Chapters 3 and 4: The Mechanics of Financial Accounting

1. 1 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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3. 3 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.

4. 4 The Double Entry SystemT- Accounts 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

5. 5 Effect of Debits and Credits Based on the accounting equation, we can increase or decrease various accounts depending on their classification: Assets = Liabilities + Equity Increase DR = CR CR Decrease CR = DR DR

6. 6 Summary by account type Assets are increased with a debit. Liabilities and equities are 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.

7. 7 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.

8. 8 Now go back to Ex. 2-44 and prepare the other journal entries: 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

9. 9 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

10. 10 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

11. 11 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

12. 12 II. The Accounting Cycle Components of the accounting cycle include: A. General Journal Entries (Post to the General Ledger) B. Adjusting Journal Entries (Post to the General Ledger) C. Trial Balances D. Financial Statements E. Closing Journal Entries

13. 13 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.

14. 14 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.

15. 15 Back to Ex. 2-44: Posting to G/LNow post transactions, for Cash, to �T� account:

16. 16 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).

17. 17 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.

18. 18 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.

19. 19 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

20. 20 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 GJE at 10/1/02 debits ASSET: Prepaid Insurance 1,200 Cash 1,200 Then AJE at end of the period (for the used portion of $300): Insurance Expense 300 Prepaid Insurance 300

21. 21 3.Deferral of Expenses (Prepaids) IF the GJE at 10/1/02 debits EXPENSE: Insurance Expense 1,200 Cash 1,200 Then AJE at end of the period (for the unused portion of $900): Prepaid Insurance 900 Insurance Expense 900

22. 22 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.

23. 23 3.Deferral of Expenses (Prepaids)

24. 24 3.Deferral of Expenses (Prepaids)

25. 25 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

26. 26 3.Deferral of Expenses (Prepaids)

27. 27 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.)

28. 28 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 GJE at 9/1/02 credits LIABILITY: Cash 2,400 Unearned Revenue 2,400 Then AJE at end of the period (for the earned portion of $800): Unearned Revenue 800 Rent Revenue 800

29. 29 4.Deferral of Revenue (Unearned) IF the GJE at 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).

30. 30 4.Deferral of Revenue (Unearned)

31. 31 4.Deferral of Revenue (Unearned)

32. 32 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

33. 33 4.Deferral of Revenue (Unearned)

34. 34 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.)

35. 35 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): Bad Debt Expense xx Allow. For Bad Debts xx

36. 36 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.

37. 37 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.

38. 38 Ex. 4-28 Adjusted 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 56 56

39. 39 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.)

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43. 43 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.

44. 44 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.

45. 45 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 56 56

46. 46 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

47. 47 E. Closing Journal Entries

48. 48 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 38 38 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.

49. 49 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) III. Worksheets

50. Additional Class Problems 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.

51. 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

52. Ex. 3-18 (General JEs) 5/15 Rent Expense 300 Cash 300 5/16 A/P 500 Cash 500 5/18 Advertising Expense 200 A/P 200 5/20 Cash 1,500 Commissions Revenue 1,500

53. 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

54. Ex. 3-18 (General JEs) 5/29 Utilities Expense 50 Cash 50

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

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

57. 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

58. Ex. 4-17 (Adjusting JEs) 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

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

60. Ex. 4-17 (Adjusting JEs) 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.

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

62. Ex. 4-26 (AJEs only)

63. Ex. 4-26 (Adjusting JEs) 2. Depreciation per year = 4,000/10 = $400 (more on salvage value in Chapter 9) AJE: Depreciation Expense 400 Accumulated Depr. 400

64. Ex. 4-26 (AJEs)

65. Ex. 4-26 (Adjusting JEs) 4. Interest Expense 20 Interest Payable 20 Note that Interest Payable is usually recorded separately from the related Notes Payable.

66. Ex. 4-26 (AJEs only)

67. Ex. 4-26 (Adjusting JEs) 6. Salaries Expense 100 Salaries Payable 100

68. Ex. 4-26 (AJEs only)

69. 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

70. Ex. 3-23 (Closing JEs) Close dividends to Retained Earnings: Retained Earnings 5,000 Dividends 5,000