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Chapter 4: The Mechanics of Financial Accounting


Title: Chapter 4 Instructor Subject: Financial Accounting in an Economic Context Author: Allison Collins, University of Memphis Last modified by – PowerPoint PPT presentation

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Title: Chapter 4: The Mechanics of Financial Accounting

Chapter 4The Mechanics of Financial
Chapter 4 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

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

Exercise 4-2 Spreadsheet
  • Cash A/R Land N/P
    CC RE
  • 1.
  • 2.
  • 3.
  • 4.
  • 5.
  • 6. _____ _____ _____ _____
    _____ _____

8,000 Rev.
(5,500) Exp.
(500) Div.
Tot. 13,000 8,000 20,000 9,000
30,000 2,000

Exercise 4-2 Financial Statements
  • Income Statement
  • Revenues 8,000
  • Expenses 5,500
  • Net Income 2,500
  • Statement of Retained Earnings
  • RE (beginning) 0
  • Add Net Income 2,500
  • Less Dividends (500)
  • RE (ending) 2,000

Exercise 4-2 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

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 not sufficient.
  • Therefore accountants use a double entry system
    based on debits and credits.

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.
  • 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.

Effect of Debits and Credits
  • Based on the accounting equation, we can increase
    or decrease various accounts depending on their
  • Assets Liabilities Equity
  • Increase DR CR CR
  • Decrease CR DR DR
  • Note that we use debits and credits instead of
    plusses and minuses.

The following rules can be derived from the basic
  • 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.

The Format of a Journal Entry
  • To initially record transactions, we use a
    journal entry to represent the debits and
  • 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. First we list the
    account (left hand entry on top), then the

Now back to E4-2, and prepare the other journal
  • 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

Now back to E4-2, and prepare the other journal
  • 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

Now back to E4-2, and prepare the other journal
  • 6 Paid 500 cash dividend to owners.
  • Dividends 500
  • Cash 500
  • Note that dividends is a contra equity and
    reduces retained earnings.

The Accounting Cycle(more detail in Appendix 4A)
  • Components of the accounting cycle include
  • A. Preparation of Daily Journal Entries
  • -Post to the General Ledger
  • -Unadjusted Trial Balance
  • B. Preparation of Adjusting Journal Entries
  • -Post to the General Ledger
  • -Adjusted Trial Balance
  • C. Financial Statements
  • D. Closing Journal Entries
  • -Final Trial Balance

A. Daily Journal Entries (DJEs)
  • 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.
  • 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
  • E 4-2 transactions are DJEs.

Another Example of DJE
  • 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
  • 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
  • The sale of inventory is recorded in a different
    manner discussed in Chapters 4 and 7.

The General Ledger (G/L)
  • The G/L serves as a place to total amounts by
    account titles.
  • After DJEs and AJEs are recorded, they are posted
    (by account) to the G/L.
  • We will use T accounts to represent G/L
    accounts where needed.
  • Appendix 4A discusses T accounts in more detail.

Back to E4-2 Posting to G/LNow post
transactions (for cash) to T account
Bal. 13,000

Unadjusted Trial Balance
  • Trial balances are prepared throughout the
    accounting cycle.
  • The Unadjusted Trial Balance represents G/L
    totals (by account) at a particular point in
  • For E4-2, the Unadjusted Trial Balance would
    consist of a list of all of the ending debit or
    credit balances taken from the various T
    account totals (illustrated on the next slide).
  • The Unadjusted Trial Balance is a preliminary
    total, and is a starting point for the Adjusting
    Journal Entries (discussed later in this chapter).

Unadjusted Trial Balance - Exercise 4-2(after
posting and totaling G/L accounts)
  • Debit Credit
  • Cash 13,000
  • Accounts Receivable 8,000
  • Land 20,000
  • Notes Payable 9,000
  • Contributed Capital 30,000
  • Retained Earnings 2,000
  • Totals 41,000 41,000

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).

Types of AJEs
  • 1. Accrual of expenses
  • 2. Accrual of revenues
  • 3. Deferrals of expenses
  • 4. Deferrals of revenues
  • 5. Revaluation adjustments

Accrual System vs. Accrual AJEs
  • The accrual system of accounting and accrual
    of revenues and expenses are both discussed in
    this chapter.
  • Note that the accrual of revenues and expenses
    is a subset of the AJEs discussed in this
  • In comparison, the accrual system of accounting
    refers to the entire process of revenue and
    expense recognition, and relates to the
    definitions of matching and revenue recognition
    discussed in Chapter 3.

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

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

3.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 is used up in the generation of
    revenue, 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).

3.Deferral of Expenses
  • Example Purchase 1 year insurance policy.
  • Daily JE at time of purchase
  • Prepaid Insurance xx
  • Cash xx
  • AJE at end of the period (for the portion that
    has been used)
  • Insurance Expense xx
  • Prepaid Insurance xx

3.Deferral of Expenses
  • Example purchase of inventory.
  • Daily JE at time of purchase
  • Merchandise Inventory xx
  • Cash xx
  • AJE at end of the period (for the portion
    that has been sold)
  • Cost of Goods Sold xx
  • Merchandise Inventory xx
  • Note the treatment of merchandise inventory is
    expanded significantly in Chapter 7.

