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Hughes • Ayers • Hoskin John Wiley & Sons, Inc. 2004 The Accounting Process Chapter Three Prepared by: Sarita Sheth Santa Monica College Why study accounting? Financial Statements are a company’s representation of its past performance, present position, and future goals.

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The accounting process l.jpg

Hughes • Ayers • Hoskin

John Wiley & Sons, Inc. 2004

The Accounting Process

Chapter Three

Prepared by: Sarita Sheth

Santa Monica College


Why study accounting l.jpg
Why study accounting?

Financial Statements are a company’s representation of its past performance, present position, and future goals.

Investors want to make decisions based on good information.

Accounting is the process of recording the transactions that are represented in the financial statements.


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Chapter Three Objectives

  • Recognizebusiness transactions and their impact of financial statements.

  • Understandthe dual nature of accounting transactions as reflected in the accounting equation.

  • Explainthe construction of the Statement of Financial Position, the Statement of Earnings, and the Statement of Cash Flows.

  • Distinguishbetween economic events that are commonly recognized in accounting as transactions and those that are not.

  • Applythe concept of nominal accounts to record revenues and expenses and their relationship to the Income and Retained Earnings Statements.

  • Describe the accounting cycle and recognize the timing issues inherent in reporting financial results.


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Balance Sheet Accounts

Cash

Marketable Securities

Accounts Receivable

Inventory

Prepaid Expenses

Equipment

Land

Buildings

Intangible Assets

Deferred Tax Assets

Assets

Represent probable future economic benefits obtained as a result of past transactions

For an example: Sale of product results in cash for a company that can be used for a variety of future activities


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Balance Sheet Accounts

Accounts Payable

Notes Payable

Accrued Liabilities

Taxes Payable

Deferred Taxes

Bonds Payable

Liabilities

Represent probable future economic sacrifices of economic benefits because of obligations from past transactions

For an example: A promise to pay (accounts payable) a supplier cash for monthly distribution of supplies.


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Balance Sheet Accounts

Contributed Capital:

Common Stock at par value

Additional Paid-In Capital

Retained Earnings:

Net Income

Dividends

Stockholders’ Equity

Represent the investors claims to assets after creditors have been paid.


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Account characteristics

  • Balance Sheet accounts are known as permanent accounts.

    • Permanent accounts do not close after the fiscal period ends.

    • Once they are placed on the books, they do not disappear because the cycle ends.

  • Nominal accounts are temporary accounts; they are closed at the end of the fiscal cycle.


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Double Entry Accounting System

  • A transaction is recorded with an double entry.

  • For every debit entry there must be a credit entry.

  • This system keeps the Accounting Equation balanced:

    Assets = Liabilities + Stockholders’ Equity


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Methodology

REMEMBER:

Debit means Left Credit means Right

  • Debit does not mean increase or decrease

  • Credit does not mean decrease or increase

  • Rules of the accounting equation dictate what the effect of a debit or credit on particular accounts


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Methodology: How do we keep Debits and Credits straight?

  • Use T-accounts to help track balances and changes in an account


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Methodology: Journalizing

  • To record transactions more formally and chronologically - use the journal.

  • Journal entries employs debits and credits

    Debit account is first and not indented xx

    Credit account is second and indented xx

For example:

Land 300

Cash 300

debit

credit


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Methodology: The Ledger

  • After journalizing the transaction, post the information to the ledger.

  • The ledger is a formal T-account that keeps track of each accounts running balance.

  • In a manual system, there is a page for the cash account, page for A/R, page for inventory etc.

Date Dr Cr Balance 101 Cash

1/1/04 500 500

2/3/04 200 300

2/15/04 800 1,100

3/2/04 100 1,200

4/7/04 500 700


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Application: Transaction Analysis

Lets look at some investing and financing activities:

Serve Inc, is a tennis supply company ready to commence operations on 2/1/0X.

  • SERVE issues 5,000 shares of $1 par Common Stock for $5.00 per share.

  • SERVE acquires property for $10,000 cash.

  • SERVE borrows $30,000 on a note payable, due in 3 years with an interest rate of 5%.


Application transaction analysis14 l.jpg

Entry 1: SERVE issues 5,000 shares of $1 par Common Stock for $5.00 per share.

