2 The Accounting Equation A = L + OE- Owner Withdrawals+ Owner Investments- Expenses - Losses+ Revenue + GainsThe accounting equation underlies the process used to capture the effects of economic events. Assets equal liabilities plus owners’ equity. Each event, or transaction, has a dual effect on the accounting equation.
3 Accounting Equation for a Corporation A = L + SE+ Retained Earnings+ Paid-in Capital- Expenses- Losses+ Revenues+ Gains- DividendsOwners’ equity for a corporation, called shareholders’ equity, is classified by source as either paid-in capital or retained earnings. Retained earnings equals net income less distributions to shareholders (primarily dividends) since the inception of the corporation.
4 Account Relationships Debits and credits affect the Balance Sheet Model as follows:A = L + PIC + REPaid-inCapitalDr.-Cr.+Retained EarningsDr.-Cr.+AssetsDr.+Cr.-LiabilitiesDr.-Cr.+Part IThe double-entry system is used to process transactions. In the double-entry system, debit means left side of an account and credit means right side of an account. Whether a debit or a credit represents an increase or decrease depends on the type of account. Accounts on the left side of the accounting equation (assets) are increased by debit entries and decreased by credit entries. Accounts on the right side of the equation (liabilities and shareholders’ equity) are increased by credit entries and decreased by debit entries. This arbitrary, but effective, procedure ensures that for each transaction the net impact on the left sides of the accounts always equals the net impact on the right sides of accounts.Part IINotice that increases and decreases in retained earnings are recorded indirectly in revenue, gain, expense, and loss accounts. For example, an expense represents a decrease in retained earnings, which requires a debit. That debit, however, is recorded in an appropriate expense account rather than in retained earnings itself. This allows the company to maintain a separate record of expenses incurred during an accounting period. The debit to retained earnings for the expense is recorded in a closing entry (reviewed later) at the end of the period, only after the expense total is reflected in the income statement. Similarly, an increase in retained earnings due to a revenue is recorded indirectly with a credit to a revenue account, which is later reflected as a credit to retained earnings.Part IIIPermanent accounts (assets, liabilities, paid-in capital and retained earnings) represent the basic financial position elements of the accounting equation. Temporary accounts (revenues, gains, expenses and losses) keep track of the changes in the retained earnings component of shareholders’ equity.Revenues and GainsDr.-Cr.+Expenses and LossesPermanent AccountsTemporary Accounts
5 The Accounting Processing Cycle During the Accounting PeriodSource documentsTransaction AnalysisRecord in JournalPost toLedgerAt the End of the Accounting PeriodFinancial StatementsAdjusted Trial BalanceRecord & Post Adjusting EntriesUnadjusted Trial BalanceThis slide presents the ten steps in the accounting processing cycle.Steps 1-4 take place during the accounting period.Step one: Obtain information about external transactions from source documents.Step two: Analyze the transaction.Step three: Record the transaction in a journal.Step four: Post from the journal to the general ledger.Steps 5-8 occur at the end of the accounting period.Step five: Prepare an unadjusted trial balance.Step six: Record adjusting entries and post to the general ledger accounts.Step seven: Prepare an adjusted trial balance.Step eight: Prepare financial statements.Steps 9 and 10 are required only at the end of the year.Step nine: Close the temporary accounts to retained earnings (at year-end only).Step ten: Prepare a post-closing trial balance (at year-end only).The Accounting Processing CycleAt the End of the YearClose Temporary AccountsPost-Closing Trial Balance
6 Accounting Processing Cycle On January 1, $40,000 was borrowed from a bank and a note payable was signed.Two accounts are affected:Cash (an asset) increases by $40,000.Notes Payable (a liability) increases by $40,000.Part IOn January 1, $40,000 was borrowed from a bank and a note payable was signed. Two accounts are affected: Cash, an asset account, increases and Notes Payable, a liability account, increases. Let’s prepare the journal entry.Part IIThe journal entry to record this transaction is a debit to the Cash account and a credit to the Notes Payable account.Prepare the journal entry.
