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The Accounting Process

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  1. Hughes • Ayers • Hoskin John Wiley & Sons, Inc. 2004 The Accounting Process Chapter Three Prepared by: Sarita Sheth Santa Monica College

  2. 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.

  3. 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.

  4. 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

  5. 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.

  6. 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.

  7. 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.

  8. 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

  9. 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

  10. Methodology: How do we keep Debits and Credits straight? • Use T-accounts to help track balances and changes in an account

  11. 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

  12. 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

  13. 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%.

  14. 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

  15. Entry 2: SERVE acquires property for $10,000. 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

  16. 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

  17. Application: Transaction Analysis 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

  18. Application: Financial Statement 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

  19. Application: Financial Statement 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

  20. More about Revenues & Expenses • 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.

  21. More about Revenues & Expenses • 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

  22. Quick Questions: 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

  23. Application: More Entries • 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.

  24. 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

  25. Date Description Debit Credit 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

  26. Date Description Debit Credit 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

  27. Date Description Debit Credit 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

  28. Date Description Debit Credit 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

  29. Date Description Debit Credit 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

  30. Date Description Debit Credit 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

  31. Date Description Debit Credit 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

  32. Date Description Debit Credit 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

  33. Date Description Debit Credit 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

  34. Application: Balances in Accounts from Transactions • 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

  35. Application: Financial Statement 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

  36. Application: Financial Statement 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

  37. Application: Financial Statement 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

  38. Application: Financial Statement 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

  39. Closing Entries • 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

  40. Application: Closing Process 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

  41. Quick Question 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