Financial accounting in an economic context 8e chapter 04

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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 Spreadsheet Cash + A/R + Land = N/P + CC + RE 30,000 30,000 = (20,000) 20,000 = 9,000 = 9,000 8,000 Rev 8,000 = (5,500) (5,500) Exp = (500) _ (500) Div _ _= _ _ _ Tot 13,000 + 8,000 + 20,000 = 9,000 + 30,000 + 2,000 Exercise 4-2 Financial Statements Income Statement Revenues $8,000 Expenses 5,500 Net Income $2,500 Statement of Retained Earnings RE (beginning) $ Add: Net Income 2,500 Less: Dividends (500) RE (ending) $2,000 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 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 10 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 36 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 to Dec 31 (6 months): P x R x T 10,000 x 12 per year x 6/12 of a year Interest Expense Interest Payable 600 600 37 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 38 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-ofyear 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 39 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 that the SSE shows all activity during the period for contributed capital and retained earnings 40 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 41 Financial Statements    The financial statements for Kelly Supply (next 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 42 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 43 Financial Statement Examples - Kelly Supply 44 45 46 Appendix 4-A Two methods are used to present the statement of cash flows—the direct method and the far more common indirect method 47 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 48 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 49 Copyright Copyright © 2011 John Wiley & Sons, Inc All rights reserved Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc The purchaser may make back-up copies for his/her own use only and not for distribution or resale The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein 50 [...]... 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 25... account and ultimately reduces retained earnings 15 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... Unadjusted Trial Balance is a preliminary total, and is a starting point for the Adjusting Journal Entries (discussed later in this chapter) 21 Unadjusted Trial Balance - Exercise 4-2 (after posting and totaling G/L accounts) Cash Accounts Receivable Land Notes Payable 9,000 Contributed Capital Retained Earnings Totals Debit 13,000 8,000 20,000 Credit 30,000 2,000 41,000 41,000 22 B Adjusting Journal Entries...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... 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... 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 30 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... 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... G/L Now post transactions (for cash) to “T” account: Cash 30,000 9,000 20,000 5,500 500 Bal 13,000 20 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... 30,000 2,000 41,000 41,000 22 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) 23 Types of AJEs 1 Accrual of expenses 2 Accrual of revenues 3 Deferrals... debit balance and are increased with a debit 11 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 12 Now back to E4-2, and prepare
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