7 General LedgerThe general ledger is a collection of accounts. Increases and decreases in each element of a company’s financial statements are recorded in these accounts. A separate account is maintained for individual assets, liabilities, retained earnings, paid-in capital, revenues, gains, expenses, and losses. An account includes the account title, an account number, and columns to record increases, decreases, the cumulative balance, and the date. For instructional purposes we use T-accounts instead of formal ledger accounts.The “T” account is a shorthand format of an account used by accountants to analyze transactions. It is not part of the bookkeeping system.
8 Posting Journal Entries On July 1, the owners invest $60,000 in a new business, Dress Right Clothing Corporation.On July 1, the owners invest $60,000 in a new business, Dress Right Clothing Corporation. We record this entry with a debit to Cash and a credit to Common Stock. Let’s see how we post the debit portion of this entry to the Cash account.Post the debit portion of the entry to the Cash ledger account.
9 Posting Journal Entries First, we find the Cash ledger account.Second, we enter the date of the transaction in the ledger account.Third, we enter the debit amount of the journal entry in the Cash ledger account.Fourth, we enter the page number of the General Ledger in the Posting Reference column of the ledger.Fifth, we determine the cumulative balance in the Cash account.Sixth, we enter the Cash account number in the Posting Reference column of the General Leger.
10 Posting Journal Entries We follow the same procedure to post the credit portion of the entry to the Common Stock account.We follow the same procedure to post the credit portion of the entry.
11 After recording all entries for the period, Dress Right’s Unadjusted Trial Balance would be as follows:A Trial Balance is a listing of all accounts and their balances at a point in time.Here is the Unadjusted Trial Balance after recording all the entries for the period for Dress Right. A Trial Balance is a listing of all accounts and their balances at a point in time. Its purpose is to check for completeness and to prove that the sum of the accounts with debit balances equals the sum of the accounts with credit balances.Debits = Credits
12 Transactions where cash is paid or received before a related expense or revenue is recognized. At the end of the period, some transactions or events remain unrecorded. Because of this, several accounts in the ledger need adjustments before their balances appear in the financial statements.Adjusting entries are necessary for three situations: Prepayments, Accruals, and Estimates. Prepayments are transactions where cash is paid or received before a related expense or revenue is recognized. Accruals are transactions where cash is paid or received after a related expense or revenue is recognized.Transactions where cash is paid or received after a related expense or revenue is recognized.
13 Items paid for in advance of receiving their benefits Prepaid ExpensesAssetExpenseUnadjustedBalanceCreditAdjustmentDebitAdjustmentPrepaid expenses represent assets recorded when a cash disbursement creates benefits beyond the current reporting period. Common prepaid expenses include payments for rent, insurance, and supplies. For example, a company may pay $60,000 for rent for the next 6 months. In this case, the cash payment precedes the expense recognition. The entry at the payment date is a debit to the asset, Prepaid Rent, and a credit to Cash. At the end of the period, an adjusting entry is required to record the amount of rent used during the period. The adjusting entry required in this example would be a debit to Rent Expense and a credit to Prepaid Rent for the amount of the rent used during the period.Today, I will payfor my first6 months’ rent.Prepaid ExpensesItems paid for in advance of receiving their benefits
14 Asset Cost - Salvage Value DepreciationDepreciation is the process of computing expense by allocating the cost of plant and equipment over their expected useful lives.Straight-LineDepreciationExpense=Asset Cost - Salvage ValueUseful LifeDepreciation is the process of allocating the cost of plant and equipment over their expected useful lives. The adjusting entry for depreciation is a specific type of a prepayment adjusting entry. Straight-line depreciation is calculated as asset cost minus salvage value divided by the useful life.
15 DepreciationRecall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance. Assume the following:Let’s calculate the depreciation expense for the month ended July 31, 2009.Recall the Furniture and Fixtures for $12,000 that was listed on Dress Right’s unadjusted trial balance. Assume the following: the asset cost is $12,000, no salvage value, and a useful life of sixty months. Let’s calculate the depreciation expense for the month ended July 31, 2009.
16 DepreciationRecall the Furniture and Fixtures for $12,000 listed on Dress Right’s unadjusted trial balance.JulyDepreciationExpense$12, $060 months==$200 per monthThe depreciation expense for one month is $200. It is calculated as $12,000 divided by 60 months.The depreciation journal entry is a debit to Depreciation Expense and a credit to Accumulated Depreciation—Furniture and Fixtures for $200. Accumulated Depreciation is a contra asset account to the asset account Furniture and Fixtures. The normal balance in a contra asset account will be a credit, that is, “contra,” or opposite, to the normal debit balance in an asset account.Let’s see how the accounts would look after posting.
