Financial accounting 9th jamie pratt chapter 04

Chapter 4:
The Mechanics of
Financial Accounting



2


The Mechanics of Financial Accounting

•
•

The first step in the accounting process is transaction analysis.
This process examines relevant, objectively measurable economic events
through their effect on the accounting equation:
Assets = Liabilities + Equity



3


Now look at E4-2 Spreadsheet


Using a spreadsheet approach, analyze the transactions. (Spreadsheet on next slide).



Note that effects may be on both sides of the equation, in the same direction, or effects
may be on one side of the equation with offsetting directions.



4


Exercise 4-2 Spreadsheet
Cash + A/R + Land = N/P
1.
2.
3.

30,000
(20,000)

30,000

20,000

=

8,000
(5,500)
(500)

_____

9,000

=

9,000

6. _____

CC + RE

=

4.
5.

+

8,000

=

(5,500) Exp.

=
_____ =

Tot. 13,000 + 8,000 + 20,000=

Rev.

_____
9,000

_____

_____

(500) Div.

+ 30,000 + 2,000



5


Exercise 4-3 Financial Statements
Income Statement
Revenues

$8,000

Expenses
Net Income

5,500
$2,500

Statement of Retained Earnings
RE (beginning)

Add: Net Income
Less: Dividends
RE (ending)

$ 0
2,500
(500)
$2,000



6


Exercise 4-3 Financial Statements
Balance Sheet
Assets
Cash $13,000
A/R
8,000
Land
20,000
Total $41,000
Liabilities and S.E.
N/P $ 9,000
CS 30,000
RE (ending)
2,000
Total $41,000



7


Now look at E4-2 Spreadsheet


Note that the transaction analysis was relatively simple with a few transactions and a
few accounts. However, with thousands of transactions and hundreds of accounts,
the spreadsheet program is inefficient.



Therefore accountants use a “double entry” system based on debits and credits.



8


Double Entry Accounting


The journal entry is an efficient representation of economic events and how they affect the
accounting equation.



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.



Note that a debit or credit, per se, does not indicate increase or decrease.



To decide the effect of a debit or credit, the type of account must be considered.



9


Effect of Debits and Credits


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



Note that we use debits and credits instead of plusses and minuses.



10


The following rules can be derived from the basic formula and Figure 4-7 (previous slide):

•

Assets have normal debit balances and are increased with a debit.

•

Liabilities and equities have normal credit balances and are increased with a credit.

•

Revenues (a part of equity) have normal credit balances and are increased with a credit.

•

Expenses (which decrease equity) have normal debit balances and are increased with a debit.

•

Dividends (which decrease equity) have a normal debit balance and are increased with a debit.



11

The Format of a Journal Entry
 To initially record transactions, we use a journal entry to represent the debits and
credits.
For example, in E4-2, Item 1:
Debit Credit
Cash
30,000
Common Stock
30,000

 Note that the debit is to the left and the credit is to the right.
(left hand entry on top), then the amount.

First we list the account



12


Back to E4-2, and prepare the other journal entries:
2: Purchased land for $20,000 cash.
Land

20,000
Cash

20,000

3: Borrowed $9,000 cash from bank.

Cash
Notes Payable

9,000
9,000



13


Back to E4-2, and prepare the other journal entries:
4: Provided services (on account) $8,000.
Accts. Receivable

8,000

Service Revenue

8,000

5: Paid $5,500 cash for expenses.
Expenses

5,500
Cash

5,500



14


Now back to E4-2, and prepare the other journal entries:
6: Paid $500 cash dividend to owners.
Dividends

500
Cash



500

Note that dividends is a contra equity account and ultimately reduces retained
earnings.



15


T-Accounts
 Running tally of the affect of transactions on an account in the General
Ledger.

 We call this process ‘posting’ to the GL.
 The running tally makes it possible to complete trial balances and financial
statements.

 16


Back to E4-2: Posting to G/L
Now post transactions (for cash) to “T” account:

Cash

30,000

20,000

9,000
5,500
500

Bal. 13,000



17


Recognizing Gains and Losses


Often, investments and noncurrent assets are sold for more or less than the amounts at which they
are carried on the balance sheet. In such cases a gain (if a credit) or loss (if a debit) must be
recognized.



Ex: Land that cost $10,000 is sold for $11,000 cash. Prepare the GJE:
Cash
11,000
Land
10,000
Gain on Sale of Land
1,000



Note: gains are a form of revenues and losses are a form of expenses on the income statement.



18


Periodic Adjustments
 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).



19


Types of Periodic Adjustments

1.

Accruals (expenses and revenues)

2.

Deferrals (expenses and revenues)

3.

Revaluation adjustments



20


Example - Accrual of Expenses
 Probably the most common type of AJE.
Ex: accrue wages at the end of the period:

Wages Expense
Wages Payable

xx
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.

 Other examples of expense/payable include interest, rent, taxes.



21


Example - 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

Another example of receivable/revenue accruals relates to rent revenue, where the
rental payment has not yet been received.



22


Deferral of Expenses

 This category of AJE relates to the concept of asset capitalization and the
matching principle.

 Asset capitalization occurs when a cost (with future economic benefit) is incurred.
An asset is recognized at that time.

 As the asset contributes to the generation of revenue (revenue recognition), the
related cost is recognized as an expense (matching).

 Some expenses are deferred for a short period of time (Supplies Expense), and
some expenses are deferred for many years (Depreciation Expense).



23




24


Deferral of Expenses

 Example: Purchase 1 year insurance policy.
Journal Entry at time of purchase:
Prepaid Insurance

xx

Cash

xx

Adjustment at the end of the period (for the portion that has been used):
Insurance Expense
Prepaid Insurance

xx
xx



25