3.Deferral of Expenses
  • Example purchase of equipment.
  • Daily JE at time of purchase
  • Equipment xx
  • Cash xx
  • AJE at end of the period (for the portion
    that has been used)
  • Depreciation Expense xx
  • Accumulated Depreciation xx
  • Note Accumulated Depreciation is a contra asset
    account, and is presented as an offset to
    Equipment on the balance sheet (more in Chapter

4.Deferral of Revenues
  • Cash is received from customer before
    goods/services are delivered (before revenue can
    be recognized).
  • Ex Received subscription in advance.
  • Daily JE at time cash received
  • Cash xx
  • Unearned Revenues xx
  • AJE at end of the period (for portion)
  • Unearned Revenues xx
  • Subscription Revenues xx

5. Revaluation Adjustments
  • These are adjustments that do not fall into the
    categories of accruals or deferrals.
  • They serve to restate certain accounts to keep
    their reported values in line with existing
  • Examples include the revaluation of
  • short-term investments
  • inventories
  • More in later chapters.

  • a. AJE at 12/31 for supplies used
  • (85,000 - 30,000 unused 55,000 used)
  • Supplies Expense 55,000
  • Supplies 55,000
  • b. AJE at 12/31 for rent owed
  • Rent Expense 2,400
  • Rent Payable 2,400

  • c. AJE at 12/31 for services performed
  • (18,000 x 2/3 12,000 earned by 12/31)
  • Unearned Revenue 12,000
  • Service Revenue 12,000
  • d. AJE at 12/31 for depreciation
  • (500,000/10 50,000 per year)
  • Depreciation Expense 50,000
  • Accumulated Depr. 50,000

  • e. AJE at 12/31 for interest owed to the bank on
    the notes payable. Use Principal x Rate x
    Time to calculate the interest owed from July 1
    to Dec. 31 (6 months)
  • P x R x
  • 10,000 x .12 per year x 6/12 of a
  • Interest Expense 600
  • Interest Payable 600

  • f. AJE at 12/31 for amount owed for advertising
  • Advertising Expense 28,000
  • Advertising Payable 28,000
  • g. AJE at 12/31 for insurance used from 7/1 to
  • (350 x 1/2 year)
  • Insurance Expense 175
  • Prepaid Insurance 175

Adjusted Trial Balance
  • The Adjusted Trial Balance reflects totals after
    the AJEs are posted to the general ledger.
  • The balance sheet accounts reflect the
    end-of-year balances, and the income statement
    accounts reflect the proper revenues and expense
    to be recognized for the year.
  • This list of accounts and amounts is used to
    prepare the balance sheet and income statement.

C. Preparation of Financial Statementsfrom the
Adjusted Trial Balance
  • The amounts in the Adjusted Trial Balance are
    used to prepare the balance sheet and the income
  • The statement of stockholders equity (SSE)
    requires some additional investigation.
  • Remember from Chapter 3 that the SSE shows all
    activity during the period for contributed
    capital and retained earnings.

Contributed Capital and Retained Earnings
  • The contributed capital in the adjusted trial
    balance is an ending balance the ledger account
    must be examined to see if any activity (like
    issue of additional stock) occurred.
  • The retained earnings on the adjusted trial
    balance is a beginning balance while the
    revenues, expenses and dividends are displayed in
    the trial balance, they have not yet been
    included in (closed to) retained earnings.

Financial Statements
  • The financial statements for Kelly Supply (next 4
    slides), and other examples in text, can be used
    as guidelines to prepare financial statements.
  • The financials should be prepared in the
    following order
  • income statement (I/S)
  • statement of stockholders equity (SSE)
  • balance sheet (B/S)
  • Note that the statement of cash flow (SCF) is not
    prepared from the adjusted trial balance, but
    from a detailed analysis of the cash flow
    activities of the company.

Financial Statements
  • Comments on the preparation of financial
    statements from adjusted trial balance (ATB)
  • revenue and expense balances from the ATB are
    carried to the income statement.
  • net income is carried to the retained earnings
    column in the SSE.
  • other activity, like dividends and issue of
    stock, are reflected in the SSE.
  • ending balances in the SSE are carried to the
    stockholders equity section of the balance
  • asset and liability balances from the ATB are
    carried to the balance sheet.

Financial Statement Examples - Kelly Supply
Kelly Supply Income Statement For the Year Ended
December 31, 2006 Revenues Sales 27,000 Inter
est revenue 50 Total revenues 27,050 Expenses
Cost of goods sold 9,000 Wages
expense 8,000 Rent expense 1,000 Interest
expense 3,000 Depreciation expense 3,000 Amortiz
ation expense 500 Total expenses .
24,500 Net income 2,550
Kelly Supply Statement of Stockholders
Equity For the Year Ended December 31, 2006
Retained Total

Earnings Beginning balance
30,000 5,000 35,000 Common stock
issuances 10,000 Net income
Dividends Ending balance

Kelly Supply Balance Sheet December 31,
2006 Assets Cash 9,500 Accounts
receivable 22,000 Interest receivable 50
Merchandise inventory 13,000 Prepaid
rent 2,000 Machinery 26,000 Less Accumulated
depreciation 8,000 18,000 Patent 4,500 Total
assets 69,050
Kelly Supply Balance Sheet December 31,
2006 Liabilities and stockholders
equity Accounts payable 5,000 Wages
payable 1,000 Interest payable 2,000 Dividends
payable 1,000 Unearned revenue 1,000 Short-term
notes payable 2,500 Long-term notes
payable 10,000 Common stock 40,000 Retained
earnings 6,550 Total liabilities and
stockholders equity 69,050
D. Closing Journal Entries (CJEs)
  • Prepared after the financial statements have been
  • 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
  • The final trial balance after closing will
    display only permanent, balance sheet accounts.
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