17 After posting, the accounts look like this: DepreciationAfter posting, the accounts look like this:After posting the depreciation adjusting entry, the Depreciation Expense account has a $200 debit balance and the Accumulated Depreciation account has a $200 credit balance. Notice that the balance in the Furniture and Fixtures account is unchanged by the adjusting entry.
18 Unearned Revenues Revenue Liability “Go Big Blue” DebitAdjustmentUnadjustedBalanceCreditAdjustmentUnearned revenues are created when a company receives cash from customers in one period for goods or services that are to be provided in a future period. Unearned revenues represent liabilities for the company receiving the cash to provide either a good or service in the future. For example, if you pay $500 for season tickets to all home basketball games, the school is in debt for services to you. They must provide $500 of basketball games during the season for you to attend. The entry the school would make is a debit to Cash and a credit to Unearned Revenue for $500. At the end of the period, an adjusting entry is required to record the amount of revenue earned during the period. The adjusting entry required in this example would be a debit to Unearned Revenue and a credit to Revenue for the amount of the games provided during the period.Buy your season tickets forall home basketball games NOW!Unearned RevenueCash received in advance of performing services“Go Big Blue”
19 Alternative Approach to Record Prepayments Prepaid Expenses Record initial cash payments as follows:Expense $$$ Cash $$$Adjusting Entry Record the amount for the prepaid expense as follows:Prepaid expense $$$ Expense $$$Unearned Revenue Record initial cash receipts as follows:Cash $$$ Revenue $$$Adjusting Entry Record the amount for the unearned liability as follows:Revenue $$$ Unearned revenue $$$The same end result can be achieved for prepayments by recording the external transaction directly into an expense or revenue account. The adjusting entry then records the unexpired prepaid expense (asset) or unearned revenue (liability) as of the end of the period. Under either approach, the net effect of the transactions are the same.
20 Accrued Liabilities Expense Liability Accrued Liabilities DebitAdjustmentCreditAdjustmentI won’t pay youuntil the job is done!Accrued LiabilitiesLiabilities recorded when an expense has been incurred prior to cash payment.Accrued liabilities represent liabilities recorded when an expense has been incurred prior to cash payment. An example of an accrued liability is salaries owed at the end of an accounting period. The adjusting entry required to record an accrued liability is a debit to an expense and a credit to a liability.
21 Accrued Receivables Revenue Asset Yes, you can pay me DebitAdjustmentCreditAdjustmentYes, you can pay mein May for your April 15 tax return.Accrued receivables involve situations when the revenue is earned in a period prior to the cash receipt. An example of an accrued receivable is when an accountant provides services and completes a tax return in one period and receives the cash from the client in future period. The adjusting entry required to record an accrued revenue is a debit to an asset, a receivable, and a credit to revenue.Accrued ReceivablesRevenue earned in a period prior to the cash receipt.
22 EstimatesUncollectible accounts and depreciation of fixed assets are estimated.An estimated item is a function of future events and developments.$Accountants often must make estimates in order to comply with the accrual accounting model. Examples of estimates include the calculation of depreciation expense and the calculation of bad debt expense. We have already looked at adjusting entries for depreciation expense, so let’s look at the adjusting entry to record bad debt expense for uncollectible accounts.
23 EstimatesThe estimate of bad debt expense at the end of the period is an example of an adjusting entry that requires an estimate.Assume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, only $1,500 will ultimately be collected. Prepare the adjusting entry for July 31.Part IAssume that Dress Right’s management determines that of the $2,000 of accounts receivable recorded at July 31, only $1,500 will ultimately be collected.Part IIThe adjusting entry for July 31, to record this information is a debit to Bad Debt Expense and a credit to Allowance for Uncollectible Accounts for $500. The Allowance for Uncollectible Accounts is a contra asset account related to Accounts Receivable. In the balance sheet, Accounts Receivable is shown net of the allowance account.
