PROFESSOR S CLASS NOTES UNIT 4 COB 241 Sections 13, 14, 15 Class on September 10, 2018

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1 PROFESSOR S CLASS NOTES UNIT 4 COB 241 Sections 13, 14, 15 Class on September 10, 2018 Administrative Items Brief Reminder of Major Topics which must be completely mastered (covered in class Sep 5) The Period Principle: accounting records are kept for a period. Net Income is Calculated: Revenue, minus expenses, plus gains, less losses, equals Net Income. Closing the period : Amounts in the Revenue, Expense, Gains and Losses accounts are transferred into Retained Earnings. Closing also involves: Moving the Distributions accounts into Retained Earnings. Accrual Accounting: Before closing, some adjustments must be made to the accounts. Adjusting Entries: The adjustments ensure the Balance Sheet will show all Rights and Obligations as of the closing date. The Matching Principle: Revenue and Expenses must be reported (recognized) in the proper period, not when payment is tendered: Revenue must be recognized in the Period in which it is earned. Expenses must recognized in the Period in which they are incurred. We use Accounts Receivable to hold the Asset consisting of amounts we can collect from customers. We use Accounts Payable to hold the liabilities we owe to vendors for goods/services they have provided. We use Prepaids to hold the amounts we have paid vendors in advance of their provision of goods/services. We use Unearned Revenue to hold the amounts customer have paid us for goods/services we will provide in the future. TODAY S MATERIAL Fiscal Year Businesses are required to issue Financial Statements at least once per year. But the requirement does not state they have to close at the end of December. A fiscal year is any 12-month period. Closing the books for the year is a time-consuming process, especially for accountants. Many companies have seasonal variations in their operations, and December is a busy time for some. Additionally, many employees (including the accountants) would like to take time off for vacations and to be with family at the end of December. For these reasons, most companies choose a slow time of year to close the year. The period comprising the annual accounting year is called its Fiscal Year. Many companies run their Fiscal Year from February 1 to January 31 of the following year, meaning that they close their books every January 31. Some companies choose November 30, March 31, or June 30 as their Fiscal year end.

2 T-Accounts Up to this point in the course, we have used the Horizontal Model to record transactions. The Horizontal model clearly illustrates the Accounting Equation (Assets=Liabilities+Equity), and also emphasizes that Revenue and Expenses are actually part of Owner s Equity. (Remember, the profit earned by a business increases the business owner s wealth.) In practice, there isn t enough room across the top of a spreadsheet to show all the dozens, hundreds, or even thousands of accounts that modern businesses require. Hence, accounting today is based on the concept of the T-Account, rather than a spreadsheet column. Concept of the T Account Think of a T-Account as a page of paper representing one single account. Originally, a T-account was a page in a notebook, on which was recorded the transaction amounts for one (1) single account. You can also think of a T-account as a column in the spreadsheet model we ve been using. You can make a T account by drawing a large T : a short horizontal line, with a vertical line coming down from the middle of the horizontal line. In our class, you can fit a dozen or more T accounts on a single page of paper. Compare the T-Account to a Horizontal-Model Column In the horizontal model, each column represented an account. To increase the account balance, we recorded positive numbers, to reduce an account balance, we used negative numbers. With T accounts, there are NO NEGATIVE NUMBERS. Every number recorded in a T-account is always a sign-less number. We denote whether the balance in the account is increasing or decreasing by which side of the T the number is recorded.