Date Description Debit Credit

2/1 Cash 25,000

Common Stock

Cash

25,000

5,000

20,000

Application: Transaction Analysis

General Journal

Common Stock 5,000

APIC 20,000

T-Accounts / Ledger

Additional Paid In Capital


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Entry 2: SERVE acquires property for $10,000. for $5.00 per share.

Date Description Debit Credit

2/1 Land 10,000

Land

Cash

25,000

10,000

Balance 15,000

Application: Transaction Analysis

General Journal

Cash 10,000

T-Accounts / Ledger

10,000


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Entry 3: SERVE borrows $30,000 on a note payable due in 3 years with an interest rate of 5%.

Date Description Debit Credit

2/1 Cash 30,000

Notes Payable

Cash

30,000

25,000

1

2

10,000

30,000

Balance45,000

Application: Transaction Analysis

General Journal

Notes Payable 30,000

T-Accounts / Ledger

3


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Application: Transaction Analysis 3 years with an interest rate of 5%.

Serve Inc.,

Ledger Accounts

as of 2/28/0X

Take the balances from the ledger to the financial statements

Notes Payable

Cash

30,000

3

1

25,000

2

10,000

3

30,000

Bal45,000

30,000 Balance

Land

Common Stock

Additional Paid In Capital

1

2

1

5,000

20,000

10,000

Balance10,000

5,000 Balance

20,000 Bal


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Application: Financial Statement 3 years with an interest rate of 5%.

Serve Inc.,

Balance Sheet

(in thousands) as of 2/28/0X

Liabilities and Stockholder’s Equity

Liabilities:

Notes Payable 30

Total Liabilities 30

Stockholders’ Equity

Common Stock 5

Additional Paid in Capital 20

Retained Earnings 0

Total Stockholders’ Equity 25

Total Liabilities &

Stockholders’ Equity 55

Assets

Current Assets:

Cash 45

Property, Plant, and Equipment 10

Total Assets 55


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Application: Financial Statement 3 years with an interest rate of 5%.

Serve Inc.,

Statement of Cash Flows

for the month ended 2/28/0X

Cash Flow from Investing Activities

Purchase of Land (10,000)

Cash Flow from Financing Activities

Proceeds from Issuance of Common Stock 25,000

Proceeds from Loan 30,000

Total Cash from Financing Activities 55,000

Net Change in Cash 45,000

Cash Balance 2/1/0X 0

Cash Balance 2/28/0X 45,000


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More about Revenues & Expenses 3 years with an interest rate of 5%.

  • Revenues increase Retained Earnings

    (credit Retained Earnings)

  • Expenses decrease Retained Earnings

    (debit Retained Earnings)

  • The Retained Earnings account is a Balance Sheet account.

  • Retained Earnings reflect the effect of revenues, expenses, and dividends since the company’s inception.


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More about Revenues & Expenses 3 years with an interest rate of 5%.

  • In order to keep track of the current year’s income, use the nominal accounts

  • Track revenues when earned in the revenue account (an increase in RE) by a credit entry.

  • Track expenses when incurred in expense accounts (a decrease in RE) with a debit entry.

Retained Earnings

Expenses

Revenues


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Quick Questions: 3 years with an interest rate of 5%.

The Accounts Receivable account is a(n):

  • Permanent Account

  • Asset Account

  • Balance Sheet Account

  • All of the above

    The Payroll Expense Account is a(n):

  • Nominal Account

  • Permanent Account

  • Income Statement Account

  • a and c

  • All of the above


Application more entries l.jpg
Application: More Entries 3 years with an interest rate of 5%.

  • SERVE purchased inventory worth $50,000 on account.

  • SERVE sold $40,000 of merchandise which cost $25,000 to a major sporting goods chain on account.

  • SERVE purchased fixtures on account for $4,000. BALL estimates that the fixtures will be used for 4 years.

  • Customers pay in full for merchandise bought on account in entry 5.

  • SERVE declares and pays dividends of $5,000.

  • SERVE pays for utilities bill of $3,000.

  • SERVE pays $2,000 for fixtures bought on acct in 6.

