Chapters 3 and 4: The Mechanics of Financial Accounting

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Chapters 3 and 4: The Mechanics of Financial Accounting I. Double Entry Accounting II. The Accounting Cycle A. General Journal Entries B. Adjusting Journal Entries C. Trial Balances D. Financial Statements E. Closing Journal Entries III. Worksheets

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Chapters 3 and 4: The Mechanics of Financial Accounting

I. Double Entry Accounting

II. The Accounting Cycle

A. General Journal Entries

C. Trial Balances

D. Financial Statements

E. Closing Journal Entries

III. Worksheets

How do you handle many transactions?
• The transaction analysis in Ex. 2-44 used a few transactions and accounts. However, with thousands of transactions and hundreds of accounts, the spreadsheet program is not sufficient.
• Therefore accountants use a “double entry” system based on debits and credits.
I. 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.
• This selection is purely arbitrary, but consistent throughout U.S. accounting history.
T- accounts are used to keep track of balances.

When cash is received, you record the amount on the left. When cash is paid, you record the amount on the right

At the end of the period, the T-account is totaled by

The Double Entry SystemT- Accounts

Cash

15,000

2,500

850

1,000

Bal. 12,350

Effect of Debits and Credits

Based on the accounting equation, we can increaseor decrease various accounts depending on their classification:

Assets = Liabilities + Equity

Increase DR = CR CR

Decrease CR = DR DR

Summary by account type
• Assets are increased with a debit.
• Liabilities and equitiesare increased with a credit.
• Revenues (a part of equity) are increased with a credit.
• Expenses (which decrease equity) are increased with a debit.
• Dividends (which decrease equity) 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 Ex. 2-44, first transaction:

Debit Credit

Cash 15,000

Common Stock 15,000

Note that the debit is to the left and the credit is to the right. First we list the account (left hand entry first), then the amount. This transaction increased Cash and increased Common Stock.

9/9 Purchased parts on account, \$5,000.

Auto Parts 5,000

A/P 5,000

9/12 Paid rent of \$2,500.

Rent Expense 2,500

Cash 2,500

Ex. 2-44, continued:

9/18 Provided repair services (on

account) \$2,200.

Accts. Receivable 2,200

Service Revenue 2,200

9/20 Auto parts used for repair.

Parts expense 1,150

Auto Parts 1,150

Ex. 2-44, continued:

9/26 Collected \$850 from customers.

Cash 850

A/R 850

9/29 Paid \$1,000 to creditors.

A/P 1,000

Cash 1,000

Ex. 2-44, continued
• The process just illustrated is the first step in the accounting cycle, the analysis of basic activity.
• These types of journal entries are called general journal entries (GJEs)
• After the GJEs are recorded, there are several additional steps to get us to the preparation of financial statements.
• These steps are discussed in Part II
II. The Accounting Cycle
• Components of the accounting cycle include:

A. General Journal Entries

(Post to the General Ledger)

(Post to the General Ledger)

C. Trial Balances

D. Financial Statements

E. Closing Journal Entries

A. General Journal Entries (GJEs)
• 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. More on special journals later.
• 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
• Ex. 2-44 transactions are GJEs. Also 3-18.
The General Ledger
• The G/L serves as a place to “total” amounts by account titles.
• After GJEs are recorded, they are posted (by account) to the G/L.
• Page 3-5 shows an example of a posting to a formal G/L account.
• However, we will use “T” accounts to represent G/L accounts where needed.
• The T-accounts are illustrated throughout Chapter 3. Please note, however, that it is not necessary to prepare a T-account after every journal entry. We will only be posting before financial statements are prepared.
Back to Ex. 2-44: Posting to G/LNow post transactions, for Cash, to “T” account:

Cash

15,000

2,500

850

1,000

Bal. 12,350

.

This posting process is done for each of the

general ledger accounts.

• 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 AJEs

1. Accrual of expenses

2. Accrual of revenues

3. Deferrals of expenses (Prepaid Expenses)

4. Deferrals of revenues (Unearned Revenues)

5. Other AJEs (using contra accounts)

- this group includes depreciation expense, and other types of activity to be discussed in later chapters.

