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# Chapters 3 and 4: The Mechanics of Financial Accounting

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

## Chapters 3 and 4: The Mechanics of Financial Accounting

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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

2. 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.

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. 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

5. 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

6. 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.

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. 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. 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. 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. 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. 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. 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. 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. 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.

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. 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. 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. 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. 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

21. 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

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. 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. .

24. 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”. .

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. 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”. .

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. 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

29. 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).

30. 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. .

31. 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”. .

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. 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”. .

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. 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. 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. 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. 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 5656

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.)

40. 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

41. 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

42. 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

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. 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. 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

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. 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.

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 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.

49. 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)

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.

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