  • Annual depreciation expense on the fixtures was $1,000 (4,000/4 yrs).

  • SERVE pays interest on the 5% note payable $30,000.


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Entry 4: SERVE purchased inventory worth $50,000 on account.

Date Description Debit Credit

2/10 Inventory 50,000

Accounts Payable

Inventory

50,000

50,000

Application: Transaction Analysis

General Journal

Accounts Payable 50,000

T-Accounts / Ledger


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Date Description Debit Credit account.

2/10 Accounts Receivable 40,000

A/R

Application: Transaction Analysis

Entry 5: Part 1 - SERVE made merchandise sale of $40,000 to a major sporting goods chain on account.

General Journal

Sales 40,000

T-Accounts / Ledger

Sales

40,000

40,000


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Date Description Debit Credit account.

2/10 Cost of Goods Sold 25,000

Cost of Goods Sold

Inventory

25,000

25,000

Application: Transaction Analysis

Entry 5 Part 2: The cost of goods sold in Part 1 was $25,000.

General Journal

Inventory 25,000

T-Accounts/ Ledger


Slide27 l.jpg

Date Description Debit Credit account.

2/11 Fixtures 4,000

Fixtures

A/P

Application: Transaction Analysis

Entry 6: SERVE purchased fixtures on account for $4,000. SERVE estimates that the fixtures will be used for 4 years.

General Journal

Accounts Payable 4,000

T-Accounts/ Ledger

4,000

4,000


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Date Description Debit Credit account.

2/11 Cash 40,000

Cash

A/R

1

40,000

40,000

2

25,000

10,000

3

3,000

40,000

7

Application: Transaction Analysis

Entry 7: Customer pay in full for merchandise bought on account in entry 5.

General Journal

Accounts Receivable 40,000

T-Accounts/ Ledger


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Date Description Debit Credit account.

2/15 Retained Earnings 5,000

Cash

R/E

2

25,000

1

5,000

10,000

3

8

5,000

30,000

7

40,000

Application: Transaction Analysis

Entry 8: SERVE declares and pays dividends of $25,000.

General Journal

Cash 5,000

T-Accounts/ Ledger


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Date Description Debit Credit account.

2/10 Utilities Expense 3,000

Cash

Utilities Expense

2

1

10,000

3,000

8

3

5,000

7

3,000

40,000

Application: Transaction Analysis

Entry 9: SERVE pays for utilities bill $3,000.

General Journal

Cash 3,000

T-Accounts / Ledger

25,000

3,000

9


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Date Description Debit Credit account.

2/10 Accounts Payable 2,000

Cash

A/P

25,000

2

1

10,000

2,000

3

8

5,000

3,000

7

9

3,000

40,000

2,000

10

Application: Transaction Analysis

Entry 10: SERVE pays $2,000 on account for the supplies bought in Transaction 6.

General Journal

Cash 2,000

T-Accounts/ Ledger


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Date Description Debit Credit account.

2/28 Depreciation Expense 1,000

Application: Transaction Analysis

Entry 11: Annual depreciation expense on the fixtures was $1,000 ($4,000/4yrs).

  • To show that SERVE has reaped the benefits of using the fixtures for one year, they must show depreciation of the asset.

  • SERVE recognizes depreciation expense (DR), and reduces the Fixtures account by crediting a special account - Accumulated Depreciation- Fixtures (a contra asset account).

  • The contra asset account will allow us to keep the fixtures on our books at the historical cost, but also keep track of the ongoing depreciation to the asset.

General Journal

Accumulated

Depreciation- Fixtures 1,000


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Date Description Debit Credit account.

2/28 Interest Expense 125

Cash

Interest Expense

1

2

25,000

10,000

125

4

25,000

3

3,000

7

40,000

9

3,000

2,000

125

Application: Transaction Analysis

Entry 12: SERVE pays interest on the note payable $125. ($30,000 x 5% X 1/12)

.

General Journal

Cash 125

T-Accounts/ Ledger

8

5,000

10

12


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Application: Balances in Accounts from Transactions account.