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.

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

3.Deferral of Expenses (Prepaids)

Cash is paid now, but expense is not recognized until later.

Ex: purchase 1 year insurance policy for \$1,200 on Oct. 1, 2002.

IF the GJEat 10/1/02 debits ASSET:

Prepaid Insurance 1,200

Cash 1,200Then AJE at end of the period (for the used portion of \$300):

Insurance Expense 300

Prepaid Insurance 300

3.Deferral of Expenses (Prepaids)

IF the GJEat 10/1/02 debits EXPENSE:

Insurance Expense 1,200

Cash 1,200Then AJE at end of the period (for the unused portion of \$900):

Prepaid Insurance 900

Insurance Expense 900

3.Deferral of Expenses (Prepaids)
• Choosing to post to an expense (Insurance Expense) at the date of payment is equally acceptable to the choice of posting to an asset (Prepaid Insurance).
• Although the use of the asset account appears to be the correct posting, once any amount of time has passed (a few days or weeks), the balance in the asset account is no longer correct.
• Large companies often direct their employees to post specific activities to specific expense accounts, then let the CPAs decide at the end of the period how much of the payment (if any) remains unused.
3.Deferral of Expenses (Prepaids)

Suggestion for analysis: Use T-accounts to analyze the balances and prepare the AJE.

First: decide what ending balances should appear in the asset (Prepaid Insurance) and expense (Insurance Expense) accounts.

In this example, 3 months expense had been “used”, therefore \$300 should be shown in Insurance Expense (\$1,200/12 months x 3 months).

Also, at December 31, there are still 9 months remaining (unused), and \$900 should be shown in Prepaid Insurance.

.

3.Deferral of Expenses (Prepaids)

Now post GJE (initial posting to asset account) and “desired” ending balances to the T-accounts:

Prepaid Insurance

Insurance Expense

-0-

1,200

300 AJE

AJE 300

900

300

Once the beginning and ending balances are inserted, you can then see the amount that must be posted as the AJE (in the boxes) to get from the starting balances to the “desired ending balance”.

.

3.Deferral of Expenses (Prepaids)
• Therefore, the AJE (when the original amount was debited to an asset account) would be:

Insurance Expense 300

Prepaid Insurance 300

3.Deferral of Expenses (Prepaids)

Now post GJE (initial posting to expense account) and “desired” ending balances to the T-accounts:

Prepaid Insurance

Insurance Expense

1,200

-0-

AJE 900

900 AJE

900

300

Note: the desired ending balances are the same as before. The initial posting has changed; therefore, the AJE must change, to get from the starting balances to the “desired ending balance”.

.

3.Deferral of Expenses (Prepaids)
• Therefore, the AJE (when the original amount was debited to an expense account) would be:

Prepaid Insurance 900

Insurance Expense 900

(This entry decreases Insurance Expense down to \$300, and creates a balance for Prepaid Insurance.)

4.Deferral of Revenue (Unearned)

Cash is received now, but revenue is not recognized until later (when goods/services delivered).

Ex: collect 1 year rent income of \$2,400 in advance on Sept. 1, 2002.

IF the GJEat 9/1/02 credits LIABILITY:

Cash 2,400

Unearned Revenue 2,400Then AJE at end of the period (for the earned portion of \$800):

Unearned Revenue 800

Rent Revenue 800

4.Deferral of Revenue (Unearned)

IF the GJEat 9/1/02 credits REVENUE:

Cash 2,400

Rent Revenue 2,400

Then AJE at end of the period (for the unearned portion of \$1,600):

Rent Revenue 1,600

Unearned Revenue 1,600

Note: this AJE decreases Rent Revenue down to the earned portion of \$800, and establishes a liability of \$1,600 which indicates that the company still owes services of \$1,600 for next year (2003).

4.Deferral of Revenue (Unearned)

Use T-accounts to analyze the balances and prepare the AJE.

First: decide what ending balances should appear in the liability (Unearned Revenue) and revenue (Rent Revenue) accounts.

In this example, 4 months revenue had been “earned” by 12/31, therefore \$800 should be shown in Rent Revenue (\$2,400/12 months x 4 months).