24 This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted.Dress Right will use these balances to prepare the financial statements.This is the Adjusted Trial Balance for Dress Right after all adjusting entries have been recorded and posted. Dress Right will use these balances to prepare the financial statements.
25 The income statement is a change statement that summarizes the profit-generating transactions that caused shareholders’ equity (retained earnings) to change during the period.The income statement summarizes the results of operating activities of the company.
26 The balance sheet is a position statement that presents an organized list of assets, liabilities, and equity at a particular point in time. Here is the asset section of Dress Right’s balance sheet.The balance sheet presents the financial position of the company on a particular date.
27 Here is the liabilities and shareholders’ equity section of Dress Right’s balance sheet. Notice that the basic accounting equation was in balance: assets equal liabilities plus equity.Notice that assets of $143,000 equal total liabilities plus shareholders’ equity of $143,000.
28 The purpose of the statement of cash flows is to summarize the transactions that caused cash to change during the period. This statement classifies all transactions affecting cash into one of three categories: (1) Operating Activities, (2) Investing Activities, and (3) Financing Activities. We will discuss this statement more in future chapters.The statement of cash flows discloses the changes in cash during a period.
29 The statement of shareholders’ equity discloses the sources of changes in the permanent shareholders’ equity accounts.The statement of shareholders’ equity presents the changes in permanent shareholder accounts.
30 Temporary and Permanent Accounts Temporary AccountsRevenuesIncome SummaryExpensesDividendsPermanent AccountsAssetsLiabilitiesShareholders’ EquityThe closing process applies only to temporary accounts.Recall that step 9 of the accounting processing cycle is to close temporary accounts to retained earnings. The closing process serves a dual purpose. First, the temporary accounts are reduced to zero balances, ready to measure activity in the upcoming accounting period. Second, these temporary account balances are closed (transferred) to retained earnings to reflect the changes that have occurred in that account during the period.The closing process applies only to temporary accounts. First, close revenues and expenses to income summary; then income summary is closed to retained earnings. The use of the income summary account is just a bookkeeping convenience that provides a check that all temporary accounts have been properly closed (that is, the balance in income summary equals net income or loss). Next, close dividends to retained earnings.
31 Post-Closing Trial Balance Lists permanent accounts and their balances.After the closing entries are posted to the ledger accounts, a post-closing trial balance is prepared. The purpose of this trial balance is to verify that the closing entries were prepared and posted correctly and that the accounts are now ready for next year’s transactions.Total debits equal total credits.
32 Conversion From Cash Basis to Accrual Basis Jeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid Insurance was $5,000, and on Dec. 31, the account balance was $3,000.Accountants sometimes are called upon to convert cash basis financial statements to accrual basis financial statements, particularly for small businesses. Adjusting entries, for the most part, are conversions from cash to accrual. Let’s look at another example.Jeter, Inc. paid $20,000 cash for insurance during the current period. On Jan. 1, Prepaid Insurance was $5,000, and on Dec. 31, the account balance was $3,000. Determine Insurance Expense for the period.Using the format provided, you can see that insurance expense must be $22,000.
33 Appendix 2A: Use of a Worksheet A worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements.Steps to Follow for Worksheet Completion:Enter account titles in column 1 and the unadjusted account balances in columns 2 and 3.Determine end-of-period adjusting entries and enter them in columns 4 and 5.Add or deduct the effects of the adjusting entries on the account balances and enter in columns 6 and 7.Transfer the temporary retained earnings account balances to columns 8 and 9.Transfer the balances in the permanent accounts to columns 10 and 11.Appendix 2A: Use of a WorksheetA worksheet can be used as a tool to facilitate the preparation of adjusting and closing entries and the financial statements. It is an informal tool only and is not part of the accounting system. The worksheet is used after and instead of step 5 in the accounting processing cycle.Here are the steps to follow for worksheet completion:Step 1: Enter account titles in column 1 and the unadjusted trial balances in columns 2 and 3.Step 2: Determine end-of-period adjusting entries and enter them in columns and 5.Step 3: Add or deduct the effects of the adjusting entries on the account balances and enter in columns 6 and 7.Step 4: Transfer the temporary retained earnings account balances to columns and 9.Step 5: Transfer the balances in the permanent accounts to columns 10 and 11.Let’s look at the completed worksheet for Dress Right.Let’s look at the completed worksheet for Dress Right.