  • Accounts Payable (50,000 + 4,000 – 2,000) = 52,000

  • Notes Payable = 30,000

  • Cash (25,000 + 30,000 + 40,000) -

  • (10,000 + 5,000 + 3,000 + 2,000 + 125) = $74,875

  • Accounts Receivable (40,000 – 40,000) = 0

  • Inventory (50,000 – 25,000) = 25,000

  • Fixtures = 4,000

  • Accumulated Depreciation = (1,000)

  • Land = 10,000

  • Total Assets $112,875

Common Stock = 5,000

Additional Paid-In Capital = 20,000

Sales = 40,000

Cost of Goods Sold = (25,000)

Utilities Expense = (3,000)

Depreciation Expense = (1,000)

Interest Expense = (125)

Dividends = (5,000)

Total Lia and SHE $112,875


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Application: Financial Statement account.

Serve Inc.,

Statement of Earnings

for the month ended 2/28/0X

Sales Revenue 40,000

Less: Cost of Goods Sold (25,000)

Gross Profit 15,000

Operating Expenses:

Utilities Expense 3,000

Depreciation Expense 1,000

Interest Expense 125

Total Operating Expenses 4,125

Net Income 10,875

Earnings per share $2.1750


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Application: Financial Statement account.

Serve Inc.,

Statement of Stockholders’ Equity

(in thousands) for the month ended 2/28/0X

Common Stock (par value $1) 5,000

Additional Paid-In Capital 20,000

Retained Earnings:

Retained Earnings 2/1/ 0X 0

Net Income 10,875

Less Dividends (5,000)

Retained Earnings 2/28/0X 5,875

Total Stockholders’ Equity 30,875


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Application: Financial Statement account.

Serve Inc.,

Balance Sheet

as of 2/28/0X

Liabilities and Stockholder’s Equity

Liabilities:

Accounts Payable $52,000

Notes Payable 30,000

Total Liabilities 82,000

Stockholders’ Equity

Common Stock 5,000

Additional Paid in Capital 20,000

Retained Earnings 5,875

Total Stockholders’ Equity 30,875

Total Liabilities &

Stockholders’ Equity $112,875

Assets

Current Assets:

Cash $74,875

Accounts Receivable 0

Inventory 25,000

Total Current Assets 99,875

Plant Property & Equipment:

Land 10,000

Fixtures 4,000

Less: Accum Deprec (1,000)

Net Book Value Fixtures 3,000

Property, Plant, and Equipment 13,000

Total Assets $112,875


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Application: Financial Statement account.

Serve Inc.,

Statement of Cash Flows

for the month ended 2/28/0X

Cash from Operations:

Net Income 10,875

Add: Noncash Expenses

Depreciation 1,000

Less Changes in Current Assets

and Current Liabilities 25,000

Total Cash from Operations 36,875

Cash Flow from Investing Activities

Cash from Investing

Purchase of Land (10,000)

Purchase of Fixtures (2,000)

Cash flow from Investing Activities (12,000)

Cash Flow from Financing Activities

Proceeds from Common Stock 25,000

Proceeds from Loan 30,000

Payment of Dividends (5,000)

Total Cash from Financing Activities 50,000

Total Change in Cash $74,875

Cash Balance 2/1/0X 0

Net Change in Cash

$74,875

Cash Balance 2/28/0X

$74,875


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Closing Entries account.

  • All of the nominal (temporary or income statement) accounts must be closed at the end of the period

  • These are Revenues and Expenses accounts

  • They are closed by making the balance zero by Debiting the Revenue Accounts and Crediting the Expense accounts

  • The balances are transferred to the Income Summary Account

  • Income Summary is then closed to Retained Earnings


Application closing process l.jpg
Application: Closing Process account.

1.

2.

Expenses

Revenues

40,000

25,000

3,000

1,000

125

40,000 Balance

Closing Dr 40,000

Balance 29,125

13,000 Closing Cr

0

0

3.

Income Summary

Retained Earnings

40,000

5,000

10,875

29,875

10,875 Balance

Closing Dr 10,875

5,875 Balance

0


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Quick Question account.

We close which of the following accounts?

  • Land account

  • Sales accounts

  • Notes Payable accounts

  • Depreciation Expense account

  • Accumulated Depreciation account

  • Cost of Goods Sold account

  • Dividends


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