FINANCIAL ACCOUNTING WEEK 4 THE MECHANICS OF FINANCIAL ACCOUNTING I. LEARNING OBJECTIVES A. State the accounting equation and describe how it relates to the balance sheet, income statement, and statement of cash flows. B. Understand what are the criteria necessary for economic events to be reflected in the financial records. C. Understand why managers need to understand how economic events affect the financial statements. D. Explain why the financial statements are adjusted periodically to reflect economic events that are not represented by transactions. II. The fundamental accounting equation: ASSETS (A) = LIABILITIES (L) + EQUITY (E) E = + CONTRIBUTED CAPITAL (CC) + BEG. RETAINED EARNINGS (RE) - DIVIDENDS (D) + REVENUE (R) - EXPENSES (Ex) + GAINS (G) - LOSSES (Lo) A = L + CC + RE - D + R - Ex + G - Lo or A + D + Ex + Lo = L + CC + RE + R + G This equation is the basis for T-accounts. III. FINANCIAL STATEMENTS A. Income Statement R - Ex + G - Lo = Net Income B. Balance Sheet A = L + E C. Statement of Changes in Shareholder Equity CC + RE + NI - D = Ending Shareholders Equity D. Cash Flow Analysis of Cash Account E. Homework: BE4-3; E4-2. 1
IV. The accounting cycle is the process through which a company's economic events are transformed into financial statements. A. Can be manual or computerized B. Internal controls are very important V. Criteria for Entering a Transaction on the Books A. Economic events must be both relevant and objectively measurable to be included in the financial statements. 1. Relevant means that the event has economic significance to the company and it affects its financial condition. 2. Objectively measurable means that the numbers are the result of realized transactions that are backed by documented evidence. 3. E4-5. B. Interpreting economic events means addressing the following three questions for each event: 1. What accounts on the financial statements are affected by the economic event? 2. What direction are the accounts affected by the event (increased or decreased)? 3. What is the dollar effect on each account? C. Journal entries record economic events in a company's accounting records. Under the double entry system, the journal entry affects at least two accounts. D. The journal is the original book of record and it provides a chronological record of transactions entered into by a company. E. The general ledger summarizes all the companies economic events by account. The information transferred from the journal to the general ledger is called posting. F. We will not be doing journal entries or preparing ledgers. An awareness of their place in the accounting process is helpful, though. G. Homework 2
1. 2. P4-6. P4-12. 3. COMMENT: It is critical that you be able to do these two problems or ones similar to them. 4. E5-10. H. Recognizing gains and losses 1. Effect on Income Statement 2. Effect on Balance Sheet 3. Effect on Statement of Cash Flows 4. Example - A machine, costing $1,000, with accumulated depreciation = $700, is sold for $280. Q: What is the effect on each of the statements? VI. Periodic Adjustments A. Periodic adjustments are necessary because not all economic events that occur during the accounting period are captured by an exchange transaction in the same period. Accrual accounting requires that all economic events that have occurred during the accounting period be recognized to achieve a proper matching of revenues and expenses. B. Adjusting journal entries are recorded at the end of the accounting cycle - after the unadjusted trial balance has proven that all increases and decreases to accounts during the accounting period are equal. C. Characteristics of adjusting journal entries 1. Are recorded to achieve a proper matching of revenues and expenses in the appropriate accounting period. 2. Always involve at least one income statement account and one balance sheet account. 3. Never involve the Cash account. D. Types of adjusting journal entries 1. Accrual adjusting journal entries a. Definition: accrue means to build up gradually. Accrual adjusting entries recognize economic events that have occurred in the current accounting period but have not been captured in a transaction. 3
b. Accrued expenses (1) Are expenses that have been incurred, but not yet paid. (2) The adjusting journal entry would be to record an expense (increase expenses which decrease NI) and increase a liability. (3) Example: Warranty Expense c. Accrued revenues (1) Are revenues that have been earned, but cash collection has not yet occurred. (2) The adjusting journal entry would be to increase a receivable and increase a revenue account (increase NI). (3) Example: Accrued Interest Income 2. Capitalizing versus expensing an expenditure a. Understand which items are routinely expensed. b. Understand which items are routinely capitalized. c. Understand effects of errors. d. EXAMPLE: Company buys some tools that will last for four years. What are the effects on the Income Statement and the Balance Sheet if the tools are (1) expensed, or (2) capitalized, and written off over 4 years. 4
3. Cost expiration adjusting journal entries a. Definition: Cost expiration adjusting journal entries write down (decrease) an already established asset or liability account. b. Cost expiration of assets (1) A cost expiration adjusting entry is made as the company consumes the asset's cost due to the passage of time. (2) The adjusting entry would be to increase an expense (decrease NI) and record a decrease in an asset. The latter is accomplished through an increase in an account ΑAccumulated Depreciation. (3) Depreciation of Long-lived Assets (4) Amortization of Intangibles c. Expiration of deferred revenues 4. Homework (1) Deferred revenues are payments collected from customers that have not yet been earned. (2) The adjusting entry would decrease a liability account and record (increase) revenue. (3) Example - During the current year, Metro Magazine sells a two year subscription on July 1 for $48. At its December 31 year end, how much revenue would Metro recognize for the current year? a. P4-8. b. E4-14. For parts a and b indicate the effect upon the accounting equation rather than preparing adjusting entries. VII. Review Learning Objectives 5