Financial accounting 10th pratt peters chapter 04

Chapter 4
The Mechanics of
Financial Accounting

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Learning Objective 1
List and explain the two criteria necessary for economic events to be
directly recorded on the financial statements.

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Economic Events Must Be:

Relevant: Have economic significance including anything that affects its financial condition.

Objectively Measurable: Recorded in dollars as determined by parties with differing
incentives.

If events are both Relevant and Objectively Measurable then the economic events are
reflected in the financial statements of the entity.

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Concept Practice 1

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Learning Objective 2
Describe the accounting equation and how it relates to each of the four
financial statements.

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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 + Shareholders’ Equity

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An event for which the appropriate monetary measure can be
derived is considered to be

a. objectively measured
b. economically viable
c. relevant
d. capitalized

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Exercise 4-2
a tabular analysis approach, analyze the transactions. (Tabular
 Using
analysis is on the next slide).
that effects may be on both sides of the equation, in the same
 Note
direction, or effects may be on one side of the equation with offsetting
directions.

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Exercise 4-2
Cash + A/R + Land

=

1.

30,000

=

2.

(20,000)

=

3.

9,000

=
8,000

4.
5.

(5,500)

N/P

+

CC +

RE

30,000

20,000

9,000

=

(5,500) Exp.

=
(500) Div.

(500)

6. _____

Rev.

8,000

_____ _____

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

=
=

_____

_____

_____

9,000 + 30,000 + 2,000

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Exercise 4-3 Financial Statements
Income Statement
Revenues

$8,000

Expenses
Net Income

5,500
$2,500

Statement of Retained Earnings
RE (beginning)

$ 0

Add: Net Income

2,500

Less: Dividends

(500)

RE (ending)

$2,000

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Exercise 4-3 Financial Statements
Balance Sheet
Assets
Cash $13,000
A/R
Land

8,000
20,000

Total $41,000
Liabilities and S.E.
N/P $ 9,000
CS

30,000

RE (ending)

2,000

Total $41,000

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Learning Objective 3
Explain the nature of journal entries (and T-accounts) and how they
relate to the accounting equation and the financial statements.

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Now Look Back at E4-2
that the transaction analysis was relatively simple with a few
 Note
transactions and a few accounts. However, with thousands of

transactions and hundreds of accounts, the table used in E4-2 would be
inefficient.

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

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Double Entry System
journal entry is an efficient representation of economic events and how they affect
 The
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 does not indicate an increase or decrease.
 To decide the effect of a debit or credit, the type of account must be considered.

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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 pluses and minuses.

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Figure 4-7

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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.

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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
Cash
Common Stock

Credit

30,000
30,000

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

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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

9,000
Notes Payable

9,000

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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

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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.

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Arcadia Company provided landscaping services and received $3,000 from customers
immediately. Which of the following occurred?

a. assets and shareholders’ equity increase by $3,000
b. assets and shareholders’ equity decrease by $3,000
c. assets and liabilities increase by $3,000
d. assets and liabilities increase by $3,000

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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.

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Back to E4-2: Posting to G/L

Now post transactions (for cash) to “T” account:

Cash

(1) 30,000
(3) 9,000

(2) 20,000
(4) 5,500
(5) 500

Bal. 13,000

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