Also, at December 31, there are still 8 months remaining (unearned), and \$1,600 should be shown in Unearned Revenue.

.

4.Deferral of Revenue (Unearned)

Now post GJE (initial posting to liability account) and “desired” ending balances to the T-accounts:

Unearned Revenue

Rent Revenue

2,400

-0-

AJE 800

800 AJE

1,600

800

Once the beginning and ending balances are inserted, you can then see the amount that must be posted as the AJE (in the boxes) to get from the starting balances to the “desired ending balance”.

.

4.Deferral of Revenue (Unearned)
• Therefore, the AJE (when the original amount was credited to a liability account) would be:

Unearned Revenue 800

Rent Revenue 800

4.Deferral of Revenue (Unearned)

Now post GJE (initial posting to revenue account) and “desired” ending balances to the T-accounts:

Unearned Revenue

Rent Revenue

-0-

2,400

1,600 AJE

AJE 1,600

1,600

800

Once the beginning and ending balances are inserted, you can then see the amount that must be posted as the AJE (in the boxes) to get from the starting balances to the “desired ending balance”.

.

4.Deferral of Revenue (Unearned)
• Therefore, the AJE (when the original amount was credited to a revenue account) would be:

Rent Revenue 1,600

Unearned Revenue 1,600

(This entry decreases Rent Revenue down to \$800, and creates a balance for Unearned Revenue.)

5. Other AJEs

Relate primarily to assets whose purchase is recorded at cost, then an estimate to be charged against the account is recorded using a contra account.

Ex. Depreciation on Equipment (more in Chapter 6):

Depreciation Expense xx

Accumulated Depr. xx

Ex: Uncollectible Accounts Receivable (more in Chapter 7):

Contra Accounts
• Note, for the previous estimates, the debit is to an expense account (on the income statement), and the credit is to a contra account on the balance sheet.
• Accumulated Depreciation (A/D) is posted as an offset to the cost of Property, Plant and Equipment on the balance sheet.
• Allowance for Bad Debts (ABD) is posted as an offset to the recorded value for Accounts Receivable on the balance sheet.
• See page 4-14 for presentation on the B/S.
• Now work Ex. 4-12, 17, and 21.
C. Trial Balances
• Trial balances are prepared throughout the accounting cycle. The represent G/L totals (by account) at a particular point in time. The three trial balances that will be of interest to us are:
• Unadjusted trial balance (reflecting totals after the GJEs). This list is used to prepare AJEs.
• Adjusted trial balance (reflecting totals after the AJEs). This list is used to prepare financial statements.
• After-closing trial balance.

Debit Credit

Cash 10

Accounts Receivable 12

Supplies 16

Accounts Payable 12

Unearned Revenues 16

Common Stock 6

Retained Earnings 2

Dividends 4

Service Revenues 20

Salaries Expense 6

Supplies Expense 8

Totals 5656

Financial Statements
• Use the previous Adjusted Trial Balance (Ex. 4-28) to prepare financial statements for Cowboy Company.
• Prepare the following for Cowboy Company:
• Income Statement
• Statement of Retained Earnings
• Balance Sheet - for the balance sheet, we will use the simple format based on Assets = Liabilities + Stockholders’ Equity, rather than a more formal classified balance sheet which presents assets and liabilities classified by current/noncurrent status (current assets, PP&E, current liabilities, long-term debt, etc.)

Ex. 4-28, Financial Statements

Cowboy Company

Income Statement

For the Year Ended December 31, XX

Revenues:

Service revenues \$20

Total revenues \$20

Expenses:

Salaries expense \$ 6

Supplies expense 8

Total expenses . 14

Net income \$ 6

Cowboy Company

Statement of Retained Earnings

For the Year Ended December 31, XX

Beginning balance \$ 2

Plus: Net income 6

Less: Dividends (4)

Ending balance \$ 4

Cowboy Company

Balance Sheet

December 31, XX

Assets:

Cash \$ 10

Accounts receivable 12

Supplies 16

Total assets \$ 38

Liabilities and Stockholders’ Equity:

