. 13,000 + 8,000 + 20,000 = 9,000 + 30,000 + 2,000

6

Exercise 4-2 Financial Statements

Income Statement

Revenues $8,000

Expenses 5,500

Net Income $2,500

Statement of Retained Earnings

RE (beginning) $ 0

Add: Net Income 2,500

Less: Dividends (500)

RE (ending) $2,000

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Exercise 4-2 Financial Statements

Balance Sheet

Assets

Cash $13,000

A/R 8,000

Land 20,000

Total $41,000

Liabilities and S.E.

N/P $ 9,000

CS 30,000

RE (ending) 2,000

Total $41,000

8

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

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: 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.

12

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.

13

Now 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

14

Now 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

15

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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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

-Final Trial Balance

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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 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 manner – discussed in Chapters 4 and 7.

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

Cash

30,000 20,000

9,000 5,500

500

Bal. 13,000

21

Unadjusted Trial Balance Trial 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 4-2

(after posting and totaling G/L accounts)

Debit Credit

Cash 13,000

Accounts 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)

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 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 AJEs

The “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.

26

27

1. 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 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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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

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

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

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 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 xx

Unearned Revenues xx

AJE at end of the period (for portion):

Unearned Revenues xx

Subscription Revenues xx

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5. 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

– inventories

More in later chapters.

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P4-8

a. 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 2,400

Rent Payable 2,400

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P4-8

c. 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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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):

P x R x T

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

Interest Expense 600

Interest Payable 600

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P4-8

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

Advertising Expense 28,000

Advertising Payable 28,000

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

($350 x 1/2 year)

Insurance Expense 175

Prepaid Insurance 175

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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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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.

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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.

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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, but from a detailed analysis of the cash flow activities of the company.

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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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47

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 and an income statement.

The approach involves T-account analysis.

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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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