The Accrual Accounting Process of Preparing Financial Statements

Accrual Accounting Process: Corporate Accounting An accountant’s functions include ƒ ƒ Classifying and summarizing, made easier by the repetitive nature of business transactions All repetitive transactions of the same nature are recorded and summarized in one account ƒ An account is a storage unit used to classify and summarize money measurements of business activity of a similar nature ƒ Each account has a title T-Account ƒ Used for illustrative and pedagogical purposes ƒ Has two sides ƒ Debit means Left ƒ Credit means Right ƒ Created for each type of ƒ Asset ƒ Liability ƒ Stockholders’ equity Recording changes in Assets and Liabilities ƒ ƒ Increases in assets are recorded on the left side of the Taccount Decreases are recorded on the right side of the T-account ƒ Reverse for liabilities and stockholders’ equity ƒ Assets = Liabilities + Stockholders’ equity ƒ Assets are on the left side of the Balance Sheet Equation ƒ Liabilities and owners’ equity are on the right side How does a T-account look like? ƒ Like a Capital “T” Summary of T-account Rules Assets (cash, receivables, equipment) Increases Decreases Liabilities (loans payable) Decreases Increases Owners’ equity (contributed capital, retained earnings) Decreases Increases About T-Accounts ƒ ƒ ƒ ƒ What is one major objective of financial statements? ƒ To provide information to “users” regarding the financial performance of a business Which T-account includes the accountant’s estimate of financial performance over a given accounting period? ƒ Retained earnings (includes current period income) Which financial statement provides the details of the financial performance over a given accounting period? ƒ Income statement How do we construct an income statement from the T-account for retained earnings? ƒ Not very easily! But we will try. Components of stockholders’ equity Common Stock Additional Capital Retained Earnings Expenses Dividends Revenue Why record expenses and revenues separately in various T-accounts? Retained Earnings Rent exp. 800 Salaries 650 Interest exp. 450 Salaries 1,000 Rent exp. 400 Dividends 2,000 Interest exp. 350 1,000 1,100 3,000 200 4,500 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue Sales Revenue (1,000 + 3,000 + 4,500) Interest Income (1,100 + 200) Rent expense (800 + 400) Salaries expense (650 + 1,000) Interest expense (450 + 350) Net Income 8,500 1,300 (1,200) (1,650) (800) 6,150 Why record expenses and revenues separately in various T-accounts? Retained Earnings Rent exp. 800 Salaries 650 Interest exp. 450 Salaries 1,000 Rent exp. 400 Dividends 2,000 Interest exp. 350 1,000 1,100 3,000 200 4,500 Interest Expense 450 350 Dividends 2,000 Sales revenue Interest Income Sales Revenue Interest Income Sales Revenue Sales Revenue 1,000 3,000 4,500 Interest Revenue 1,100 200 Rent Expense 800 400 Salaries Expense 650 1,000 Why record expenses and revenues separately in various T-accounts? Retained Earnings Sales Revenue 1,000 3,000 4,500 Rent Exp. 1,200 8,500 Sales Revenue Salaries Exp. 1,650 1,300 Interest Revenue Interest Exp. 800 Dividends 2,000 Interest Revenue 1,100 200 Interest Expense 450 350 Rent Expense 800 400 Dividends 2,000 Salaries Expense 650 1,000 Why record expenses and revenues separately? A Summary ƒ ƒ ƒ ƒ ƒ ƒ ƒ Revenues, expenses and dividends are temporary Taccounts Information on changes in retained earnings - pertaining to a single accounting period - is collected in these temporary accounts At the end of the accounting period, balances in these Taccounts are transferred to Retained Earnings The temporary accounts are set to zero at the end of an accounting period in order to start collecting information for the next period Revenues, expenses and dividend accounts are flow accounts Retained earnings is a stock account In fact, all balance sheet accounts are stock accounts Recording expenses: A Summary ƒ Expenses decrease retained earnings. ƒ Decreases in retained earnings are recorded on the left side ƒ Expenses are recorded on the left side Recording Revenues: A Summary ƒ Revenues increase retained earnings. ƒ Increases in retained earnings are recorded on the right side ƒ (Increase in) revenues are recorded on the right side ƒ Decrease in revenues are recorded on the left side Recording Dividends: A Summary ƒ Dividends decrease retained earnings ƒ Therefore, treated similarly to expenses, but dividends is not an expense ƒ Dividends are recorded on the left side Expenses and Revenues: Debits and Credits ƒ Retained earnings (in general) has a credit balance. ƒ Revenues have credit balance because ƒ they increase retained earnings ƒ Expenses and dividends have debit balance because ƒ they decrease retained earnings ƒ Can retained earnings have a debit balance? ƒ Yes, when cumulative earnings are less than cumulative dividends Recap: T-Account Has two sides ƒ Debit means Left ƒ Credit means Right Recap: Summary of T-account Rules Assets (cash, receivables, equipment) Increases Decreases Liabilities (loans payable) Decreases Increases Owners’ equity (contributed capital, retained earnings) Decreases Increases The Ledger ƒ Accounts are collectively referred to as the ledger ƒ Types of accounts ƒ Balance Sheet accounts or real accounts or permanent accounts ƒ Income statement accounts or nominal accounts or temporary accounts, ƒ i.e., revenue, expenses, and dividends - all these are subdivisions of retained earnings The Recording Process ƒ Journal entries ƒ Posting to T-accounts ƒ Trial Balance ƒ Adjusting entries (Next class) ƒ Financial statement preparation The Journal ƒ Journal contains a chronological record of the transactions of a business Emily’s Bakery Emily contributes $10,000 in cash ƒ Assets ƒ Cash ƒ +$10,000 = Liabilities + Owners’ Equity Contributed Capital +$10,000 Journal Entry Dr Cash (+A) Cr Contributed Capital (+CC) 10,000 10,000 The company borrows $3,000 from the bank ƒ Assets ƒ Cash Loans Payable ƒ +$3,000 +$3,000 = Liabilities Journal Entry Dr Cash (+A) Cr Loans Payable (+L) + Owners’ Equity 3,000 3,000 Company purchases equipment for $5,000 cash ƒ Assets ƒ Cash ƒ -$5,000 = L + OE Equipment +$5,000 Journal Entry Dr Equipment (+A) Cr Cash (-A) 5,000 5,000 Company performs service for $12,000. The customer pays $8,000 in cash and promises to pay the balance at a later date. ƒ Assets ƒ Cash ƒ +$8,000 = L + Owners’ Equity Receivables Retained Earnings +$4,000 +$12,000 Journal Entry Dr Cash (+A) Dr Receivables (+A) Cr Service Revenue (+RE) 8,000 4,000 12,000 Company pays $9,000 for expenses (wages, interest, and maintenance) ƒ Assets ƒ Cash ƒ -$9,000 = Liabilities + Journal Entry Dr Expenses (-RE) Cr Cash (-A) Owners’ Equity Retained Earnings -$9,000 9,000 9,000 Company pays a dividend of $1,000 ƒ Assets = Liabilities + ƒ Cash ƒ -$1,000 Journal Entry Dr Dividends (-RE) Cr Cash (-A) Owners’ Equity Retained Earnings -$1,000 1,000 1,000 Posting ƒ Transactions from the journal are posted to the ledger (we will ignore this step) Trial Balance ƒ Trial balance is a listing of all the accounts and their balances in this order: ƒ ƒ ƒ ƒ ƒ Assets Liabilities shareholders’ equity Revenues Expenses ƒ Prepared prior to the preparation of financial statements ƒ Duality is an important check of arithmetic accuracy ƒ However, equality of debits and credits in a trial balance does not mean that accounting is error free ƒ ƒ ƒ Complete omission of a transaction Recording an entry in the wrong account Compensating errors Emily’s Bakery Trial Balance Cash Accounts Receivable Equipment Loans Payable Contributed Capital Retained Earnings Service Revenue Expenses Dividend Total Debit 6,000 4,000 5,000 Credit 3,000 10,000 0 12,000 9,000 1,000 25,000 25,000 Prepare Income Statement For the year ended December 31, 1997 Revenues: Fees earned for service $12,000 Expenses: Wages, interest, maintenance $ 9,000 Net income $ 3,000 Statement of Retained Earnings For the year ended December 31, 1997 Beginning retained earnings balance 0 Plus: Net income 3,000 Less: Dividend to stockholder 1,000 Ending retained earnings balance $ 2,000 Summary ƒ T-accounts ƒ ƒ ƒ ƒ ƒ ƒ ƒ Debit is Left Credit is Right Increases in Assets – Debits Increases in liabilities – Credits Increases in shareholders’ equity – Credits Expenses are Debits Revenues are Credits ƒ Use balances from T-accounts to prepare financial statements at the end of a fiscal period