Accounts payable \$ 12

Unearned revenue 16

Common stock 6

Retained earnings 4

Total liabilities and stockholders’ equity \$ 38

E. Closing Journal Entries (CJEs)
• Prepared after the financial statements have been prepared.
• 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.
E. Closing Journal Entries
• Using Ex. 4-28 as an example, prepare the journal entries to:
• Close revenues and expenses to Income Summary.
• Close Income Summary to Retained Earnings.
• Close dividends to Retained Earnings.
• Note: the use of the Income Summary account is not required. You may close revenue and expense totals directly to retained earnings for any class applications.
Ex. 4-28 Adjusted Trial Balance - Use the following information to prepare closing journal entries:

Debit Credit

Cash 10

Accounts Receivable 12

Supplies 16

Accounts Payable 12

Unearned Revenues 16

Common Stock 6

Retained Earnings 2

Dividends 4

Service Revenues 20

Salaries Expense 6

Supplies Expense 8

Totals 5656

E. Closing Journal Entries

1.Close revenues and expenses to retained earnings:

Service Revenue 20

Salaries Expense 6

Supplies Expense 8

Retained Earnings 6

2. Close dividends to retained earnings:

Retained Earnings 4

Dividends 4

E. Closing Journal Entries

What is the ending balance in Retained Earnings

after all these items are closed? Post to T-account:

Retained Earnings

2 Beginning Balance

6 Net Income

Dividends 4

4 Ending Balance

.

Now work Ex. 3-23.

E. After-closing Trial Balance

Debit Credit

Cash 10

Accounts Receivable 12

Supplies 16

Accounts Payable 12

Unearned Revenues 16

Common Stock 6

Retained Earnings 4

Totals 3838

Note: the After-closing Trial Balance consists only of balance sheet accounts. All of the temporary accounts have been closed to Retained Earnings, and we are now ready to start a new year, and accumulate new balances for revenues, expenses, and dividends.

III. Worksheets
• Worksheets can aid the accountant in the preparation of financial statements, but are not required to complete the accounting cycle as discussed in Part II.
• Worksheets are helpful for the preparation of adjusting journal entries, and for audit/tax work.
• The worksheet for financial accounting sorts the accounts into columns for each financial statement (see illustration, Page 4-9).
• Note that the totals (at the bottom of the income statement, statement of retained earnings, and the balance sheet) represent the closing journal entry process.

(End of Chapters 3 and 4)

• For the remainder of the semester, we will be working a number of exercises that are not set up in your class notes. When you see a plain white screen (like this) with no border, you will not find the information in your Power Point Class Notes.
• You should be prepared to take notes and work problems that are not part of your Class Notes. Now to Ex. 3-18.
Ex. 3-18 (General JEs)

5/1 Cash 20,000

Common Stock 20,000

5/3 Office Equipment 1,800

A/P 1,800

5/5 Automobiles 3,000

Cash 1,000

N/P 2,000

5/10 Office Supplies 500

A/P 500

Ex. 3-18 (General JEs)

5/15 Rent Expense 300

Cash 300

5/16 A/P 500

Cash 500

A/P 200

5/20 Cash 1,500

Commissions Revenue 1,500

Ex. 3-18 (General JEs)

5/21 A/P 200

Cash 200

5/23 A/R 800

Commissions Revenue 800

5/25 Salaries Expense 400

Cash 400

5/27 Cash 800

A/R 800

Ex. 3-18 (General JEs)

5/29 Utilities Expense 50

Cash 50

Ex. 4-12, part (a)(AJEs)

Next, calculate and insert ending balances:

2,400/12 = \$200/mo., so

7 mos. earned =\$1,400, 5 mos. unearned = \$1,000.

Unearned Rent Revenue

Rent Revenue

2,400

-0-

AJE 1,400

1,400 AJE

1,000

1,400

Finally, calculate and insert the amount for the AJE that would be needed to get to the ending balances.

.

AJE: Unearned Rent Revenue 1,400

Rent Revenue 1,400

Ex. 4-12, part (b)(AJEs)

Ending balances?