34 Here is the completed worksheet for Dress Right Clothing Corporation Here is the completed worksheet for Dress Right Clothing Corporation. You may want to take a few minutes and review the steps provided on the previous slide and work your way through the worksheet preparation.
35 Appendix 2B: Reversing Entries Reversing entries remove the effects of some of the adjusting entries made at the end of the previous reporting period for the sole purpose of simplifying journal entries made during the new period. Reversing entries are optional and are used most often with accruals.Appendix 2B: Reversing EntriesAccountants sometimes use reversing entries at the beginning of a reporting period. Reversing entries remove the effects of some of the adjusting entries made at the end of the previous reporting period for the sole purpose of simplifying journal entries made during the new period. Reversing entries are optional and are used most often with accruals.
36 Appendix 2C: Subsidiary Ledgers Subsidiary ledgers contain a group of subsidiary accounts associated with particular general ledger control accounts. Subsidiary ledgers are commonly used for accounts receivable, accounts payable, plant and equipment, and investments.For example, there will be a subsidiary ledger for accounts receivable that keeps track of the increases and decreases in the accounts receivable balance for each of the company’s customers purchasing goods and services on credit.Appendix 2C: Subsidiary LedgersAccounting systems employ a subsidiary ledger which contains a group of subsidiary accounts associated with particular general ledger control accounts. Subsidiary ledgers are commonly used for accounts receivable, accounts payable, plant and equipment, and investments. For example, there will be a subsidiary ledger for accounts receivable that keeps track of the increases and decreases in the accounts receivable balance for each of the company’s customers purchasing goods and services on credit.After all of the postings are made from the appropriate journals, the balance in the accounts receivable control account should equal the sum of the balances in the accounts receivable subsidiary ledger accounts.
37 Appendix 2C: Special Journals Special journals are used to capture the dual effect of repetitive types of transactions in debit/credit form.Special journals simplify the recording process in the following ways:Journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats.Individual transactions are not posted to the general ledger accounts but are accumulated in the special journals and a summary posting is made on a periodic basis.The responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them.Appendix 2C: Special JournalsFor most external transactions, special journals are used to capture the dual effect of the transaction in debit/credit form. Examples of common special journals are cash receipts journals, cash disbursements journals, sales journals, and purchases journal.Special journals simplify the recording process in the following ways:Journalizing the effects of a particular transaction is made more efficient through the use of specifically designed formats.Individual transactions are not posted to the general ledger accounts but are accumulated in the special journals and a summary posting is made on a periodic basis.The responsibility for recording journal entries for the repetitive types of transactions is placed on individuals who have specialized training in handling them.Let’s look at some special journals.Let’s look at some special journals.
38 Sales JournalSales journals record all credit sales. Every entry in the sales journal has the same effect on the accounts; the sales revenue account is credited and the accounts receivable control account is debited.Other columns capture information needed for updating the accounts receivable subsidiary ledger.Sales journals record all credit sales. Every entry in the sales journal has the same effect on the accounts; the sales revenue account is credited and the accounts receivable control account is debited. Other columns capture information needed for updating the accounts receivable subsidiary ledger.The total of all the transactions in the sales journal is posted to the Accounts Receivable control account and to the Sales Revenue account. Each individual transaction is also posted to the Accounts Receivable subsidiary ledger for each customer.
39 Cash Receipts JournalCash receipts journals record all cash receipts, regardless of the source. Every entry in the cash receipts journal produces a debit to the cash account with the credit to various other accounts.Cash receipts journals record all cash receipts, regardless of the source. Every entry in the cash receipts journal produces a debit to the cash account with the credit to various other accounts.Because every transaction in the cash receipts journal results in a debit to cash, a column is provided for that account. At the end of August, $11,750 debit is posted to the general ledger cash account. Similar postings occur for the accounts receivable and the sales revenue column totals. Each individual transaction that affects accounts receivable is also posted to the Accounts Receivable subsidiary ledger for each customer. The last two columns of this journal provide information needed to post individual transactions to uncommon accounts that may be affected by a cash receipt.