3 DEBIT and CREDIT Terminology. Remember, in the Horizontal Model we recorded each event in two columns (two accounts), as to maintain the equality of the Accounting Equation. so Using T-accounts, as events occur, we record the amount of the event into two T-accounts. Just like the horizontal model, we call this Double-Entry Bookkeeping. An entry made on the left side of the T is called a Debit. An entry made on the right side of the T is called a Credit. Remember: Debits on the left, Credits on the right. Effect of Debits and Credits on Account Balances Many students get confused, because whether a debit increases or decreases an account balance depends ENTIRELY on what kind of account the account is. Rules for the Effect of Debits and Credits on Account Balances Stop before reading this section, and make sure you have completely memorized: Debits on the left, Credits on the right. Here are the rules: ASSET ACCOUNTS (Left side of the accounting equation): Debits (left side of the T) increase the account balance. LIABILITY ACCOUNTS (Right side of the accounting equation): Credits (right side of the T) increase the account balance. EQUITY ACCOUNTS (Right side of the accounting equation): Credits (right side of the T) increase the balance of owner s equity. In a nutshell, you increase an account balance by making an entry to the side of the T account corresponding to where the account is within the accounting equation (left or right side).

4 Note: Expenses and Distributions are usually debits Remember in our horizontal model, expenses were always negative amounts. (That is, expenses always reduced owner s equity.) Thus, practically all entries to Expense accounts will be debits. Like expenses, distributions (of profits to the owners) reduce the amount of equity. Thus, practically all entries to the Distributions accounts will also be debits. SUMMARY (Worth Memorizing) DEBIT-BALANCE ACCOUNTS: ASSETS -- EXPENSES -- DISTRIBUTIONS Debiting an asset account, increases Assets. Debiting an expense account, increases Expenses (which decreases owner s equity) Debiting a distribution account increases Distributions (which decreases owner s equity). CREDIT BALANCE ACCOUNTS: LIABILITIES, CONTRIBUTED CAPITAL, REVENUE, RETAINED EARNINGS Crediting these accounts increases the balance in the account. Crediting a liability account increases Liabilities Crediting a Contributed Capital account increases Owner s Equity Crediting a Revenue Account increases the period s Revenue (increasing owner s equity) Crediting Retained Earnings increases Retained Earnings.

5 Classroom Examples 1. Grundy Corporation starts on January 1 by issuing $500,000 in common stock to its owners. 2. Grundy management then uses $100,000 of the money to buy land. 3. Grundy management obtains a loan from the bank, secured by a note, for $250, Grundy management purchases supplies on account for $6, Grundy rents a building, and prepays six months of rent, at $1500 per month ($9000 total). 6. Grundy pays for 1 month s rent on some heavy equipment for January, paying $ Grundy performs services on account for its clients, and bills them $65, One client pays in advance for services to be performed in February, for $8,000) 9. During January, Grundy s clients pay $55,000 towards their bills. 10. Grundy uses electricity during January, estimated at $2, Grundy has used half of its supplies by the end of January. 12. Grundy has used up one month s of the six month s rent. 13. Grundy accrues $1,000 interest expense on its loan. 14. Grundy closes its books on January 31 and creates financial statements.

6 Classroom Examples (position matters!) Cash Accts Payable Contributed Capital Notes Payable Retained Earnings Accts Receivable Unearned Revenue Prepaids Supplies Land Expenses Revenue

7 Classroom Solution Cash Accts Recerivable Prepaid Rent Accts Payable Notes Payable Unearned Revenue 8 8 Contributed Capital Retained Earnings Supplies Land Expenses Revenue

8 Grundy Corporation INCOME STATEMENT For Month Ending January 31 All Amounts listed in thousands of dollars Revenue $ 65 Less Expenses $-11.5 NET INCOME $ 53.5 Grundy Corporation BALANCE SHEET As of January 31 All Amounts listed in thousands of dollars ASSETS Cash $700 Accounts Receivable 10 Prepaids 7.5 Supplies Inventory 3. TOTAL SHORT TERM ASSETS $720.5 Land $100 TOTAL LONG TERM ASSETS $100 TOTAL ASSETS $820.5 LIABILITIES Accounts Payable $ 8 Unearned Revenue 8 Notes Payable 251 TOTAL LIABILIIES $267 EQUITY Contributed Capital $500 Retained Earnings $ 53.5 TOTAL EQUITY $553.5 TOTAL LIABILITIES PLUS EQUITY $820.5