SAME \$1,400 earned, \$1,000 unearned

Unearned Rent Revenue

Rent Revenue

-0-

2,400

1,000 AJE

AJE 1,000

1,000

1,400

AJE?

.

AJE: Rent Revenue 1,000

Unearned Rent Revenue 1,000

Ex. 4-12, part (c) (AJEs)

None paid yet,

so accrue 7 months x \$200 = \$1,400.

AJE: Rent Receivable 1,400

Rent Revenue 1,400

a. Property Tax Expense 500

Property Tax Payable 500

b. Wages Expense 2,400

Wages Payable 2,400

c. Interest Receivable 75

Interest Revenue 75

d. From Oct. 31 - December 31: 62 days x \$4

Rental Expense 248

Rental Payable 248

Ex. 4-17, part (e)(AJEs)

Ending balances?

3,600/12 = \$300/mo., so

2 mos. earned = \$600, 10 mos. unearned = \$3,000.

Unearned Rent Revenue

Rent Revenue

3,600

-0-

AJE 600

600 AJE

3,000

600

AJE?

.

AJE: Unearned Rent Revenue 600

Rent Revenue 600

f. 3 months rent earned, but not collected.

1,200/12 = \$100/month x 3 = \$300

AJE:

Rent Receivable 300

Rent Revenue 300

g. How much rent owed as of Dec. 31?

None, so NO AJE.

Ex. 4-17, part (h)(AJEs)

Ending balances?

360/36 months = \$10/mo., so (through 12/31/X1)

4 mos. used = \$40, 32 mos. unused = \$320.

Prepaid Insurance

Insurance Expense

-0-

360

AJE 320

320 AJE

320

40

AJE?

.

AJE: Prepaid Insurance 320

Insurance Expense 320

Ex. 4-26 (AJEs only)

1. Where was original entry posted?

Prepaid Insurance

Ending balances:

900/36 months = \$25/mo., so (through 12/31/X1)

6 mos. used = \$150, 30 mos. unused = \$750.

Prepaid Insurance

Insurance Expense

900

-0-

150 AJE

AJE 150

750

150

AJE?

.

AJE: Insurance Expense 150

Prepaid Insurance 150

2. Depreciation per year = 4,000/10 = \$400

(more on salvage value in Chapter 9)

AJE:

Depreciation Expense 400

Accumulated Depr. 400

Ex. 4-26 (AJEs)

3. Where was original entry posted?

Unearned Revenues

Ending balances?

1,500/3 = \$500 earned on Dec. 1

so unearned = \$1,000.

Unearned Revenue

Service Revenue

1,500

-0-

AJE 500

500 AJE

1,000

500

AJE?

.

AJE: Unearned Revenue 500

Service Revenue 500

4. Interest Expense 20

Interest Payable 20

Note that Interest Payable is usually recorded separately from the related Notes Payable.

Ex. 4-26 (AJEs only)

5. Where was original entry posted?

Rent Expense

Ending balances?

600/12 months = \$50/mo., so (through 12/31/X1)

5 mos. used = \$250, 7 mos. unused = \$350.

Prepaid Rent

Rent Expense

-0-

600

AJE 350

350 AJE

350

250

AJE?

.

AJE: Prepaid Rent 350

Rent Expense 350

6. Salaries Expense 100

Salaries Payable 100

Ex. 4-26 (AJEs only)

7. Where was original entry posted?

Supplies Expense

Ending balances:

Supplies on hand = unused = Supplies Inventory = 500

So supplies used = Supplies Expense = 1,500

Supplies Inventory

Supplies Expense

-0-

2,000

AJE 500

500 AJE

500

1,500

AJE?

.

AJE: Supplies Inventory 500

Supplies Expense 500

Ex. 3-23 (Closing JEs)

Close revenues and expenses to Retained Earnings (or Income Summary, then to RE):

Fees Earned 37,000

Supplies Expense 1,000

Salaries 14,000

Utilities 900

Property Taxes 500

Retained Earnings 20,600

Ex. 3-23 (Closing JEs)

Close dividends to Retained Earnings:

Retained Earnings 5,000

Dividends 5,000